Forensic Accounting Update Exam II Copyrighted 2002 D

Transcript Forensic Accounting Update Exam II Copyrighted 2002 D

Forensic and Fraud Techniques Copyrighted 2001 D. Larry Crumbley, CPA, Cr.FA

KPMG Endowed Professor Department of Accounting Louisiana State University Baton Rouge, LA 70803 225-578-6231 225-578-6201 Fax [email protected]

Dr. Crumbley is the editor of the Journal

of Forensic Accounting: Auditing, Fraud, and

Taxation, former chair of the Executive Board of Accounting Advisors of the American Board of Forensic Accountants, member of the Fraud Deterrence Board, and on the AICPA’s Fraud Task Force. A frequent contributor to the Forensic Examiner, Professor Crumbley is a co-author of CCH Master Auditing Guide, 2 nd Edition, along with more than 45 other books. His latest book entitled Forensic and Investigative Accounting is published by Commerce Clearing House (800 224-7477). Some of his 12 educational novels have as the main character a forensic accountant. His goal is to create a television series based upon the exciting life of a forensic accountant and litigation consultant.

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 or minor inconsistency forensic accountant can solve a fraudulent mystery.

One Small Clue

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.

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

individuals to develop the truth, of especially if some are presumed to be lying.

Robert G. Roche, a retired chief of the IRS Criminal Investigation Division of the IRS [D.W. Yockey, “So You Want to Be a Forensic Accountant,”

Management Accounting,

November 1988, pp. 19-23.] 4

Forensic Accounting Areas

 Investigative Auditing  Litigation Support Forensic: Latin for “forum,” referring to a public place or court.

Black’s Law Dictionary: Forensic, belonging to the courts of justice.

Note: Corporate spooks are used to check on competitors.

Forensic Auditing

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 ----------------------------------------------------------------- Like a competitive game of tennis, forensic accounting skills require practice.

Top Niche Services

1. Business Valuations 2. Estate Planning 3.

Litigation Support

4. Mergers & Acquisitions 5. Business Mgt. Wealthy clients 6.

Forensics/fraud

7. Employee benefits 8. Computer systems/consulting 78% 77%

73%

61% 56%

55%

55% 53% Source: J.M. Covaleski, “Many Top

100

Growth Areas Revolve Around Synergy of CPA/Attorney Relationship,”

Accounting Today

, March 18-April 7, 2003, p.1.

Forensic Accounting vs. Fraud Auditing

Fraud Auditor:

An accountant especially skilled in auditing who is generally engaged in auditing with a view toward fraud discovery, documentation, and prevention.

----------------------------------------------------- “Economic crimes and fraud often do not involve obvious evidence like the smoking gun. Forensic accountants look behind the deals and handshakes and probe beyond the numbers to uncover the reality of financial situations.” Source: D.W. Squires, “Problems Solved with Forensic Accounting: A Legal Perspective,”

Journal of Forensic Accounting

., Vol. IV (2003),. P. 131.

Potpourri of Gambling News

• • • •

Coinless slots might seem an oxymoron, but the machines are gaining popularity. Ultimately, we believe the casino floor will evolve into a completely cashless environment. July 11, 2001, Lisa Snedeker.

EZ Pay system offers casinos the option of paying customers with a printed ticket. Customers can then take the ticket to a cashier for payment or can insert it into a bill receptor of another slot machine to get coins. July 11, 2001, Lisa Snedeker.

Internal audits of Leech Lake casinos find 111 serious deficiencies : individual casinos are at risk of losing money, either by neglect or intent.

Caesars Atlantic City Hotel Casino fined $241,500 for two separate incidents in which the casino broke internal accounting rules of 1) not reading and recording the amounts on slot machine meters when the machines’ coin buckets were removed, and 2) for failure to verify the validity of certified checks that were presented by an unidentified gambler who needed more money to play.

Potpourri of Gambling News (cont.)

• • •

Five arrested in alleged casino cheating scheme in Louisiana. A pit boss and four others employees allegedly falsified information to qualify friends and family for thousands of dollars in cash rebates (e.g., filled out customers rating cards to make it appear they had gambled large sums of money). Surveillance tapes showed they had not gambled.

State police have limited regulatory authority over the Coushatta-owned casino near Kinder, in Allen Parish. In May, a former financial controller [Eric] found a $40 million deficit. Current CFO said Eric just didn’t understand the audit and other financial matters.

Three Indian reservations are not taxed by the state and are not required to report their revenue figures publicly.

Potpourri of Gambling News (cont.) IGT’s monitoring video-poker system contract ends in June 2004 . All the machines in the state are embedded with computer codes that enable them to talk to State Police through IGT’s proprietary monitoring system. Operators of such systems do not release their codes to another company because of potential security problems.

If IGT builds the new system, it can be built to talk to all the machines because it has the codes. But if another company builds the new system, it will not have the codes to talk to all the machines. Other prospective bidders have told State Police they can design a new system to talk to the newer machines in the state, but they will not design a system around obsolete machines. That means about 12,226 machines could have to be replaced virtually overnight at a cost of $134 million, industry observers say.

Potpourri of Gambling News (cont.)

• • • A low take from the blackjack tables last year “can be indicative of theft or others.” Lac du Flambeau Casino, May 15, 2001. The casino did not write reports showing sources of revenue by departments, making it difficult if not impossible to detect wrongdoing.” Lacked an internal auditor, also.

by employees, patrons, management, Ohio banker embezzled nearly $50 millions and funnelled it into Stardancer Casino. Between July 1999 and January 2002, Stardancer received $15.5 million from the chief executive of Oakwood Deposit Bank Co. Stardancer has not been charged in the case, and Stardancer president Sam Gray Sr. has denied being invovled with the bank executive. April 7, 2003.

Ten employees at an Indian casino in Yolo County have been arrested on charges they stacked the deck $400,000.The investigation began when the against the house in a scam that cost the tribe as much as casino’s at mini-baccarat tables fell below a “volatility win rates index ,” triggering increased surveillance. Videotapes allegedly showed dealers arranging cards so players involved in the scheme knew which hand to bet on. In the game, players bet on which hand comes closest to totaling nine, with face cards and 10s valued at zero and aces worth one. April 7, 2003 .

Source: GamblingMagazine.com

Potpourri of Gambling News (cont.)

• Scott Redd, a distant relative of gaming equipment pioneer and casino owner Si Redd, was terminated after an investigation and audit conducted by Palace Station and the Nevada Gaming Control Board revealed Redd had allegedly processed up to 100 improper fill transactions each month between May 2002 and January 2003, the lawsuit said ($263,000). A fill transaction, which refers to the process of refilling slot machines with coins, requires a fill slip or a receipt bearing the signature of the slot service ambassador and two witnesses to be submitted to Palace Station’s accounting department. April 6, 2003.

• A high-flying Singapore executive is alleged to have 2003.

forged documents to obtain about $98 million in credit and loans from banks in Japan, Germany and Sweden. Police are yet to recover $76 million and fear it has been lost at casino gaming tables in Asia and Australia, including at Crown. October 16, Source: GamblingMagazine.com

Potpourri of Gambling News (cont.)

• A Minnesota man has been charged with defrauding the St. Croix Casino of more than $1.6 million by billing it for food that was never delivered and then sharing profits with a casino manager who allegedly approved phony invoices. A food and beverage manager authorized payments to October 5, 1998.

bogus seafood and wild-game companies created by vendor then sent him money or paid some of his bills. • A New York man accused of using fraudulent $1 million checks the 21 st as front money to gamble 21 times at an Atlantic City casino did well enough to at least break even 20 times. But on outing, Anastasios Samaras lost $1.6 million at the Atlantic City Hilton. When the casino tried to cash the check to cover the losses, it discovered it was no good. Two employees at a Queens branch of Interbank of New York, which issued the check, have pleaded guilty to conspiracy in the scheme. The checks were a type usually issued only after a customer covers the amount from his account. They are the equivalent of cash. October 19, 2003 14 Source: GamblingMagazine.com

Potpourri of Gambling News (cont.)

• Seventy-three-year-old man is behind bars, suspected of the casino by marking cards inside Coarsegold’s popular Chukchansi Casino. He was caught on videotape taking in at least $13,000 in winnings. May 6, 2004.

• State Police working with casinos’ surveillance employees, discovered that a casino dealer of Atlantic City, defrauded either paying the two other men even when they lost a bet while he was dealing blackjack or three-card poker, or by not collecting on their losing and tie bets, State Police Detective 1 • Three people have been arrested on tech gadgets. The police were calculate the speed of the ball place. March 22, 2004.

on the spinning wheel and its likely resting st Class Kevin Rehmann said. May 6, 2004.

suspicion of winning more than $$A2.46 million at a London casino using high investigating whether they had used a laser scanner inside a mobile phone to Source: GamblingMagazine.com

Potpourri of Gambling News (cont.)

• The indictment alleges that Aponte, who worked as a floor person at the Trump Taj Mahal Casino Resort, devised the scheme and would forge the signature of the floor supervisor in order to collect the comps . The Casino Prosecution Bureau charged a former casino employee with devising a fraudulent player-rating scheme. The man is accused of attempting to inflate patron gaming activity to increase the value of complimentary benefits offered to the casino player. May 6, 2004.

Source: GamblingMagazine.com

Stealing Tips

•

Casino dealer charged with theft of tips . September 29, 2003. When casino patrons tip a dealer, that money is placed in a locked box that is kept at the center of the table. The money is collected and taken to a secured room where it is counted. The room is equipped with two surveillance cameras. The money is counted by four volunteers who are paid $20 an hour to count the chips. The suspended employee was part of the volunteer group that was assigned to count the tip money each night. It’s reported that the employee had been counting the tip money for the past eight months. Employees say patrons can be very generous with their tips, especially when they win big. A few weeks ago, a dealer took in $10,000 in tips in a single day. At the Casino, tips amount to about $500,000 every two weeks. That money is shared by about 1,000 employees. A dealer at the casino said it’s quite easy for someone to “palm” a chip inside their hand so it cannot be detected by the cameras.

Source: www.gamblingmagazine.com

Leech Lake Casinos: Serious Deficiencies

• • • • • • • • • 

White Oak Casino (24) Marketing department not following proper procedures and not maintaining adequate and required records.

Purchase orders written after invoices received (rather than submitting a purchase order and then receiving inventory).

Purchase orders lacked authority signatures and some exceeded the dollar limits set for marketing director’s approval.

No policies in place which address conflict of interest for the purchasing department.

In gift shop cost of various items not entered into their tracking system.

Adequate inventory controls not in place.

Inventory counts resulted in double counting.

Entire inventory not counted and missing items were found stored in a garage.

Accounting clerk did not confirm orders received in a timely manner.

Leech Lake Casinos: Serious Deficiencies

• • • • • • • 

Complimentary services had no written internal control procedures.

No clear audit trails for reimbursements of check cashing fees along with the reasons for those reimbursements.

Accounting office does not submit a weekly report of comps to the gaming accounting office.

Employee comps were expensed to marketing department.

Northern Lights Casino (38) Vault forms were not always completed properly and accurately.

Bank account numbers, control numbers, and cashier signatures were missing from debit and credit logs and vault receipts.

Accounting staff did not initial their corrections to vault paperwork (without initials, anyone could alter vault paperwork) and no checks or balances are in place to validate these ‘corrections.’

Leech Lake Casinos: Serious Deficiencies Key control logs are not being completed properly, and no listing is in place of authorized personnel.

Cage cashier are not properly logging vouchers by serial numbers.

Bagged coins taken in from the cages are not properly verified when counting the vault and are not stored in a safe manner.

Plus variances in the vault are not adequately documented or investigated, which can lead to inaccuracies, losses, and fraud.

In the Blackjack department, the hold percentages were not investigated or documented.

The Blackjack shift supervisors were not documenting in writing any suspicious or unusual game plays.

Source: Jean Pagano, “Internal Audits of Leech Lake Casino Finds 111 Serious Deficiencies,” 12/20/02, www.press-on.net/articles/12-20audits.htm.

Some Basic Concepts: High Risk

3.02 Experience has shown that a greater possibility of irregularities exists in operations where there people handling large amounts of cash .

3.05 Regulations require many casinos to have internal audit staffs.

4.01 Gaming operations are subject to a greater-than-normal risk dishonesty of loss as a result of employee or customer because (a) it is not practical to record all individual table game transactions, (b) cash receipts or equivalents are not recorded until they are removed from the drop boxes and counted, and (c) the revenues produced are not from the sale of products or services that are readily measurable. Source: Audits of Casinos, AICPA, 1995 21

Some Basic Concepts: High Risk

4.02 The broad area of casino controls covers controls over authorization , accountability , and safekeeping . These controls take the form of paper safeguards, physical safekeeping, and human safeguards. Transactions are normally subject to being witnessed, recounted, validated, analyzed, initiated, or a combination of these.

1.41 At the end of each shift the casino cage prepares a reconciliation, or accountability, of cash and cash equivalents in its possession. These may be summarized on a daily basis.

1.43 In addition to cage accountability over cash and cash equivalents in its possession, general ledger control is also maintained. The general ledger control accounts at the period’s end should agree with the cage’s daily summaries .

Source: Audits of Casinos, AICPA, 1995 22

Some Basic Concepts: High Risk

2.02 Casino revenue is reported on the accrual basis. Revenue recognized and reported by a casino is generally defined as the win from gaming activities, that is, the difference between gaming wins and losses , not the total amount wagered.

2.04 The retail amount of promotional allowances should not be included in gross revenues expenses.

and

charged to operating expenses because that would overstate both revenues and 2.05 Credits granted to gamblers are accounts receivable.

Source: Audits of Casinos, AICPA, 1995 23

Some Basic Concepts: High Risk 3.09 The audit procedures for casino receivables require special care by the auditor and cooperation from the client so that customers are not alienated and the scope of the audit is not restricted. Since the response to positive confirmation of transactions and account balances might be low, the auditor should be prepared to use alternative methods of determining the existence and proper valuation of casino receivables.

2.11 When a customer exchanges cash for gaming chips, the casino has a liability as long as those chips are not redeemed or won by the house. That liability is established by determining the difference between the total chips placed in service and the actual inventory of chips in custody or under the control of the casino. The chip liability is adjusted periodically to reflect an estimate of chips that will never be redeemed ( for example, chips that have been lost, taken as souvenirs, and so on).

Source: Audits of Casinos, AICPA, 1995 24

Some Basic Concepts: High Risk

2.12 Customers deposits are liabilities.

3.06 Tests of controls over accountability and casino revenue should normally be performed periodically during the year. Generally, these audit procedures include observations of compliance with controls, such as those relating to the casino cage, count rooms, pits, and other casino operating procedures. Specifically, these audit procedures normally include the observations of (a) the collection of drop boxes and drop buckets; (b) cage and count room procedures; (c) fill, credit, and credit instrument procedures; and (d) other casino procedures.

Source: Audits of Casinos, AICPA, 1995 25

Some Basic Concepts: High Risk

3.07 The observation of the cash count, the principal substantive test regarding existence of cash, is usually done as of the balance sheet date, but the count may be performed at an earlier or later time in some instances.

3.13 The auditor should be aware of the casino’s promotional programs, such as coupon redemptions, junkets, promotional allowances, and other give-away programs. The nature, timing, and extent of audit procedures regarding them will depend on the type of programs in use and their significance.

4.11 Critical people-to-people checks often do not involve a trail of documentary evidence.

Source: Audits of Casinos, AICPA, 1995 26

Some Basic Concepts: High Risk

4.13 Since the auditor’s tests of controls attempt to determine whether the controls are actually in effect, his observation of casino floor operations should not be announced in advance undisclosed. In a similar fashion, cage and count room should not be announced in advance even though , and some phases of the observation may be observation of operations in the casino casino security procedures will usually prevent them from being undisclosed.

4.14 In addition, these observations should be carried out at various times throughout the period and under audit. Letters of introduction to casino personnel should be obtained, and arrangements should be made for prompt access to restricted areas during such visits in order to maintain the element of surprise.

27 Source: Audits of Casinos, AICPA, 1995

Forensic Techniques Become Popular

“In many of the large accounting blow-ups,

auditors knew what was happening

,” says Charles Niemeir, “but they were willing to look the other way.” There is a need to provide “

incentives

for people finding problems,” says Douglas Carmichael. “Right now there are no incentives for finding problems, and one who does is treated as a trouble maker.” E&Y will

require

its auditors to undergo about 50,000 hours of fraud-related training and another 300,000 hours of instructions on attesting to internal controls as mandated by Sarbanes-Oxley.

Dennis Nally, at PricewaterhouseCoopers, says his firm has identified at least 50 high-risk clients and will

add at least one forensic auditor to each

. Typically, we do not have a forensic auditor on the audit team.

Deloitte & Touche: Focus more on

potential fraud

by incorporating forensic auditors. Using new computer software for quantitative analysis.

Source:

Cassell Bryan Low, “Accounting Firms Attempts to Dispel the Cloud of Fraud,”

Wall Street J.

, May 27, 2003.

Popular (cont.)

• 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

Find It, or I’ll Sue

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.

Forensic Accounting Knowledge Base LAW Investigative auditing Criminology Accounting Forensic Accountant

Be like

Fictional Hero

© D.L. Crumbley “Forensic accounting is turning up more frequently in the world of fiction, too. The financial intrigue of fraud and the investigative process of forensic accounting are a natural fit with mystery of suspense novels. Add exotic locations, colorful characters and a murder or two, and you have all the elements of a classic thriller.

There is a selection of books featuring forensic accountants as the heroes of their own stories, as well. Lenny Cramer, perhaps the most prominent of this fictional group, is the star of a series of novels written by I.W. Collett and various co-authors.

In one of these novels, Cramer tracks forged receipts to uncover a plot to steal Burmese religion treasures . Another features Cramer, while conducting an audit at Coca-Coca, uncovering a scheme to steal the company’s secret formula . In yet another, Cramer uses his forensic accounting skills to solve a series of murders in the New York art world .” Source: “Book ‘em! Forensic Accounting in History and Literature,”

The Kessler Report

, Vol. 1, No. 2.

Forensic-Type Organizations American College of Forensic Examiners

(2750 E. Sunshine, Springfield, MO 65804; 800-423-9737; www.acfi.com

. DABFA and Cr.FA; 2000)

Certified Fraud Examiners

(Association of CFEs, The Gregor Bldg., 716 West Avenue Austin, TX 78701; 800-245-3321; www.cfenet.com

Certified Insolvency and Reorganization Accountant

. 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 Accounting Society Of North America

(FASNA, 8712 W. Dodge Road, Suite 200, Omaha, NE, 68114; 402-397-9433). About 9 firms. Insurance.

Certified Forensic Financial Analyst

(NACVA, Salt Lake City, Utah 84106; 801-486-0600). Also, Certified Fraud Deterrence (CFD) analyst.

National Litigation Support Services Association

(NLSSA, III East Wacker Drive, Suite 990, Chicago, IL 60601; 800-869-0491). Not-for-profit. 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 anti fraud corporation located in Sacramento, Calif., for those dealing in white-collar crime, fraud, and abuse issues. Association of Certified Fraud Specialists. http://acfsnet.org

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.” 35

Fraud is Possible

Biggleman’s Safe – a safe builder wrote blueprints of a unbreakable safe and locked the blueprints inside the safe.

Internal controls can be broken, often by top executives.

White-Collar Crime: Rich People Steal

• Edwin Sutherland coined the term “white-collar crime.” [Indiana University sociology professor.] • Sutherland believed that white-collar crime is a

learned behavior

, a consequence of corporate culture where regulations are regarded as harassment, and profit is the measure of the man.

• “White-collar crime violates trust and thus creates distrust, and this lowers social morale and produces social disorganization on a large scale.

Cynthia Crossen, “A Thirties Revelation: Rich People Who Steal are Criminals, Too,”

Wall Street Journal

, October 15, 2003, p. B-1.

Tyco Prosecutor’s Closing Argument

“

Remember, these are two very, very smart men; they are not charged with being stupid men,” she said of Mr. Kozlowski and Mr. Swartz. “These crimes have an element of sophistication so you can be sure that when they were committing them they built in an element of deniability.” She added: “Every good scheme has it. That is how white collar criminals work.” • Mistrial on April 2, 2004.

Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,”

N.Y. Times

, March 17, 2004, p. C-1.

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

years.

of lead audit partner every

five

• For now no requirement firm to rotate auditing 39

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.

Incumbent Auditors

• An incumbent auditor may

not

perform legal services and expert services unrelated to an audit

for audit clients

(i.e., can not be an expert witness).

• An auditor is

not

prohibited from legal and expert services for

nonaudit

clients 41

Legal Services

Under the rules, CPAs

cannot

provide a service for an audit client that only someone licensed to practice law can perform. The concern this rule addresses is that the auditor would be acting as an

advocate

, which the SEC (partly in reliance on

United States v. Arthur Young

) concludes would preclude the CPA from maintaining the “objectivity and impartiality that are necessary for an audit.” Source: T.J. Purcell, III and D. Lifson, “Tax Service After Sarbanes-Oxley,”

Journal of Accountancy,

November, 2003, p. 37.

Expert Service Unrelated to Audit

This covers engagements where the CPA firm’s specialized knowledge, experience and expertise support audit client positions in

adversarial proceedings

. The prohibition includes providing an opinion to the client or a client representative to

advocate

a client’s interests in litigation or in a regulatory or administrative investigation or proceeding. The rules do not define this term.

The examples involve the SEC Division of Enforcement,

forensic accounting engagements for the client itself and helping the audit committee investigate potential accounting impropriety

. The rules appear to reject the proposal that the advocacy prohibition be confined to public settings and allow internal investigations and fact-finding engagements for the audit committee, as well as providing factual accounts, testimony or explanations of positions taken, conclusions reached or work performed.

Source: T.J. Purcell, III and D. Lifson, “Tax Service After Sarbanes-Oxley,”

Journal of Accountancy,

November, 2003, p. 37.

Tax Services Not Defined

not

define tax services, but will be inspecting them.

Representing an audit client in court could impair independence.

PCAOB “will focus on the profession’s role in both structuring and signing off on abusive tax shelter designed to make their clients’ financial statements look better.” PCAOB’s annual inspections will examine how accounting companies audit and structure “questionable, tax-orientated transactions.” Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will Inspect Them,”

Tax Notes

, October 20, 2003, p. 330; C. Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”

Wall Street Journal

., October 22, 2003, p. A-2.

Acceptable Non-audit Services

• • • Payroll sales, property, state income, federal income and other tax-compliance services, even though the audit firm reviews the client’s work that becomes part of the financial records through the recording of a liability.

Traditional tax planning services

, such as where the CPA prepares an analysts of a transaction (lease vs. buy) and the client uses the CPA’s work product to develop the appropriate financial accounting entries.

Analysis of clients

records (with recommendations for redesign) to determine strategies for minimizing state and local income sales, property and payroll taxes.

Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will Inspect Them,”

Tax Notes

, October 20, 2003, p. 330; C. Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”

Wall Street Journal

., October 22, 2003, p. A-2.

Acceptable Non-audit Services (cont.)

•

Appraisal services

undertaken for tax compliance reasons (such as assigning values to intangible assets under IRC section 197, calculating gains on distributions of assets to shareholders under section 338 election, implementing mark-to-market values under section 475 and allocating purchase prices under section 1060), even though the company uses the derived values in part for financial statement purposes.

•

Tax-consulting engagements

that examine, for example, the efficiency of internal tax departments, procedures used to protest state and local property tax valuations or state income tax studies.

• “

Loaning

” tax staff or supervisors to an audit client for special projects or short-term personnel emergencies.

Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will Inspect Them,”

Tax Notes

, October 20, 2003, p. 330; C. Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”

Wall Street Journal

., October 22, 2003, p. A-2.

Acceptable Non-audit Services (cont.)

•

Designing or commenting

on the tax aspects of a compensation package for specific individuals or the general management staff of the audit client-for example, reviewing the applicability of anti-discrimination provisions of IRC section 132 and the reasonable compensation and incentive compensation provisions of section 162(m).

•

Meeting

with prospective candidates for the tax director or CFO position to discuss the tax issues the company faces.

•

Recommending

that controlling shareholders sell their stock to an ESOP to take advantage of IRC section 1042; advising a client to consider an ESOP as part of a benefits package (or,if an ESOP already exists, that a client sell additional shares to it); or recommending that an estate sell its stock in an audit client to use the provisions of IRC section 303 or to otherwise efficiently administer the estate.

Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will Inspect Them,”

Tax Notes

, October 20, 2003, p. 330; C. Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”

Wall Street Journal

., October 22, 2003, p. A-2.

Acceptable Non-audit Services (cont.)

• •

Representing

the audit client in IRS exams, sales tax proceedings, state income tax audits, payroll tax audits, local government property tax proceedings and the like.

Helping

an audit client prepare requests for a ruling or changes in accounting periods or method or for determination letters on various issues from the IRS or other administrative agencies.

Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will Inspect Them,”

Tax Notes

, October 20, 2003, p. 330; C. Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”

Wall Street Journal

., October 22, 2003, p. A-2.

Sarbanes-Oxley Act of 2002

• If you are going to be an auditor, you have to be an auditor, not an auditor and a consultant [Senator Jack Reed].

• In order to be independent, an accounting firm should

not

– –

Audit ones own work.

Function as part of management or an employee.

–

Act as an advocate.

• No limitations are placed upon accounting firms in providing non-audit services to public companies they do not audit

or any private companies

• Audit services and non-audit services (e.g., tax) must be pre-approved by the audit committee, if not prohibited by the Act (

before

the non-audit service commences).

• Auditor must report to the audit committee on a timely basis.

• Cooling off period of one year for hiring an auditor if CEO and other senior officers worked for the auditor.

• There is

requirement to rotate the auditors.

• There was discussion of requiring a forensic audit irregularly. Harvey Pitt suggested this proposal.

Sarbanes-Oxley (contd.)

effective

July 30, 2002 (postponed).

www.tnwinc.com

The Network • Thus, SEC will

control

the accounting standards, not the AICPA.

• Auditors to report to audit committee, and audit committee must approve all services.

• Crime to corruptly alter, destroy, mutilate, or conceal any document with the intent to impair the object’s integrity or availability (up to

years).

• Statute of limitations for the discovery of fraud is now

two

years from the date of discovery and

years after the act.

• Maximum penalty for mail and wire fraud is increased from

5 to 10

years.

• Financial statement filed with SEC: certified by CEO and CFO. Maximum penalties for willful and knowingly violation: fined not more than $5 million and/or imprisonment of up to

20 years

• Sense of Congress: CEO should sign the Federal income tax return.

SEC’s Proposed Rules (12-5-2002)

Auditor may

not

1. Audit own work.

2. Perform management function.

3. Act as an advocate of a client.

 Traditional tax preparation service okay: • preparation of tax returns.

• tax compliance.

• • • tax planning.

tax recovery.

other tax-related services.

 Reviewing tax accruals is audit service.

 Tax Court representation would impair an auditor’s independence.

 Formation of tax strategies (e.g., tax shelters) is

not

okay.

 Unknown: Tax opinions for tax shelters.

 The audit committee must weigh the risk associated with using the company auditor for tax services versus the cost savings of using the company auditor.

Source: Sheryl Stratton, “SEC Seeks Input on Defining Scope of Tax Service,”

Tax Notes

, December 9, 2002, pp. 1265 – 1266.

Sarbanes-Oxley Act Creates Need For Forensic Accounting

1.To assist corporations in their quest to ensure compliance with the mandates of S-O, especially the audit committee.

2.Public accounting firms must introduce forensic techniques into audits, and they may request help from forensic experts .

3.Internal auditors should introduce forensic accounting techniques into their audit programs.

---------------------------------------------------------------- SEC Chairman William Donaldson responds to a question why there is “such appalling fraud” in business in the following manner. There are 15,000 companies out there,” and “the majority of those companies are run by honest, dedicated people.” But he admitted that “there has been in my view, a gradual erosion of corporate ethics over the bull market of the last decade, and particularly the last five years.” Bobby Eberle, “Justice Department Celebrates One Year of Corporate Fraud Task Force,” Talon News, July 23, 2003, www.gopusa.com/news/2003/july/0723corporatefraud.shtml.

Assistance of Forensic Accountants

1. S-O requires principal executives and financial officer to

personally

certify annual and quarterly reports.[Section 302]. Effective August 2002.

2. Certification must cover internal controls, disclosure controls, and fraud. Need for a Chief Forensic Officer? The SEC suggests the entity assign the duties of monitoring internal controls to a specific individual. SEC suggests a disclosure committee, also.

3. Officers and directors are prohibited from influencing, coercing, manipulating, or misleading the accountant performing the independent audit.

4. Civil and criminal penalties against officers for violations of S-O.

5. Auditors work paper retentions for five years.

6. PCAOB shall adopt auditing standards.

7. SEC may censure auditors.

Section 404-Sarbanes-Oxley

• Beginning November 15, 2004, large companies must have in place tight internal controls, assess the effectiveness of these controls annually (and issue a report of their effectiveness), and pay for an independent assessment by external auditors.

• Need an internal control framework (e.g., COSO or similar).

• Companies are paying steep fees to fund the PCAOB.

• Audit fees have increased by as much as 30% since S/O.

Audit Committee Board of Directors Top Management PCAOB and SEC Internal Auditors External Auditors

The COSO Model

Control environment

attitude toward controls, or the “tone at the top.” – management’s

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.coso.org

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 57

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.

2. Determine areas to assess – conduct at company wide, business-unit, and significant account levels.

3. Identify potential schemes and scenarios – typically affecting the industry or locations.

• Fraudulent financial reporting.

•Misappropriation of assets.

•Expenditures and liabilities for an improper purpose (cash kickbacks and corruption).

•Organization commits a fraud against employees or third parties.

•Tax fraud.

•Financial misconduct by senior management.

© D.L. Crumbley Fraud Risk-Assessment Process 4. Assess likelihood of fraud •Remote •Reasonably possible •Probable 5. Assess significance of risk •Inconsequential •More than inconsequential •Material 6. Link antifraud controls – identify the control activities for fraud risks that are

both

more than likely to occur and more than inconsequential in amount.

7. Apply assessment results to the audit plan – consider and document the results of the fraud assessment when developing the audit plan.

Source: Jonny Frank, “Fraud Risk Assessments,”

Internal Auditor

, April, 2004, pp. 43-47.

FEI’s Costs of Compliance

Revenue Less than $25 million $25 to $99 million $100 to $499 million $500 to $999 million $1 to $4.9 billion Over 5 billion First-Year Costs $.28 million $.74 million $.78 million $1.04 million $1.83 million $4.67 million First-Year Hours 1,996 3,080 5,118 6,950 13,355 41,201 Source: Financial Executive Institute 61

Using Work of Specialists (SAS No.73)

Specialist defined: a professional service firm or individual who possesses special skills or knowledge in a particular field other than accounting and auditing To reply on specialist’s findings, auditor  Must understand the objectives and scope of work performed.

  Assumptions used must be clear to auditor.

Auditor must consider the appropriateness of utilizing the specialists findings.

 Auditor must test the data that client provides to the specialist.

  Auditor must evaluate whether findings support the assertions in the financial statements.

If specialist’s findings inconsistent, SAS No.73 provides additional procedures which auditor must follow.

 Auditor will need copies of work papers of specialists.

Michael Comer’s Types of Fraud

1. Corruptions (e.g., kickbacks).

2. Conflicts of interest (e.g., drug/alcohol abuse, part-time work).

3. Theft of assets.

4. False reporting or falsifying performance (e.g., false accounts, manipulating financial results).

5. Technological abuse (e.g., computer related fraud, unauthorized Internet browsing).

Comer’s Rule: Fraud can happen to anyone at anytime.

Source: M.J. Comer,

Investigating Corporate Fraud

, Burlington, Vt.: Gower Publishing Co., 2003, pp. 4-5.

Starwoods Hotels Poll of Executives

Starwoods Hotels interviewed 401 top executives who golf. The results are surprising.

Consider themselves to be honest in business Played with someone who cheats at golf Cheated themselves at golf Hated others who cheated at golf Believe that business and golf behaviors are parallel

99% 87% 82% 82% 72%

Source: Del Jones, “Many CEOs Bend The Rules (of Golf),”

USA Today

, June 26, 2002, p. A-1.

The Cost of Fraud

6 percent

of annual revenue to fraud and abuse.

Fraud and abuse costs U.S. organizations more than

$600

billion

annually ($4,500 per employee).

The average organization loses more than

$12

a day per employee due to fraud and abuse.

Source: 2002 Wells Report

The Cost of Fraud (cont.)

     Over

80%

of occupational frauds involve

asset misappropriations

Average length of a fraud scheme is

18 months

Most common way of detecting occupational fraud is by

tips

from employees, customers, vendors, or anonymous sources.

Second most common detection:

accident

The most targeted asset is cash.

Source: 2002 Wells Report

Fraud Multiplier

Suppose 20% profit margin How much new revenue needed to offset the lost income?

$100,000 = $500,000 20% So ACFE says $600 billion lost per year.

$600 billion = $3 trillion needed revenue 20% 67

Put Fraud In Perspective

The Iraq War may cost as much as $200 billion. Since fraud and abuse reduce the bottom lines of businesses as much as $600 billion per year (assuming a tax rate of 30%), the federal government loses in taxes

each year

$180 billion.

So in less than 14 months , stopping fraud and abuse would pay for the Iraqi war.

Advantage of Compliance Spending

General Counsel Roundtable says that each $1 of compliance spending

saves

organizations, on the average, $5.21 in heightened avoidance of legal liabilities, harm to the organization’s reputation, and lost productivity.

Source: Jonny Frank, “Fraud Risk Assessments,”

Internal Auditor

, April 2004, p. 47.

Ernst & Young Study (2000)

       Leading companies and public bodies in

(82) countries More than

82%

(50%) have been victims of fraud in the past year.

82%

(84%) of total losses can be attributed to staff.

33%

(50%) of the most serious frauds were committed by the organization’s own management.

Most with company more than

(25% more than 10 years).

years

Theft of cash

and

purchasing schemes

(i.e., employee kickbacks) constituted the

majority

of frauds.

Reasons: Poor internal controls

and

finance directors had a limited knowledge of internal controls.

2003 PricewaterhouseCooper Survey

• • Survey to several hundred of the largest companies (with 91 responses).

Half

of the detected economic crimes at responding companies

were found by auditors

, but it did not distinguish between internal audits.

Another 36 percent

of the frauds were reported by whistle-blowers • Although 76 percent of the United States respondents were covered by insurance,

fewer than half

were able to recover from their insurers. And less than a third of insured companies affected by fraud collected more than 20 percent of the amount lost.

• The

average amount lost

was

$2.2 million

, and the

highest levels of economic crime

were reported in Africa and North America (including Canada and the United States).

Source: J.D. Glater, “Survey Finds Fraud’s Reach in Big Business” www.nytimes.com/2002/07/08/business/08CHIE.html.

Scienter Necessary

scienter

was present.

• That is, the fraudster must have known that his or her actions were intended to deceive.

Fraud

Legally,

Black’s Law Dictionary

as: defines fraud All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth, and includes all surprise, trick, cunning or dissembling, and any unfair way by which another is cheated.

The four legal elements to fraud are 

A false representation or willful omission regarding a material fact.



The fraudster knew the representation was false.

 

The target relied on this misappropriation.

The victim suffered damages or incurred a loss.

----------------------------------------------------------------------

Institute of Internal Auditors definition: Any illegal acts characterized by deceit, concealment, or violation of trust. These acts are not dependent upon the applications to obtain money, property, or services; to avoid payment or loss of services; or to secure personal or business advantage.

SEC’s Definition of Fraud

a) It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or the mails, or of any facility of any national securities exchange, To employ any device, scheme, or artifice to defraud, b) c) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made,

not

misleading, or To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

SEC Rule 106-5 74

Foreign Corrupt Practices Act of 1977

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

FCPA Section 102 75

Federal Sentencing Guidelines Monitoring Mechanism

Systems reasonably designed to detect criminal conduct by its employees and other agents and by having in place and publicizing a reporting system whereby employees and other agents could report criminal conduct by others within the organization without fear of retribution.

FCPA Sec. 8A1.3(k)(5).

Superseded SAS No. 53

Accounting Fraud Referred To As “Irregularities”

The term “irregularities” refers to intentional misstatements or omissions of amounts or disclosures in financial statements. Irregularities include fraudulent financial reporting undertaken to render financial statements misleading, sometimes called management fraud, and misappropriation of assets, sometimes called defalcations. Irregularities may involve acts such as the following: •Manipulation falsification, or alteration of accounting records or supporting documents from which financial statements are prepared.

•Misrepresentation or intentional omission of events, transactions, or other significant information.

•Intentional misapplication of accounting principles relating to amounts, classifications, manner of presentation, or disclosure.

Superseded SAS No. 82

Accounting Fraud Referred To As “Misstatement” Misstatements

arising from fraudulent financial reporting are intentional misstatements or omissions disclosures of amounts or in financial statements to deceive financial statement users.

--------------------------------------------------------- Three most important red flags according to external/internal auditors (out of 25): 1) 2) 3) Known history of securities law violations

(14.6%)

Significant compensation tied to aggressive accounting practices

(12.9%)

Management’s failure to display appropriate attitude about internal controls

(12.6%)

Source: B.A Apostolou et.al, “The Relative Importance of Management Risk Factors,”

Behavioral Research in Accounting,”

January 1, 2001, pp. 1-24.

SEC Staff Accounting Bulletin No.99

Fraudulent accounting entries known by senior management can

not

be left

unadjusted

merely because they are “immaterial” by some mechanical, quantitative standard (e.g., percentage of net income).

Thus materiality loophole

eliminated

in 1999.

Something is material if there is a substantial likelihood that a reasonable person would consider it important.

SEC SAB No. 99 Examples

render material a quantitatively small misstatement

of a financial statement item are— •Whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate.

•Whether the misstatement masks a change in earnings or other trends.

•Whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise.

•Whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability.

SEC SAB No. 99 Examples

•Whether the misstatement affects the registrant’s compliance with loan covenants or other contractual requirements.

•Whether the misstatement has the effect of increasing management’s compensation - for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation.

•Whether the misstatement involves concealment of an unlawful transaction.

SAB No. 99, Appendix B.

COSO’s Most Common Fraud Methods

Overstatement of earnings.

Fictitious earnings Understatement of expenses.

Overstatement of assets.

Understatement of allowances for accounts receivable.

Overstatements of the value of inventories by

not

writing down the value of obsolete goods.

Overstatement of property values and creation of fictitious assets.

Committee on Sponsoring Organizations.

COSO’s Major Motives for Fraud

Cover up assets misappropriated for personal gain.

Increase the stock price to increase the benefits of insider traders and to receive higher cash proceeds when issuing new securities.

Obtain national stock exchange listing status or maintain minimum exchange listing requirements to avoid de-listing.

4. Avoiding a pretax loss and bolstering other financial results.

www.coso.org.

Fraudulent Disbursements

   Fraudulent disbursements account for

three-quarters

of the losses, and the most expensive tend to be fraudulent disbursements through billing schemes (

45%).

Therefore, internal auditors seeking to get the biggest bang for their investigative bucks should begin by making sure company vendors are for real.

Check tampering (

30%).

Source: J.T. Wells, “An Unholy Trinity,”

Internal Auditor

, April 1998, p. 33.

Joseph W. Koletar’s Opinions

firm grasp on the size

and components of their fraud problems. Usually they rely on incidental reports and, in turn generate incremental responses.” p. 99.

Business failures and financial statement fraud “occur

because existing controls were not operating, not because they were improperly designed and installed.

Often internal auditors are not permitted to do their jobs. Serious audit results impact executives, and many executives are resistant to change or feel threatened. Consequently, those who make a difference are stifled.” Barry Lipton’s letter, p. 104.

“Far too many organizations are penny wise and pound foolish in their approach to internal controls staffing and monitoring….” p. 117.

------------------------------------------------------------- Michael J. Comer: “

The Cow grows fat under the eyes of the owner

.” p. 8.

Source : J.W. Koletar,

Fraud Exposed

, John Wiley & Sons, 2003.

The Methods

   Asset misappropriation accounted for more than four out of five offenses

(80%).

Bribery and corruption constituted about

% of offenses.

Fraudulent statements were the smallest category of offense (

most costly

). $4.25 million per scheme.

Source: 2002 Wells Report 86

Restatements of Financial Statements 2002 2001 2000 1999 1998 330 270 233 216 158

Reasons for 2002 restatements: 1. Accounting rules.

2. Human and system errors.

• • 3. Fraudulent behavior.

Although the number of public registrants have

decreased

by 14% since 1999, restatements have the cause of 85 of the restatements (22%) in 2002.

risen

by 53%. Revenue recognition was Arthur Andersen had averaged 11 restatements before 2002. In 2002, they had 40, with 26 after new auditors were retained.

Source: “An Analysis of Restatement Matters,” Huron Consulting Group, www.huronconsultinggroup.com

. 87

Cynthia Cooper’s Suggestions

• Improve the tone at the top (e.g., a fish rots from the top).

• Robust Codes of Conduct.

• Training on Ethics/Internal Controls.

• Holistic approach to Risk Assessment/Internal Controls.

• Fraud Hotlines.

• Control self-assessment.

• Control repositories.

Source: Cynthia Cooper, L.S.U., November 24, 2003.

Triple Fraud Sting

    A Michigan woman received an e mail from a Nigerian asking her to set up a bank account in the U.S. in order to help him

steal

$18 million.

She set up the bank account (to help pay the so-called bribes and fees) by allegedly

embezzling

$2 million from her employer during seven months in 2002.

Guess what? She never received a penny. She was indicted on 13 counts of wire fraud.

Fraud schemes are much like derivatives. They spring up, die out, and new ones are started each week.

Source

: Kim Komando, “Delete These Scams – Now,” MSN Business, www.bcentral.com/articles/komando/109.asp

. Reviewed June 15, 2003.

Rite Aid Fraud Case

 Former CEO Martin Glass bragged that the computer used to generate backdated letters had

disappeared at sea

. “They have no computer. The letters that were done on the computer…they do not have and never will have, unless they use a Trident submarine.”  Wrong. President Timothy Noonan was

wearing a wire

. He recorded 6 meetings over 10 weeks. Federal investigators heard everything.

 CFO Franklyn Bergonzi:  Obtained $30 million in extra profits by dunning Rite Aid’s suppliers for merchandise that was supposedly outdated or damaged (but not so).

 Another $75.6 million came from rebates from pharmaceutical firms that had yet to be earned.

  Failed to report certain expenses properly.

Increased the useful life of some assets.

 The financial restatements wiped out $1.6 billion in profits.

 KPMG agreed to pay $125 million fine.

Source

: Mark Maremont, “Call To Account: Rite Aid Case Gives Early View of Fraud on Trial,”

Wall Street J.

, June 11, 2003, p. A-6.

One Piece at a Time

One Piece At A Time

Well, I left Kentucky back in '49 An' went to Detroit workin' on a 'sembly line The first year they had me puttin' wheels on cadillacs Every day I'd watch them beauties roll by And sometimes I'd hang my head and cry 'Cause I always wanted me one that was long and black.

One day I devised myself a plan That should be the envy of most any man I'd sneak it out of there in a lunchbox in my hand Now gettin' caught meant gettin' fired But I figured I'd have it all by the time I retired I'd have me a car worth at least a hundred grand.

CHORUS

I'd get it one piece at a time And it wouldn't cost me a dime You'll know it's me when I come through your town I'm gonna ride around in style I'm gonna drive everybody wild 'Cause I'll have the only one there is a round.

So the very next day when I punched in With my big lunchbox and with help from my friends I left that day with a lunch box full of gears Now, I never considered myself a thief GM wouldn't miss just one little piece Especially if I strung it out over several years.

One Piece At A Time

The first day I got me a fuel pump And the next day I got me an engine and a trunk Then I got me a transmission and all of the chrome The little things I could get in my big lunchbox Like nuts, an' bolts, and all four shocks But the big stuff we snuck out in my buddy's mobile home .

Now, up to now my plan went all right 'Til we tried to put it all together one night And that's when we noticed that something was definitely wrong .

The transmission was a '53 And the motor turned out to be a '73 And when we tried to put in the bolts all the holes were gone.

So we drilled it out so that it would fit And with a little bit of help with an A-daptor kit We had that engine runnin' just like a song Now the headlight' was another sight We had two on the left and one on the right But when we pulled out the switch all three of 'em come on.

The back end looked kinda funny too But we put it together and when we got thru Well, that's when we noticed that we only had one tail-fin About that time my wife walked out And I could see in her eyes that she had her doubts But she opened the door and said "Honey, take me for a spin." 93

One Piece At A Time

© D.L. Crumbley 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.

The Perpetrators

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 95

characteristics:

        Likely to be married.

Member of a church.

Educated beyond high school.

No arrest record.

Age range from teens to over 60.

Socially conforming.

Employment tenure from 1 to 20 years.

Acts alone 70% of the time.

Source: Jack Robertson,

Fraud Examination for Managers and Auditors

(1997).

Other Characteristics of Occupational Fraudsters:

     

Egotistical



Risk taker



Hard Worker



Greedy



Disgruntled or a complainer



Overwhelming desire for personal gain

 

Pressured to perform Inquisitive Rule breaker Under stress Financial need Big spender Close relationship with vendors / suppliers

Source: Lisa Eversole, “Profile of a Fraudster,” Some Fraud Stuff, http://www.bus.lsu.edu/accounting/faculty/lcrumbley/fraudster.html

Insights on cheaters and deceivers:

 People who have experienced failure are more likely to cheat.

 People who are disliked and who dislike themselves tend to be more deceitful.

 People who are impulsive, distractible, and unable to postpone gratification are more likely to engage in deceitful crimes.

 People who have a conscience (fear, apprehension, and punishment) are more resistant to the temptation to deceive.

 Intelligent people tend to be more honest than ignorant people.

 Middle- and upper-class people tend to be more honest than lower-class people.

 The easier it is to cheat and steal, the more people will do so.

 Individuals have different needs and therefore different levels at which they will be moved to lie, cheat or steal.

 Lying, cheating, and stealing increase when people have great pressure to achieve important objectives.

 The struggle to survive generates deceit.

Source: Gwynn Nettler,

Lying, Cheating, and Stealing,

Cincinnati, Ohio: Anderson, 1982.

Quotes

To be a forensic auditor, you have to have a knowledge of fraud, what fraud looks like, how it works, and how and why people steal.

Source: Robert J. Lindquist

"Finding fraud is like using a metal detector at a city dump to find rare coins. You're going to have a lot of false hits."

- D. Larry Crumbley

“Fraud can be best prevented by good people asking the right questions at the right time.”

- Michael J. Comer

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

H.R. Davia suggests that for every three fraud events which are detected, two remain undetected, and that conclusions drawn from studying those that are detected do not necessarily apply to those whose existence has not been revealed.

Source: Davia, H.R., “Fraud Specific Auditing,”

Journal of Forensic

Accounting,” June 2002.

100

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.

101

Forensic Audit of a Forensic audit

Harris Tories (Canada) tarred by Andersen Consulting and Accenture deals - - $200 million blown to save $16 million in welfare funds.

Firms found $58.2 million in so called welfare fraud, saving up to $16 million.

James Clancy calls for forensic audit of Ontario’s payments to the two companies.

The union leader said, “instead of wasting $200 million in this manner, the money could have been used to improve education, healthcare, and all the other social services.” 102

How Fraud Is Detected

1. Tips

from employees (26.3%).

2. By accident (18.8%).

3. Internal audit (18.6%).

4. Internal controls (15.4%).

5. External audits (11.5%).

6. Tips

from customers (8.6%).

7. Anonymous

tips

(6.2%).

8. Tips

from vendors (5.1%).

Therefore, 46.2% from tips.

Source:

2002 Wells Report.

103

Tips Are Important

Some of the biggest recent accounting scandals (e.g., WorldCom, 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.

104

Finding Fraud In The Midst of a Conspiracy

When speaking about the fraud of HealthSouth, a spokesman for Ernst & Young emphasized the

difficulty of detecting accounting fraud in the midst of a conspiracy

of senior executives and false documentation. An accountant testified that HealthSouth employees would move expenses of $500 to $4,999 from the income statement to the balance sheet throughout the year. Overall the SEC said about $1 billion in fixed assets were falsely entered. The employees moved only those expenses

less than $5,000

because Ernst & Young automatically looked at those expenses over $5,000

. An ex-bookkeeper even sent Ernst & Young an e mail flagging one area of the fraud, but E & Y still did not catch it. Employees actually produced

false invoices

when the accounting firm asked for back-up.

Source:

Charles Mollenkamp, “Accountant Tried in Vain to Expose HealthSouth Fraud,”

Wall Street Journal

, May 20, 2003, pp. A-1 and A-13.

105

HealthSouth

Billy Massey, 37-year-old CPA, had a wife and two children and looked like an accountant from central casting.

Massey was the

personal accountant

for HealthSouth’s Richard Scrushy. He was Scrushy’s personal CFO for his private interests, doing the financing, paying the bills, moving around money – and

stealing some $500,000.

Massey spent the money on lavish dinners and gifts for his mistress. One week after he was found to be an embezzler and adulterer, he

committed suicide

Source

: John Helyar, “The Insatiable King Richard,”

Fortune

, July 7, 2003, p. 78.

106

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

107

Difficult Task

More forensic techniques should become a part of both external and internal auditing. But Stephen Seliskar says that “in terms of the sheer labor, the magnitude of effort, time and expense required to do a single, very focused [forensic] investigation -- as contrasted to auditing a set of the financial statements -- the difference is incredible.” It

is physically impossible

to conduct a generic fraud investigation of an entire business.

Source

: Eric Krell, “Will Forensic Accounting Go Mainstream?”

Business Finance Journal

, October 2002, pp. 30-34. www.investigation.com/artilces/library/2002Articles/15.htm

108

Stealth

Once a forensic accountant (e.g., Cr.FA, CFE, CFFA) is engaged, Michael Kessler says that they

should not be disruptive

. Most employees are not aware that an investigation is taking place. We go in as just another set of auditors, favoring a Columbo-esque investigative style. “

‘forensic accountant

.’”

We don’t wear special windbreakers that say

Source: Eric Krell, “Will Forensic Accounting Go Mainstream?”

Business Finance Journal

, October 2002, pp. 30-34. www.investigation.com/articles/library/2002Articles/15.htm

109

D.R. Cressey’s Fraud Pyramid

“It was definitely the perfect fraud… unfortunately they hired the perfect investigator.” Cartoon in M.J. Comer’s book 110

Kessler Survey (2001)

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

, ParkRider, N.Y.: London House Press, 1989, pp. 1-5.

111

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

112

Fraud Pyramid

   Motive  Excessive spending to keep up appearances of wealth.

   Other, outside business financial strains.

An illicit romantic relationship.

Alcohol, drug or gambling abuse problems.

Opportunity  Lack of internal controls.

 Perception of detection = proactive preventative measure.

Rationalization   “Borrowing” money temporarily.

Justifying the theft out of a sense of being

underpaid

.(“I was only taking what was mine”)  Depersonalizing the victim of the theft. (I wasn’t stealing from my boss; I was stealing from the company.”) 113

Greed

“I don’t see many ways to eliminate greed; it is an inherent part of the human character. So antifraud measures must be aimed at educating people on the risks and the type of technical controls that they can implement.” Alan Oliphant Source: David G. Banks, “The Fight Against Fraud,”

Internal Auditor

, April 2004, pp. 36-37.

114

© D.L. Crumbley 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.

115

Financial Statements Fraud Formula CRIME

Cook Recipes + + Incentives + Monitoring (lack of) + End Results CRIME = Source: Zab Rezaee “Cooking The Books Is a Crime,

Journal of Forensic Accounting

Vol. IV (2003), pp. 137-144 116

Rite Aid’s Bag of Tricks

• Rite Aid overstated its income in every quarter from May 1997 to May 1999, by massive amounts.

• Restated its pre-tax income by $2.3 billion and net income by $1.6 billion, the largest restatement ever.

Source: SEC Announces Fraud Charges Against Former Rite Aid Senior Management. http://www.sec.gov/news/press/2002-92.htm

117

Rite Aid’s Bag of Tricks

Wayne M. Carlin, Regional Director of the Commission's Northeast Regional Office, stated: "The charges announced today reveal a disturbing picture of dishonesty and misconduct at the highest level of a major corporation. Rite Aid's former senior management employed an extensive bag of

tricks to manipulate the company's

reported earnings and defraud its investors. At the same time, former CEO Martin Grass concealed his use of company assets to line his own pockets. When the house of cards teetered on the edge of collapse, Grass fabricated corporate records in a vain effort to forestall the inevitable. The Commission's enforcement action, and the related criminal prosecutions announced today, demonstrate that there will be no refuge for corporate executives who commit this kind of wrongdoing.” Source: http://www.sec.gov/news/press/2002-92.htm

118

Rite Aid’s (Cont.)

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

Source: http://www.sec.gov/news/press/2002-92.htm

119

Rite Aid’s (Cont.)

•Stock Appreciation Rights (SARs) — Rite Aid failed to

record an accrued expense

for stock appreciation rights it had granted to employees, in a program that gave the recipients the right to receive cash or stock in amounts tied to increases in the market price of Rite Aid stock. Rite Aid should have accrued an expense of $22 million in FY 1998 and $33 million in FY 1999 for these obligations. When questioned by Rite Aid's independent auditors about the existence of any SARs, Bergonzi

falsely denied that any had been issued.

Source: http://www.sec.gov/news/press/2002-92.htm

120

Rite Aid’s (Cont.)

reverse amounts that had been recorded for various expenses

incurred and already paid. These reversals were completely unjustified and, in each instance, were put back

on the books in the subsequent

quarter, thus moving the expenses to a period other than that in which they had actually been paid. The effect was to overstate Rite Aid's income during the period in which the expenses were actually incurred. For example, Bergonzi directed entries of this nature which caused Rite Aid's pre-tax income for the second quarter of FY 1998 to be overstated by $9 million.

Source: http://www.sec.gov/news/press/2002-92.htm

121

Rite Aid’s (Cont.)

•"Gross Profit" Entries — Bergonzi directed Rite Aid's accounting staff to make improper adjusting entries to

reduce cost of goods sold and

accounts payable in every quarter from the first quarter of FY 1997 through the first quarter of FY 2000 (but not at year end, when the financial statements would be audited). Source: These entries had no substantiation, and were intended purely to manipulate Rite Aid's reported earnings. For example, as a result of these entries alone, Rite Aid overstated pre-tax income by $100 million in the second quarter of FY 1999.

http://www.sec.gov/news/press/2002-92.htm

122

Rite Aid’s (Cont.)

vendors for undisclosed markdowns on those

vendors' products. The vendors did not agree to share in the cost of markdowns at the retail level, and Rite Aid misled the vendors into believing that these deductions — taken in February 1999 — were for damaged and outdated products. As a result, Rite Aid overstated its FY 1999 pre-tax income by $30 million.

Source: http://www.sec.gov/news/press/2002-92.htm

123

Rite Aid’s (Cont.)

• Vendor Rebates — On the last day of FY 1999, Bergonzi directed that Rite Aid record entries to reduce accounts

payable and cost of goods sold by

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

Source: http://www.sec.gov/news/press/2002-92.htm

124

Rite Aid’s (Cont.)

$17 million from a litigation

settlement. Recognition was improper, as the settlement was not in fact consummated in legally binding form during the relevant period.

Source: http://www.sec.gov/news/press/2002-92.htm

125

Rite Aid’s (Cont.)

• "Dead Deal" Expense — Rite Aid routinely incurred expenses for legal services, title searches, architectural drawings and other items relating to sites considered but later rejected for new stores. Rite Aid capitalized these costs at the time they were incurred. Rite Aid subsequently determined not to construct new stores at certain of these sites. Under Generally Accepted Accounting Principles, Rite Aid should have written off the pertinent "dead deal" expenses at the time that it decided not to build on each specific site. Such write-offs would have reduced reported income in the relevant periods. Instead, Rite Aid continued to

carry these items on its balance

sheet as assets. By the end of FY 1999, the accumulated dead deal expenses totaled $10.6 million.

Source: http://www.sec.gov/news/press/2002-92.htm

126

Rite Aid’s (Cont.)

• "Will-Call" Payables — Rite Aid often received payment from insurance carriers for prescription orders that were phoned in by customers but never picked up from the store. Rite Aid recorded a "will-call" payable that represented the total amount of these payments received from insurance carriers, that Rite Aid would be obligated to return to the carriers. In the fourth quarter of FY 1999, Rite Aid

improperly reversed this $6.6

million payable. When Rite Aid's general counsel learned of this reversal, he directed that the payable be reinstated. Bergonzi acquiesced in the reinstatement, but then secretly

directed that other improper

offsetting entries be made which had the same effect as reversing the payable.

Source: http://www.sec.gov/news/press/2002-92.htm

127

Rite Aid’s (Cont.)

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

Source: http://www.sec.gov/news/press/2002-92.htm

128

Rite Aid’s (Cont.)

Related-Party Transactions with Grass

Grass caused Rite Aid to fail to

disclose his personal interest in

three properties that Rite Aid leased as store locations. Rite Aid was obligated to disclose these interests as related party transactions. Even after press reports in early 1999 prompted Rite Aid to issue corrective disclosure regarding these matters, Grass continued to conceal and misrepresent the facts, which caused Rite Aid's corrective disclosures to be false.

Source: http://www.sec.gov/news/press/2002-92.htm

129

Rite Aid’s (Cont.)

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

Source: http://www.sec.gov/news/press/2002-92.htm

130

Rite Aid’s (Cont.)

Fabrication of Minutes by Grass

In September 1999, when Rite Aid was in perilous financial condition, and in order to obtain a bank line of credit to keep the company afloat, Grass caused minutes to be prepared for a meeting of Rite Aid's Finance Committee, stating that the Committee had authorized the pledge of Rite Aid's stock in PCS Health Systems Inc. as collateral. Grass signed these

minutes even though he knew that no such meeting occurred and the pledge was not authorized.

Source: http://www.sec.gov/news/press/2002-92.htm

131

Which of these statements are false?

a. A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting.

b. Personal guarantees of debt of a company that are significant to one’s personal net worth is an example of a pressure/incentive for fraudulent financial reporting.

c. A heavy concentration of one’s wealth in a particular company would be an example of a rationalization condition for fraudulent financial reporting.

d. An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting.

e. Anticipated future layoff would be an example of an incentive to misappropriate assets.

f. A large amount of cash on hand would be an example of a rationalization to misappropriate assets.

g. Inadequate internal controls is an example of an opportunity to misappropriate assets.

132

Which of these statements are false?

a. A high degree of competition accompanied by declining margins would be an example of an opportunity for fraudulent financial reporting.

F (I/P)

b. Personal guarantees of debt of a company that are significant to one’s personal net worth is an example of a pressure/incentive for fraudulent financial reporting.

c. A heavy concentration of one’s wealth in a particular company would be an example of a rationalization condition for fraudulent financial reporting.

F (I/P)

d. An excessive interest by management in maintaining a company’s stock price is an example of rationalization for fraudulent financial reporting.

e. Anticipated future layoff would be an example of an incentive to misappropriate assets.

f. A large amount of cash on hand would be an example of a rationalization to misappropriate assets.

F (O)

g. Inadequate internal controls is an example of an opportunity to misappropriate assets.

133

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

134

How Fraud is Discovered-Singapore 2002

• • • • •

Management investigation (41%).

Anonymous letter/informant (35%).

Internal controls (33%).

By chance (26%).

Internal auditor review (12%).

Source

KPMG Fraud Survey Report, 2002.

135

Singapore Fraud Survey, 2002

Management investigation, informant notification, and good internal controls rank highly as methods of fraud detection.

76% of the frauds were perpetrated internally [management (41%) and non management employees (35%)] Poor internal controls, override of internal controls, and collusion between employees and third parties were the top three reasons cited as to why frauds were allowed to take place “Red flags,” which should have alerted respondents to the fraud, were present and ignored in 29% of cases.

The main reason for not reporting fraud was lack of evidence The typical fraudster is predominantly male within the age group of 26-40 years and has an annual income between $15,000 to $30,000. 44% of fraudsters have tertiary educational qualifications.

136

Rationalization

Sherron Watkins provides an excellent comment about

rationalization

with respect to Enron’s Jeff Skilling and Andy Fastow. At what point did they turn crooked? “But there is not a defining point where they became corrupt. It was one small step after another, with more and more rationalizations. There was a

slow erosion of values over time

.” Source: Pamela Colloff, “The Whistle Blower,”

Texas Monthly

, April 2003, p. 141.

137

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.

138

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.

139

More Brainstorming

• Best to write ideas down, rather than say them out loud.

• Take plenty of breaks.

• Best ideas come at the end of session.

• Important to not define the problem too narrow or too broad.

• Goal should be quantity, not quality.

• Geniuses develop their most innovative ideas when they are generating the greatest number of ideas.

• No such things as bad ideas.

• Many companies are great at coming up with good ideas, but lousy at evaluating an implementing them.

Source: A.S. Wellner, “Strategies: A Perfect Brainstorm,”

Inc. Magazine

, October 2003, pp. 31-35 140

Potential Pitfalls

• • • •

Group domination

: one or two participants dominating the process can quickly squelch the creative energies of the groups as a whole, reducing the likelihood the team will identify any actual fraud risks .

Social loafing

: participants disengage from the process, expecting other team members to pick up the slack.

Groupthink

: team members become so concerned with reaching consensus that they fail to realistically evaluate all ideas or suggestions.

Group shift

: avoid allowing the team to take an extreme position on fraud risk.

Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud Risks,”

Journal of Accountancy

, December 2003, pp. 33-34.

141

Three Types of Brainstorming

Open brainstorming:

unstructured; few rules; free-for-all; someone should record ideas.

Round-robin brainstorming

: start with no talking, silent period; assigned homework ahead; each individual presents own ideas; each member has a turn.

Electronic brainstorming

: shortens meetings, increases ideas, and reduces personalizing ideas because an idea’s author remains anonymous.

Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud Risks,”

Journal of Accountancy

, December 2003, pp. 33-34.

142

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.

143

Overriding Internal Controls?

Saddam’s son presented a note with his father’s signature to the Iraqi Central Bank which resulted in a world record bank theft of $1 billion. A team of workers took two hours to load $900 million in U.S. $100 bills and $100 million in Euros into three tractor trailer trucks. This dirty deed was done before the employees came to work.

Was this a straight bank robbery or an example of overriding internal controls by a high official

144

Bias Assumptions

• • • • There are almost as many oil/gas reserve

definitions

countries.

as there are During the first week of January 2004, Royal Dutch/Shell Group slashed its estimates of oil reserves by 20% or about 3.9 billion barrels of oil .

Stock fell 9%.

Shell, Exxon/Mobil, and Chevron/Texaco make the estimates

themselves

Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil Reserves Prove Unrefined,”

Wall Street Journal

, January 14, 2004, p. C-4 145

Shell Board Kept In the Dark

• • • • • One memo drafted on February 11, 2002, warned that about one billion barrels of oil-equivalent reserves appeared

not

to be in compliance with SEC guidelines.

Board learned of information only in early January 2004.

Chairman Sir Philip was

ousted

early March 2004.

in Most of the misstated reserves were recorded from 1997 to 2000, when Sir Philip was in change of exploration and production.

Oil/gas reserves were increased (not by discovery) by changing its accounting.

Source: Stephen Labaton and Jeff Gerth, “At Shell, New Accounting and Rosier Oil Outlook,”

New York Times

, March 12, 2004, pp. A-1 and C-4.

146

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.

147

Expensing Stock Options: Black Scholes Model If risk-free rate higher Option value higher If dividend yield higher Option value lower If expected life longer Option value higher If volatility higher Option value higher

148

Most Firms Underreport

• They fool around with the assumptions to keep fair value down.

• Only about 10% are truth tellers.

• Most companies are underreporting volatility.

• Only 8 firms did not use Black-Scholes.

Source: L.D. Holder, W. Mayew, M.C. McAnally, and C.D. Weaver, “Employee Stock Option Valuation: How Reliable are Black-Scholes Disclosures,” working papers, March 5, 2004 149

Journal Entries at Year End

 Apparently, Arthur Andersen was given

limited access

to the general ledger at WorldCom, which had a $11 billion fraud (largest accounting fraud in history). Most of the original entries for online costs were

properly placed

into expense accounts.

 However, near the end of the period these entries were

reversed

. One such entry was as follows: Other Long-term Assets $629,000,000 Construction in Progress $142,000,000 Operating Line Costs $771,000,000 The support for this entry was a

yellow post-it note

 WorldCom’s outside auditors refused to respond to some of Cynthia Cooper’s questions and told her that the firm had approved of some of the accounting methods she questioned.

150

Yellow Peril

•

Fourth Quarter of 1999:

"The $239 million [international line cost accrual release] was entered in WorldCom's general ledger ... The only support recorded for the entry was '$239,000,000,' written on a Post it Note and attached to a printout of the entry." •

Third Quarter of 2001:

"Myers gave Sethi a Post-it Note that said 'Assume $742 million.' Later, Myers and Sethi had a conversation confirming that $742 million identified on the Post-it Note was the line cost capitalization entry for the quarter.” http://thestreet.com/pf/markets/dumbestgm/10093441.html

151

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

152

WorldCom Fraud Massive

 At least

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

access.

complain about denied  Cynthia Cooper ignored her boss and started doing financial audits, looking at the financial information the company was reporting.

Source: Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Was Widespread,”

Wall Street J.

, June 10, 2003, p. 3.

153

WorldCom Fraud Massive (contd.)

 David Schneedan, CFO at a division, refused to release reserves twice.

 E-mail from David Myers, WorldCom comptroller, to Schneedan: “I guess the only way I am going to get this booked is to fly to DC and book it myself. Book it right now; I can not wait another minute.”  Buddy Gates [director of general accounting] said to an employee complaining about a large accounting discrepancy: “Show those numbers to the damn auditors, and I’ll throw you out the f_____ window.”

Source:

Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Was Widespread,”

Wall Street J.

, June 10, 2003, p. 3.

154

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.

155

How Fraud Took Place?

• Operating Expenses to Assets?

-Mr. Sullivan’s directions affected the income statement: Revenues xxx (no change) COGS xxx (no change) Operating Expenses: Fees paid to lease other companies phone networks: xxx (Huge Decrease) Computer expenses: xxx (Huge Decrease) NET INCOME xxx (Huge Increase) © 2003 by the AICPA 156

How the Fraud took place?

•

Operating Expenses to Assets?

-Mr. Sullivan’s directions affected the balance sheet: Assets: Computer assets+ xxx (Huge Increase) Leasing assets+ xxx (Huge Increase) Liabilities xxx (no change) Stockholders Equity: Retained Earnings + xxx (Huge Increase) © 2003 by the AICPA

=HAPPY INVESTORS

157

How the Fraud took place?

•

Operating Expenses into Assets?

-WorldCom’s journal entry for $500 million in computer expenses: Computer Assets 500 million Cash 500 million

The documents supporting the expenses were not found !

How the Fraud took place?

• Huge losses turned into enormous profits. – $1.38 billion in net income in 2001 • Inflated the company’s value in its assets – “Essentially, they were buying paper clips and recording them as buildings” © 2003 by the AICPA 159

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.

160

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.

161

Falsification

Enron’s crude oil trading operation based in Valhalla, New York was

fictitious

, according to one auditor. “It was pretend. It was a playhouse. There were a lot of expensive people working there, and it was impressive looking, but it wasn’t legitimate work. The traders were keeping

two sets of books

, one for legitimate purposes – to show Enron and auditors from Arthur Andersen – one other set in which to record their ill-gotten gains.

Source: Mimi Swartz and Sherron Watkins,

Power Failure

, New York: Doubleday, 2003, p.31.

162

SAS No. 99 Ways to Overcome the Risk of Management Override of Controls



Examining journal entries and other adjustments, especially near the end of the quarter.

 

Reviewing accounting estimates for bias, including a retrospective review of significant management estimates.

Evaluating the business rationale for significant unusual transactions.

163

Examine Journal Entries

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

$1.2

billion.

HealthSouth allegedly

overstated

by at least $

profits billion by billing Medicare for physical – therapy services the company never performed. The company submitted

falsified documents

to Medicare to verify the claims over 10 years.

E&Y collected

$2.6

million from HealthSouth (as audit-related fees) to check the cleanliness and physical appearances of 1,800 facilities. A 50- point checklist was used by dozens of junior level accountants in unannounced visits. For 2000, E&Y audit fee, other fees,

$2.65

million.

$1.03

million; 164

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.

165

SAS No. 99 Types of Fraud

Unlike errors, fraud is intentional and most often involves deliberate concealment of facts by mgt., employees, or third parties  Fraudulent Financial Reporting: does not follow GAAP (e.g., recording fictitious sales)  Misappropriation of Assets: embezzling receipts, stealing assets, or causing an entity to pay for goods or services that have not been received.

Often accomplished by false or misleading records or documents, possibly created by circumventing internal controls.

166

Comparison of Auditing and Forensic Examination Issue

Timing Scope Objective Presumption

Audit

Recurring: audits are conducted on a regular basis General: collection of sufficient, competent data to support the opinion rendered.

Opinion: express opinion on financial statements Methodology Audit techniques applied primarily to financial data.

Forensic Examination

Nonrecurring: fraud examinations are nonrecurring. They are conducted only with sufficient predication.

Specific: the fraud examination is conducted to resolve specific allegations.

Affix blame: determine if fraud occurred and who is responsible. Adversarial in nature.

Fraud examination techniques include document examination, public record searches, and interviews.

Professional skepticism Proof to support or refute an allegation of fraud.

Source:

Apostolou, B, “Course 992003: Fundamentals of Fraud Detection and Prevention,” www.education.smartpros.com

, 1998.

167

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.

168

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.

169

The Good, The Biased, and Ugly Results

 Auditors are vulnerable to “unconscious bias,” because accounting is subjective and the relationship between accounting firms and clients are often tight (or internal auditors v. audited units).

 Auditor may

unintentionally distort

numbers in ways to

mask

the a company’s true financial picture [or a unit].

 Psychological studies show that our desires have a powerful influence on the ways we interpret information.

 We tend to

discount

information that contradicts the conclusions we wish to reach.



Five

structural aspects of accounting create opportunity for bias to influence judgment.

     Ambiguity.

Attachment (They hire and fire us).

Approval.

Familiarity (Not willing to harm friends).

Discounting (focus on immediate events).

Source

: M.H. Bazerman et.al, “Why Good Accountants Do Bad Audits,”

Harvard Business Review

, November 2002.

170

Public Company Accounting Oversight Board (PCAOB)

• • The Sarbanes-Oxley Act of 2002 created a new,

five-member

oversight group called the PCAOB.

• The PCAOB is empowered to

set accounting standards

that establish auditing, quality control, and ethical standards for accountants. • The PCAOB is also empowered to

adopt or amend standards

issued or recommended by private accounting industry groups or to adopt its own standards independent of such private industry standards or recommendations.

http://www.pcaob.us

, to get free subscription to PCAOB Update.

171

Assessment of Internal Controls

The PCAOB believes that an attestation is an expert’s communication of a conclusion about the

reliability of someone else’s assertion

(e.g., a financial statement audit is a form of attestation). S-O Act Section 404(b) states that an auditor’s attestation of management’s assessment of internal controls is

not a separate engagement

. Instead, PCAOB states that an “integrated audit results in two audit opinions: one on internal control over financial reporting and one on the financial statements.” ----------------------------------------------------- PCAOB 2004 budget: $103 million.

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

172

Internal Controls

PCAOB states that internal controls over financial reporting includes company policies and those procedures “designed and operated to provide

reasonable assurance

- -a high, but not absolute, level of assurance - - about the reliability of a company’s financial reporting and its process for preparing financial statements in accordance with generally accepted accounting principles.” Also included are those policies and procedures for “the maintenance of accounting records, the authorization of receipts and disbursements, and the safeguarding of assets.” Even the PCAOB believes that internal controls “

cannot provide absolute assurance of achieving financial reporting objectives because of inherent limitations

(e.g., a process that involves human diligence and compliance can be intentionally circumvented).” Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.

173

The Costs and Benefits of Internal Controls

Reliable financial reporting adds value and also can offset risks in a manner that is cost-beneficial to a company.Evaluating a company’s internal control over financial reporting is sometimes

costly

, but also has many

far-reaching benefits

Some of the benefits of a company developing, maintaining, and improving its system of internal controls include identification of cost-effective procedures, reducing costs of processing accounting information, increasing productivity of the company’s financial function, and simplifying financial control systems.

The

primary benefit

, however, is to provide the company, its management, its board and audit committee, and its owners, and other stakeholders with a reasonable basis to rely on the company’s financial reporting.

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

174

Auditing Internal Controls

The audit of internal controls includes these steps: Planning the audit.

Evaluating the process management used to perform its assessment of internal control effectiveness.

Obtaining an understanding of the internal controls.

Evaluating the effectiveness of both the design and operation of the internal controls.

5. Forming an opinion about whether internal control over financial reporting is effective.

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

175

Anti-Fraud Program

An auditor must perform “company-wide anti-fraud programs and controls and work related to other controls that have a pervasive effect on the company,

such as general controls over the company’s electronic data processing

.” Further, the auditor must “obtain directly the ‘principle evidence’ about the effectiveness of internal controls.” Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.

----------------------------------------------------------------------------------- The world is not the way they tell you it is.

Adam Smith, in the “Money Game.” 176

Walkthroughs

An auditor must perform “walkthroughs” of a business’ significant processes. PCAOB suggest that an auditor should confirm his or her understanding by performing procedures that include making

inquires of

and

observing the personnel that actually perform the controls

; reviewing documents that are used in, and that result from, the application of the controls; and comparing supporting documents (for example, sales invoices, contracts, and bills of lading) to the accounting records.” According to PCAOB, in a walkthrough an auditor traces “company transactions and events – both those that are routine and recurring and those that are unusual – from origination, through the company’s accounting and information systems and financial report preparation processes, to their being reported in the company’s financial statements.

” Auditors should perform their own walkthroughs which provides auditors with appropriate evidence to make an intelligent assessment of internal controls.

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

177

PCAOB On Walkthroughs

• “An auditor should perform at least one walkthrough for each major class of transactions.” • Walkthroughs cannot be achieved secondhand.

• Auditors should be able to use judgment in considering risk and materiality to determine which transactions and events within a given significant and process to walk through.

• An auditor might be able to achieve the objectives of a walkthrough by performing a combination of procedures, including inquiry, inspection, observation, and reperformance of procedures; however, performing a walkthrough represents the most efficient and effective means of doing so. The auditor’s work on the control environment and walkthroughs is an important part of the principal evidence that the auditor must obtain himself or herself.

PCAOB Release 2004-001 178

Slot Machine Example

179

Revenue Flows

© D.L. Crumbley 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: one 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.

181

Significant Accounts: PCAOB

The auditor should identify significant accounts disclosure-component level. Determining specific controls to test begins by identifying significant accounts and disclosures within financial statements. When identifying significant accounts, the auditor should evaluate both quantitative and qualitative factors.

An account is significant if there is more that a remote likelihood that the account could contain misstatements that individually, or when aggregated with others, could have a material effect on the financial statements, considering the risks of both overstatement and understatement.

PCAOB Release 2004-001 182

Levels of Risk

Different types of major classes of transactions have different levels of inherent risk associated with them and require different levels of management supervision and involvement. For this reason, the auditor might further categorize the identified major classes of transactions by transaction type: routine , non-routine , and estimation .

• Routine transactions are recurring financial activities reflected in the accounting records in the normal course of business (for example, sales, purchases, cash receipts, cash disbursements, payroll).

• Non-routine transactions are activities that occur only periodically (for example, taking physical inventory, calculating depreciation expense, adjusting for foreign currencies). A distinguishing feature of non-routine transactions is that data involved are generally not part of the

Level of Risk

• Estimation transactions are activities that involve management judgments or assumptions in formulating account balances in the absence of a precise means of measurement (for example, determining the allowance for doubtful accounts, establishing warranty reserves, assessing assets for impairment).

PCAOB Release 2004-001 184

© D.L. Crumbley Identifying Significant Processes and Major Classes of Transactions An auditor should identify each significant process over each major class of transactions affecting significant accounts or groups of accounts. Major classes of transactions are those classes of transactions that are significant to the company's financial statements. For example, at a company whose sales may be initiated by customers through personal contact in a retail store or electronically through use of the internet, these types of sales would be two major classes of transactions within the sales process if they were both significant to the company's financial statements. As another example, at a company for which fixed assets is a significant account, recording depreciation expense would be a major class of transactions.

PCAOB Release 2004-001.

185

Performing Walkthrough: PCAOB

An auditor should perform at least one walkthrough for each major class of transactions. In a walkthrough, the auditor traces a transaction from origination through the company's information systems until it is reflected in the company's financial reports.

Walkthroughs provide the auditor with evidence to: • Confirm the auditor's understanding of the process flow of transactions; • Confirm the auditor's understanding of the design of controls identified for all five components of internal control over financial reporting, including those related to the prevention or detection of fraud; PCAOB Release 2004-001 186

© D.L. Crumbley Performing Walkthroughs: PCAOB (cont.) • Confirm that the auditor's understanding of the process is complete by determining whether all points in the process at which misstatements related to each relevant financial statement assertion that could occur have been identified; • Evaluate the effectiveness of the design of controls; and • Confirm whether controls have been placed in operation.

PCAOB Release 2004-001.

187

Reducing External Auditing Fees: PCAOB

An auditor's own work must provide the principal evidence for the auditor's opinion is one of the boundaries within which the auditor determines the work he or she must perform himself or herself in the audit of internal control over financial reporting.

In all audits of internal control over financial reporting, an auditor must perform enough of the testing himself or herself so that the auditor's own work provides the principal evidence for the auditor's opinion. The auditor may, use the work of others to alter the nature, timing, or extent of the work he or she otherwise would have performed. For these purposes, the work of others includes relevant work performed by internal auditors, company personnel (in addition to internal auditors), and third parties working under the direction of management or the audit committee that provides information about the effectiveness of internal control over financial reporting.

188

Reducing External Auditing Fees: PCAOB

As these factors increase in significance, the need for the auditor to perform his or her own work on those controls increases. As these factors decrease in significance, the need for the auditor to perform his or her own work on those controls decreases .

• The materiality of the accounts and disclosures that the control addresses and the risk of material misstatement.

• The degree of judgment required to evaluate the operating effectiveness of the control (that is, the degree to which the evaluation of the effectiveness of the control requires evaluation of subjective factors rather than objective testing).

• The pervasiveness of the control. PCAOB Release 2004-001 189

Reducing External Auditing Fees: PCAOB (cont.)

• The level of judgment or estimation required in the account or disclosure.

• The potential for management override of the control.

PCAOB Release 2004-001 190

Reducing External Auditing Fees: PCAOB

• If internal auditors have performed an extensive amount of relevant work and the auditor determines they possess a high degree of competence and objectivity, the auditor could use their work to the greatest extent an auditor could use the work of others.

• On the other hand, if the internal audit function reports solely to management, which would reduce internal auditors' objectivity, or if limited resources allocated to the internal audit function result in very limited testing procedures on its part or reduced competency of the internal auditors, the auditor should use their work to a much lesser extent and perform more of the testing himself or herself.

191

Reducing External Auditing Fees: PCAOB

• The auditor should test some of the work of others to evaluate the quality and effectiveness of the work. The auditor's tests of the work of others may be accomplished by either (a) testing some of the controls that others tested or (b) testing similar controls not actually tested by others.

PCAOB Release 2004-001 192

Examples of Using Works of Others : PCAOB

• Since there are significant risk of misstatement for the period-end reporting process, be careful using the work of others (except possibly internal auditors).

• Program change controls over routine maintenance charges: O.K.

• Controls to detect attempts to override controls that prevent unauthorized journal entries: careful.

• Controls over the calculation of depreciation: O.K.

• Many controls over accounts payable, including cash disbursements: O.K.

193 PCAOB Release 2004-001

© D.L. Crumbley Significant Deficiencies and Material Weaknesses: PCAOB • External auditors to communicate in writing to the company’s audit committee all significant deficiencies and material weaknesses found.

• Auditors must tell management in writing of all control deficiencies found.

• A material weakness in internal control over financial reporting requires an adverse opinion.

• A material weakness in internal control is a reportable condition in which the design or operation of one or more of the internal control components does not reduce to a relatively low level the risk that misstatements caused by error or fraud in amounts that would be material in relation to the financial statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.

194

© D.L. Crumbley Significant Deficiencies and Material Weaknesses: PCAOB • A significant deficiency (same as reportable conditions) is defined as follows: Matters coming to the auditor’s attention that, in his judgment, should be communicated to the audit committee because they represent significant deficiencies in the design or operation or internal control, which could adversely affect the organization’s ability to initiate, record, process, and report financial data consistent with the assertions of management in the financial statements.

PCAOB Release 2004-001 195

Strong Indicators of Material © D.L. Crumbley Weaknesses and Defacto Significant Deficiencies • Restatement of previously issued financial statements to reflect the correction of a misstatement.

• Identification by the auditor of a material misstatement in financial statements in the current period that was not initially identified by the company’s internal control over financial reporting (even if management subsequently corrects the misstatement).

• For larger, more complex entities, the internal audit function or the risk assessment function is ineffective.

• For complex entities in highly regulated industries, an ineffective regulatory compliance function.

• Identification of fraud of any magnitude on the part of senior management.

196

Material Weaknesses

material weaknesses

exist in internal controls:

Ineffective oversight

of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee.

Material misstatement

in the financial statements not initially identified by the company’s internal controls.

Significant deficiencies

that have been communicated to management and the audit committee but that remain uncorrected after a reasonable period of time.

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

197

Pre SAS 99 Consulting Standards Auditing Standards

Traditional Investigation Traditional Audit © D.L. Crumbley

Consulting Standards Post SAS 99 Auditing Standards

Traditional Investigation Forensic Procedures in the Audit Environment SAS 99

Source: Ronald L. Durkin et.al,

Litigation and Dispute Resolution Services Subcommittee,

Incorporating Forensic Procedures in an Audit Environment, AICPA, 2003,

Fraud Task Force .

198

Steps Toward Forensic Audit

 Traditional audit [forensic techniques & fraud prevention program].

 If suspect fraud, bring

in-house forensic talent

into the audit.

 If no in-house talent or fraud complex, engage an

outside forensic accountant

(e.g., Cr.FA, CFFA, or CFE).

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

199

AICPA Audit Committee Toolkit

“In some situations, it may be necessary for an organization to look beyond the independent audit team for expertise in the fraud area. In such cases, CPA

forensic accounting consultants can provide additional assurance or advanced expertise

, since they have special training and experience in fraud prevention , deterrence , investigation , and detection .

Forensic accounting consultants may also

provide fresh insights into the organization’s operation

, control systems, and risks. The work of forensic accounting consultants may also provide comfort for the organization’s CEO and CFO, who are required to file certifications under Sarbanes-Oxley.” 200

Types of Forensic Engagements

 Determine if fraud is occurring.

 Support criminal or civil action against dishonest individuals.

 Form a basis for terminating a dishonest employee.

 Support an insurance claim.

 Support defense of an accused employee.

 Determine whether assets or income were hidden by a party to a legal proceeding (such as a bankruptcy or divorce).

 Identify internal controls to prevent it from happening again.

Source: D.R. Carmichael, et. al,

Fraud Detection

, 5 th , Fort Worth: Practitioners Publishing, 2002, p. 2 – 4.

201

Two Major Types of Forensic Investigations

Reactive

: Some reason to suspect fraud, or occurs after a significant loss.

Proactive

: First, preventive approach as a result of normal operations (e.g., review of internal controls or identify areas of fraud exposure). There is no reason to suspect fraud. Second, to detect indicia of fraud.

Source: H.R. Davia, “ Fraud Specific Audting,”

Journal of Forensic Accounting,

Vol. 111, 2002, pp. 111-120 202

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.] 203

Guilt Pyramid

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

204

Koletar’s Murder vs. Fraud Comparison

 Fraud is committed for only one reason - greed.

 Fraud is committed in the workplace, where there should be

tighter controls

 Those committing fraud return to the scene of their crime time and time again, often for many years.

 Fraud tends to be

accumulative

, getting bigger with time.

 Fraudsters wear the same employee badges we do and eat in the same cafeterias.

 Normally, there is a victim available with a fraud, with detailed knowledge about the perp, technique, and motive.

 Since the penalties are less severe for fraud, the possibilities for cooperation is increased.

Source: J.W. Koletar,

Fraud Exposed

, John Wiley & Sons, 2003, p. 153.

205

How Fraud Occurs

Source: KPMG Fraud Study

206

Types of Fraud

Source: KPMG Fraud Study

207

Certain Fraud is Increasing

Source: KPMG Fraud Study

208

Measures Helpful in Preventing Fraud

1. Strong Internal Controls

(1.62)

2. Background checks of new employees

(3.70)

3. Regular fraud audit

(3.97)

4. Established fraud policies

(4.08)

5. Willingness of companies to prosecute

(4.47)

6. Ethical training for employees

(4.86)

7. Anonymous fraud reporting mechanisms

(5.02)

8. Workplace surveillance

(6.07) 1 = Most effective

8 = Least effective Source: 2002 Wells Report 209

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.” 210

SAS No. 99 Recommendations

• •

Brainstorming.

Increased emphasis on professional skepticism.

• • •

Discussions with management.

Unpredictable audit tests.

Responding to management override of controls.

211

Internal Auditor’s Fraud Responsibility

The internal auditor should have sufficient knowledge to identify the indicators of fraud but is not expected to have the expertise of a person whose primary responsibility is detecting and investigating fraud .

Source: Implementation Standard 1210. A2 (Assurance Engagements).

212

Internal Auditors and Fraud Detection

The Institute of Internal Auditors’ Due Professional Care Standard (Section 280) assigns the internal auditor the task of

assisting in the control of fraud

by examining and evaluating the adequacy and effectiveness of the internal control system. However, Section 280 says that

management has the primary responsibility

for the deterrence of fraud, and management is responsible for establishing and maintaining the control systems. In general, internal auditors are more concerned with employee fraud than with management and other external fraud.

213

When Fraud Is Discovered

Notify

management or the board when the incidence of significant fraud has been established to a reasonable certainty.

If the results of a fraud investigation indicate that previously undiscovered fraud materially adversely affected previous financial statements, for one or more years, the internal auditor should

inform appropriate management

and the audit committee of the board of directors of the discovery.

A written report should include

all

findings, conclusions, recommendations, and corrective actions taken.

A draft of the written report should be

submitted to legal counsel

for review, especially where the internal auditor chooses to invoke client privilege.

214

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

215

Audit Committee

© D.L. Crumbley The audit committee is the subcommittee of an organization’s board of director’s charged with overseeing the organization’s financial reporting and internal control processes. The audit committee’s biggest responsibility is monitoring the component parts of the audit process.

---------------------------------------------- An audit committee should engage forensic accountants as a matter of right, rather than because of allegations.

216

CEO Duality

Eight of the ten recent scandals had board chairs who were also CEO: 1.Enron

5. HealthSouth 2.Adelphia

3.Tyco

4.Waste Management 6. Quest 7. Homestore 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.

217

Audit Tests

The

Panel on Audit Effectiveness

recommended that surprise or unpredictable elements should be incorporated into audit tests, including: –

Recounts

of inventory and unannounced visits to locations –

Interviews

of financial and nonfinancial client personnel in different locations –

Requests for written confirmations

from client employees regarding matters about which they have made representations to the auditors –

Tests of accounts

not normally preformed annually –

Tests of accounts

traditionally or frequently deemed “low risk” 218

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.” 219

SKEPTICISM

Ronald Reagan said with respect to Russia, “

Trust, but verify

.” FA’s motto should be “

Trust no one; question everything; verify

.”

220

Example of Management Override/Skepticism

“And second, I want to tell you that you and your people did nothing short of uncovering a quarter-of-a-million –dollar embezzling scheme that Loomis [the controller of the entity who had a gambling problem] was involved in.” Looking around the room, he explained to the other partners how Pat [an auditor] investigated the mysterious check made out to Richard Loomis and how he used the bank and Nationwide Express to get the statement back to the unsuspecting controller.

He told them that Pat had talked privately to Gordon Banks [Executive Director], explaining to him how Loomis had switched the checks before giving the statement back to Pat.

“After Pat left Banks’ office, Gordon called me personally and told me that he needed my help. He wanted a fresh pair of eyes to look over what Pat showed him.

“So Russell and I drove down there the same day to meet Gordon. He showed us the check made payable to the post office, and it appeared to have cleared the bank. And sure enough, it was for the same amount and had the same check number as the check that did, in fact, clear the bank with Loomis as the payee. Fortunately, Pat made a copy of the check before Loomis had a chance to destroy it.” “What did you do next?” Bob Ramsey asked. He and the others were mesmerized.

“I asked Gordon to get a few old bank statements for us, and Russell and I pulled out every check payable to the post office, and the three of us went to the bank.” “And?” “We asked the bank to pull their photocopy of each check that we had payable to the U.S. Postal Service. There was the proof. The bank’s copies of several of the checks had the same number and were for the same amount, but had Loomis as the payee.” 221

“But you said that the checks had the same check numbers, and appeared to have cleared the bank. How did he manage to do that?” Ramsey asked again, astonished.

“Actually, it was very simple once it was uncovered. As it turned out, Loomis ordered two sets of identically numbered checks from two different check printing companies. They looked exactly the same.” “And?” “He ran checks routinely on his office computer. Every week or so, he would make one check out to the U.S. Postal Service and, of course not mail it because the post office had nothing to do with it. He’d go home with a copy of the diskette he used to make out the checks in the office. There he used his name as the payee on that particular check, printed the check on his printer, forged a signature, and cashed the check at a different bank, of course. Because he got the bank statements, he only had to pull out the check he cashed, destroy it, and replace it with the original check from the bank statement, payable to the post office.” “But you said that it looked like the check had been cashed and it had a receipt. How did he manage that?” one of the other partners asked.

“Simple. He had a friend who worked at the post office in on the scheme. His friend endorsed the check with the post office’s actual endorsement stamp and then gave him a real post office receipt.” “But how about the bank’s encoding information on the bottom right front of the check and their clearinghouse stamps on the back. How did he fake that?” Bob Ramsey asked, incredulous.

“That wasn’t hard,” Autry continued, “He had duplicates of clearinghouse stamps made at a rubber stamp company. They’ll make just about anything you need. He stamped them himself, and they looked authentic enough to fool anyone.” Source: E.J. McMillan,

The Audit

, Churchton, MD: Harwood Publishing, 2000, pp. 36-39.

222

SAS No. 99: Questions for Management

      Whether management has knowledge of any fraud that has been perpetrated or any alleged or suspected fraud.

Whether management is aware of allegations of fraud, for example, because of communications from employees, former employees, analysts, short sellers, or other investors.

Management’s understanding about the risks of fraud in the entity, including any specific fraud risks the entity has identified or account balances or classes of transactions for which a risk of fraud may be likely to exist.

Programs and controls the entity has established to mitigate specific fraud risks the entity has identified, or that otherwise help prevent, deter, and detect fraud, and how management monitors those programs and controls.

For an entity with multiple locations, (a) the nature and extent of monitoring of operating locations or business segments, and (b) whether there are particular operating locations or business segments for which a risk of fraud may be more likely to exist.

Whether and how management communicates to employees its views on business practices and ethical behavior.

223

BE SKEPTICAL

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.

224

Think Like A Crook

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.

225

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?

226

Be a Scientist

He had to think like a scientist, not a detective. Detectives move on a linear plane. They move from clue to clue and then put together the picture. But sometimes the clues added up to the wrong picture.

Pierce was a scientist. He knew he had to go with what had always worked for him. He had to approach this the way he had approached and solved the question of the car search. From the bottom. Find the logic gateways, the places where the wires crossed. Take apart the frame and study the design, the architecture.

Throw out linear thinking and approach the subject from all new angles. Look at the subject matter and then turn it and look at it again. Grind it down to a powder and look at

it under the glass.

Life was an experiment conducted under uncontrolled conditions. It was one long chemical reaction that was as unpredictable as it was vibrant. But this setup was different. It had occurred under controlled circumstances. The reactions were predicted and expected. In that he knew was the key. That meant it was something that could be taken apart.

Source: Michael Connelly,

Chasing The Dime

, Hieronymous, Inc., 2002, p.337.

227

See Things Differently

© D.L. Crumbley Can’t see a way out? Take the time to see things differently. See the two white swans instead of the one black one. See the slice of pie instead of the pie with the slice missing.Flip the Necker cube outward instead of inward. Master the gestalt. It will make you free. (p.327).

-------------------------------------------------------- “Must always look for butterfly. In the middle of nothing, thing that does not belong. In cascade of digital transfer codes, you ask: is there butterfly? Yes. Always butterfly. Flap, flap, flap. So. You must know how to look.” (pp. 242 243) Robert Ludlum,

The Janson Directive,

New York: St. Martin’s Paperback, 2002.

228

Thinking as a Forensic Auditor

The Iceberg Theory of Fraud Overt Aspects Hierarchy Financial Resources Goals of the Organization Skills and Abilities of Personnel Technological State Performance Measurement Structural Considerations Water line Covert Aspects Attitudes Feelings (Fear, Anger, etc.) Values Norms Interaction Supportiveness Behavioral Considerations Satisfaction

Source: G.J. Bologna and R.J. Lindquist,

Fraud Auditing and Forensic Accounting

, 2 nd Edition, New York: John Wiley, 1995, pp. 36-37 229

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.

230

Investigative Techniques

“Facts weren’t the most important part of an investigation,

the glue was

. He said the glue was made of instinct, imagination, sometimes guesswork and most times just plain luck.” (p. 163).

------------------------------------------------- “In his job, he [Bosch] learned a lot about people from their rooms, the way they lived. Often the people could no longer tell him themselves. So he learned from his observations and believed that he was good at it.” (p. 31).

------------------------------------------------- Michael Connelly,

The Black Ice

, St. Martin’s Paperbacks, 1993.

231

Three Major Phases of Fraud

1. The Act itself.

2. The concealment of the fraud (in financial statements).

3. Conversion of stolen assets to personal use.

One can study any one of these phases.

Examples: Things being stolen: conduct surveillance and catch perp.

If liabilities being hidden, look at financial statements for concealment.

If perp has unexpected change in financial status, look for source of wealth.

Source

: Cindy Durtschi, “The Tallahassee Bean Counters: A Problem-Based Learning Case in Forensic Audit,”

Issues in Accounting Education

, Vol. 18, No. 2, May 2003, pp. 137-173.

232

Be Proactive

          Fraud hotline (reduce fraud losses by 50% re 2002 Wells 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).

233

For Internal Auditors



Do not sell shares of stock in your company.



Do not say anything in public.



Put it in your report and push it upwards.



Get rid of e-mail after about a month.

234

IAs Need Accounting Knowledge

Observers say a move to more intense checking of company financials would be a substantial shift in duties for many audit teams. For years, those teams have focused just on keeping information systems and operations running smoothly, says the IIA’s Bishop.

After all, most internal auditors aren’t CPAs. Before the current accounting scandals,

internal auditors largely steered clear of such complicated financial maneuverings

as off balance-sheet accounting, third-party investment vehicles, and derivatives accounting. Some internal auditing executives still feel they shouldn’t get involved in auditing those processes. “Should the internal auditing function be plowing the same ground [as independent auditors]?” asks David Richards. “My own view is that it’s a waste of corporate resources.” But “if a corporation is engaging in activities beyond the understanding of the internal auditing department, that’s a warning sign.” Richard Marsh (First Energy) Source: David M. Katz, “Do Internal Auditors Have a Bigger Role to Play in Ensuring the Integrity of Financial Reports?”

Tax and Accounting

Budgeting

, October 2002 235

Changing the Culture

“The idea is to change the culture. We work very closely with audit committees and management to build up their fraud awareness. We also talk about the leading practices that an organization should have. That could be a code of conduct, and we help the audit committee understand its oversight responsibilities.”

Richard Girgenti, KPMG Source: H.W. Wolosky, “Forensic Accounting to the Forefront,”

Practical Accounting

, February 2004, pp. 23-28.

236

Hot Lines – Sarbanes-Oxley

 Audit Committee (AC) must provide a mechanism for employees to remain anonymous when reporting concerns about accounting and auditing problems.

 AC must provide a process for the receipt, retention, and treatment of complaints regarding accounting problems (Section 301, S-O).

 Annual report must contain a statement regarding the effectiveness of internal controls.

 Employees have the right to sue companies for whistle-blowing retaliation.

 Managers found guilty of retaliation face penalties, including up to

10 years

in prison.

See The Network, www.tnwinc.com/hotlines 237

Inside v. Outside Hotlines

“Organizations with fraud hotlines cut their losses by 50% per scheme - The Wells Report EthicsLine and The Network, Inc. (800 357-5137) www.tnwinc.com

ComplianceLine of Compliance Concepts, Inc. (800-617-0415) www.complianceline.com

Cor-Tech of Management Communication Systems, Inc. (612-926 7988) www.getintouch.com

Edcor (888-222-9950) www.edcor.com

Ethicspoint, Inc. (866-297-0224) www.ethicspoint.com

238

Ethics Programs/Background Checking

Stephen J. Burns: “If only on paper, corporate business ethics programs exist in most large international companies. Unfortunately, many of these efforts would have to be regarded as

meaningless

.” The good news is there is no more effective and, in the long run, efficient process to select employees than through the use of a professional, fair, well-designed, and

well-run background and selection program

. Basic background inquiries for about $50 per person.” J.W. Koletar, p. 141.

“There are also companies and vendors who will sell or design software programs that permit an organization’s own human resources (HR) department to do these checks themselves.” Koletar, p. 141.

Sources

: Burns, “Combating Corruption,”

Internal Auditor

, June 1997, p. 56; J.W. Koletar,

Fraud Exposed,

John Wiley & Sons, 2003 239

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 240

Whistle-Blowing

It almost always turns out badly for the whistle-blower. Often they regret it. They lose their job, have family problems, or they are shunted off to the side. The kiss of death for a career to get a reputation as someone who is not a team player.

Name

David Chacon Fate of Recent Whistle-Blowers

Company Allegations Personal Outcome Company Outcome

Cynthia Cooper Salmon Smith Barney WorldCom Improper IPO allotments Massive accounting fraud Left firm, filed lawsuit Talking to U.S. Justice Department Subject of congressional and NASD probes Forced into bankruptcy Roy Olofson Barron Stone Global Crossing Duke Energy Round-trip trades and improper accounting Improper accounting Fired, filed lawsuit Forced to change jobs at Duke Forced into bankruptcy Awaiting results of an audit Sherron Watkins Enron Massive acctg. Fraud Testified to Congress Forced into bankruptcy Source: Joseph McCafferty, “Whistle-Blowing, Talk or Walk,”

CFO

, October 2002, pp. 90-91.

241

Danger of Whistle-Blowing

Sherron Watkins had a very real reason to be concerned about the corporate behemoth she had decided to challenge. At the time she wrote the memo, she was concerned about her personal safety . She was concerned enough to store in a lockbox a copy of the memo she sent Kenneth Lay. She wanted to ensure that the memo was somewhere safe, where it could not be destroyed Source: Joe Anastasi,

The New Forensics

, John Wiley & Sons, 2003, p. 91 ------------------------------------------------------------------------------------------ Today the SEC is getting 1,300 complaints per day from whistleblowers, compared to 1,300 per year in 1996.

Source: Krane, H., “Securities Law Update,”

California Lawyer,

February 2004.

242

RED FLAGS

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

Replaced

by SAS No. 99

243

Daryl Zero

Daryl Zero, the world’s greatest detective in the movie

Zero Effect

, has the appropriate mottos for FAs:



Precise Observation and Careful Intervention.



Passion is the enemy of Precision.

244

Roadmap For An Embezzler: 14 Ways

1.Sam diverted payroll taxes meant for the IRS to himself through a dummy account. He switched the IRS correspondence address to his home, hiding the default letters. He carried on an extensive letter-writing campaign with the IRS to confuse and delay action. He made back payments, disguising them to us as current payments.

2.He set up dummy bank accounts to skim funds before they made their way into legitimate accounts.

3.Sam got one employee fired for doing “sloppy management,” which “lost” some deposits. Of course, Sam gave me the “proof” that this employee was incompetent.

4.He refocused attention by pointing fingers at “slow payers” on our accounts receivable. He claimed that some people had never paid (they had) and that he had sent them to collections (he hadn’t). Of course, his records showed that their payments had never made it into our account (they went into a dummy account.) Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm

. 245

Roadmap For An Embezzler: 14 Ways (contd …)

He stole postage and then “reported” it, to alert me that he was honest; if anything was amiss, I would then blame others (and he offered his opinions on the least trustworthy employees).

He diverted bank statements to his home and altered them before filing them at the office.

Sam volunteered to run daily deposits to the bank, skimming off the cash and changing the deposit tickets.

He made reimbursements to himself and his wife for “business expenses” that didn’t exist.

Sam set up his landlord, once or twice a year, as an accounts payable.

10. A fax machine was stolen from the office. Also a TV and VCR. He was supposedly the first to arrive; he hastened to point out the broken window. He personally handled the police report. (I doubt that anyone broke in; the window was high up and fairly small.) Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm

. 246

Roadmap For An Embezzler: 14 Ways (contd …)

11. He put his wife on the payroll (a sweet woman who divorced him when she found what he really was). He “miscalculated” withholding to overpay her, and adjusted her W-2s downward to match. She was hourly, so he also padded her hours by $20 to $50 per pay period, and altered the time log sheets. We figured that over the course of four years, he overpaid her by at least $3,000. Of course, he was in charge of their family finances, and he deposited all her checks.

12. Sam double-reimbursed himself for legitimate expenses.

Here’s how: He would list perhaps four expenditures on one voucher, three on another. So the first would say “Office Depot, $21.64; Kinkos, $18.92; Office Depot, $39.12; Office Depot, $16.10.” A month or two later, one would show up like this: “Kinkos, $11.30; Office Depot, $39.12; Shay Office equipment, $26.20.” Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm

. 247

Roadmap For An Embezzler: 14 Ways (contd …)

Yes, receipts were stapled to the voucher, and all the vouchers/receipts added up. Here’s how he handled that: for some vendors he copied receipts by running them through an old fax machine that used thermal paper. He made two copies for double submissions. Many cash registers use thermal paper, so the receipts looked real.

This technique survived an outside audit

13. Increasingly arrogant, he began making “phone-authorized” wire transfers out of company accounts into his personal checking account.

14. Sam did an amazing job of doctoring the financial statements. (If this man spent half the effort on legitimate pursuits that he did on embezzling, he’d be a millionaire instead of an ex-con).

Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm

. 248

Some Take A-Ways

Have a

mandatory

vacation policy.

Rotation

of assignments.

Have a written/signed ethics policy.

Do things differently each time you audit a unit.

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 should have

control of the confirmation process

When checking endorsements, be careful with the ones with only the account number (may have a fake name on the account).

249

       

More Take A-Ways

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.

not assume

you have honest employees.

Bond employees.

Source: Gary Zeune 250

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.

251

Check References and Resume

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

252

Integrity 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.

253

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

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.

254

Tyco’s Payments to Executives

The accountant, Sheila Rex, testified that Tyco had three accounts where Mr. Dennis Kozlowski’s spending was recorded – his Key Employee Loan account, intended to help pay taxes on restricted stock after it was vested; a relocation account, where mortgages and other house-related spending were logged; and a third account, for short-term loans, to be paid back within 30 days.

Ms. Rex told jurors the accounting department had procedures for recording spending by Mr. Kozlowski. Mr. Swartz and other senior executives. Mr. Kozlowski’s relocation loans were listed under “Note Receivable Employee A,” Ms. Rex said, Mr. Swartz was “Note Receivable Employee C.” The third account, where Sardinia expenses were logged, was “Notes Receivable LDK,” Ms. Rex said.

She also described the way forgiven loans were accounted for on Tyco’s books, including $38.5 million that was forgiven in 1999 . Of that amount; Mr. Kozlowski received $25 million; Mr. Swartz, $12.5 million; and an events planner, Barbara Jacques, $1 million.

Source

Bloomberg News, “Accountant at Tyco Tells of Payments to Executives,”

New York Times

, November 11, 2003, C-3.

255

$6,000 Shower Curtain

In Dennis Kozlowski’s $18 million apartment on Fifth Avenue in Manhattan paid from Tyco International funds.

• $6,000 shower curtain in maid’s room.

• Art work by French Impressionists.

• $15,000 umbrella stand.

• $70,000 salary for maid, with two $10,000 bonuses.

•Borrowed $13.5 million for a yacht and $5 million for a diamond ring for his wife.

•$2 million birthday party for wife.

•$30,000 worth of opera glasses.

Although PWC auditor testified that he reviewed some of the disputed loans and compensation, he did not determine

if approved by the BOD.

“That wasn’t part of our auditing procedures.” 256

Acted With Criminal Intent

•Government used cover-up conspiracy to obtain conviction of 5 former Rite Aid executives accused of accounting fraud.

•Martha Stewart was charged with and convicted for obstructing investigations into her conduct and securities fraud (not insider trading).

•The two Tyco executives (CEO and CFO) used as their it?”

defense

that they were open about their conduct. “What kind of fraud can you have when you don’t try to conceal •Prosecutors of the Tyco executives argued that they hid the disputed bonuses and loans from two important groups: company directors and shareholders. Also, employees who helped process the disputed items shared in the largesse; thus they had incentives to not ask too many questions.

Mark Maremont, “Kozowski’s Defense Strategy: Big Spending Was No Secret,”

WSJ

, February 9, 2004, pp. A-1 and A-23.

257

No Crime Being Committed?

Prosecutor Ann Donnelly said this about the argument that the Tyco executives committed no crime because they were committed in plain view: “Simply a red herring. Theft that occurs at a corporation on this level has to be on the books and records; there is no other way to steal the money.” Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,”

N.Y.Times

, March 17, 2004, p. C-9 258

To Find Compensation Data

      www.monster.com

www.careerjournal.com

www.overseasjobs.com

www.careerbuilder.com

www.salary.com

www.jobsmart.com

259

Internal and External Fraud

Internal Fraud

Employee Management

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

Check Forgery

Check Forgery False insurance claims Credit card fraud False invoices Product substitution Bribes/secret commission Bid rigging/price fixing False representation of funds Shoplifting Source: KPMG,

Fraud Awareness Survey,

Dublin: KPMG, 1995, pp. 10-12. 260

External Fraud-Shoplifting

It’s not just stars (e.g., Bess Myerson, Hedy Lamarr, and may be Winona Ryder). Why, each year, ordinary people shoplift $13 billion of lipstick, batteries, and bikinis from stores.

800,000 times a day the thrills and temptations win over fear – a product of the late 19 th century with the larger stores.

Source:

Jerry Adler, “The Thrill of Theft,”

Newsweek,

February, 2002.

261

Three M’s of Financial Reporting Fraud

•

Manipulation

, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared •

Misrepresentation

in or intentional omission from the financial statements of events, transactions, or other significant information • Intentional

misapplication

of accounting principles relating to amounts, classification, manner of presentation, or disclosure Source: Zab Rezaee,

Financial Statement Fraud

, 2002, John Wiley.

262

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.

263

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

264

Earnings Management

Companies that consist solely of

independent directors

and meet at least four times a year are likely to have lower non-audit service fees.

L.J. Abbott et.al, “An Empirical Investigation of Audit Fees, Non Audit Fees, and Audit Committees,”

Contemporary Accounting Research,

Summer, 2003, p. 230.

An auditor who is also an industry specialist further enhances the credibility of accounting information (e.g., less earnings management).

G.V. Krishnan, “Does Big 6 Auditor Industry Expertise Constrain Earnings Management?”

Accounting Horizons

, Vol. 17, Supplement 2003, p. 15.

265

Earnings Management

Lower perceptions of earnings quality lead investors to

more thoroughly

examine a firm’s audited financial statements. A more thorough analysis of a firm’s financial statements lead investors to lower their assessment of the firm’s earnings quality. F.D. Dodge, “Investors perceptions of Earnings Quality, Auditor Independence, and the Usefulness of Audited Financial Information,” p. 46.

Found

no evidence

that short sellers trade on the basis of information contained in accruals. Scott Richardson, “Earnings Quality and Short Sellers,” p. 49.

266

Earnings Management

Small

companies tend to more frequently manage earnings to avoid losses than large companies. Auditors type appears insignificant.

Brain Lee and Ben Choi, “Company Size, Auditor type, and Earnings Management.”

Journal of Forensic Accounting,

Vol. 3 (2002), pp. 27-50 267

Professor Ketz’s Shoddy Accounting Practices

•Pro forma means “as if,” so pro forma earnings means earnings that would have been reported had the corporation been using alternative methods (e.g., everything but the bad stuff).

•“Today, however, pro forma numbers are seldom published for the purpose of informing investors and creditors in a better manner. Instead, these disclosures have become a way of under-minding orthodox accounting by not recognizing a variety of items as expenses.” •Examples: Goodwill never declines. Moving expenses and losses from operating items to so called nonrecurring items. Kodak has taken one-time charges every year for the past 12 years (to improve PE ratio).

•Contrast the income with the firm’s operating cash flow.

Source: J.E. Ketz,

Hidden Financial Risks

, John Wiley & Sons, 2003 268

Spotting Financial Fakery

Do the Sniff Test

– This one’s subjective, but it’s powerful. Essentially, if something looks wrong, and management can’t provide a convincing explanation, it probably is wrong. Trust your gut.



Remember that Cash is Always King

– Does accounting gobbledygook make your head spin? Fear not – there is one very simple thing you can do:

Keep an eye on cash flow

. Over time, increases in a company’s cash flow from operations should roughly track increases in net income.

If you see cash from operations decline even as net income keeps marching upward – or if cash from operations increases much more slowly than net income – watch out.

Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance, February 11, 2004.

269

Spotting Financial Fakery

Beware Overstuffed Warehouse

– When inventories begin rising faster than sales, trouble is likely on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that’s usually more the exception than the rule.



Keep an Eye on Accounts Receivable

– Roughly speaking, watch A/R as a percentage of sales, and watch the growth rate in A/R relative to the growth rate of sales. If A/R is moving up much faster than sales, something may be amiss.

Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance, February 11, 2004.

270

Spotting Financial Fakery

Watch the Honeypot

– Companies in the midst of big changes will often take a huge charge – which Wall Street is supposed to look right through, because, hey, it’s a one – time thing – to set up a “restructuring reserve,” and then slowly reverse some of the charge later on. This technique is known as a “honeypot,” because the company can dip into it whenever its operational results aren’t looking so great.

Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance, February 11, 2004.

271

Hiding Debt

Companies hide debt by these techniques: 1.

Using the equity method (rather than Trading Security and Available for Sale methods). Nets the assets and liabilities of the investee.

Lease accounting (arguing that leases are operating leases). Understates 10 to 15% .

Pension accounting – netting of the projected benefit obligation and the pension assets. Must un-net them.

Hiding debt inside Special – Purpose Entities – trillions of dollars of SPE debt is off the books (e.g., securitization, SPE borrowings, synthetic leases).

Readers can make analytical adjustments by searching footnotes for 1,2, and 3. But no disclosures for asset securitization, SPE borrowings, and synthetic leases.

Source: J.E. Ketz,

Hidden Financial Risks

, John Wiley & Sons, 2003 272

Water Into Wine

• • • • • •

A Parmalat subsidiary issues a security of 500 million euros, and buyer makes an irrevocable commitment to convert debt into equity in 2008.

Balance sheet treats 500 million euros transaction as $523.8 million in funds for capital increase.

Amount rolled into a single entry of $764 million which encompasses minority interest funds for capital increase and shareholder equity.

On consolidation under equity method shown as $523.8 million equity.

Therefore, debt into equity.

Of Parmalat $18 billion debt, nearly $16 billion was not disclosed. Until mid-2003, Parmalat received a clean bill of health from auditors.

Source: Henry Sender, “Parmalat Unit May Offer Accounting Clues,”

Wall Street Journal

, January 29, 2004, p. C-5 273

Corporate Fraud Task Force



Interagency

July 2002.

Corporate Fraud Task Force was formed in  To

coordinate

investigations into alleged misconduct at major corporations (e.g., Adelphia Communication and Quest Communications).

 To equip local staffs with the expertise and resources to obtain indictments.

  In the past accounting fraud has been difficult to prosecute,

but lawyers now believe many common accounting restatements can put corporate executives at risk for jail time

According to John K. Markey, “With the new Sarbanes Oxley requirement to have strong internal controls and officer certification of financial statements, the bar has been lowered on the ‘knew or should have known’ standard,” says Markey. “

The presumption will be that the CFO must have known if something has gone wrong

.”  The Department of Justice is now encouraging prosecutors to “flip” lower level participants to get the “big guys.” The FBI has an agency-staffed hotline that should “generate

four or five new corporate fraud cases each month

.”

Source:

Alix Nyberg, “Fraud Squad,”

CFO,

April 2003, pp. 36-44 274

Corporate Fraud Task Force…

offices (with the then holders) make up the Task Force, with the Deputy Attorney General as the chairperson: Larry Thompson, Deputy Attorney General (leader) Robert Mueller, Director of the Federal Bureau of Investigation Michael Chertoff, Assistant Attorney General for the DOJ’s Criminal Division Eileen O’Connor, Assistant Attorney General for the DOJ’s Tax Division James Comey, U.S Attorney for the Southern District of New York Roslynn Mauskopf, U.S. Attorney for the Eastern District of New York Patrick Fitzgerald, U.S. Attorney for the Northern District of Illinois Michael Shelby, U.S. Attorney for the Southern District of Texas Kevin Ryan, U.S. Attorney for the Northern District of California Debra Yang, U.S. Attorney for the Central District of California John Snow, Secretary of the Treasury Elaine Chao, Secretary of Labor William Donaldson, Chairman of the Securities and Exchange Commission James Newsome, Chairman of the Commodity Futures Trading Commission Patrick Wood III, Chairman of the Federal Energy Regulatory Commission Michael Powell, Chairman of the Federal Communications Commission Lee Heath, Chief Postal Inspector of the U.S. Postal Inspection Service 275

Indictments

Adaptec

•US v. Michael Allen Ofstedahl Indictment

Adelphia

•US v John J. Rigas, Timothy J. Rigas, Michael J. Rigas, James R. Brown, Michael C. Mulcahey Sealed Complaint • Indictment

Allfirst

•US v. John M. Rusnak Indictment , June 5, 2002

Alliance

•US v. Susan Denice Browne, Charles Edward Browne, Laurence Crowell Leafer, David Lee Halsey, Braccus Lucien Giavanno, Jonathan Walter Lang Indictment

Anicom

•US v. Carl Putnam, Donald Welchko, John Figurelli, Daryl Spinell, Ronald Bandyk, and Renee Levault Indictment

AremisSoft

•US v. Lycourgos K. Kyprianou, Roys S. Poyiadjis, and M.C. Mathews Indictment •US v. Roys S. Poyiadjis Indictment

Biocontrol

•US v. Fred E. Cooper Information

Capital City Bank

•US v. Clinton Odell Weidner II, and David C. Wittig First Superseding Indictment

Capital Consultants

•US v. Dean Kirkland, Gary Kirkland, Robert Legino Indictment , August 22, 2002

Cendant

•US v. Walter A. Forbes and E. Kirk Shelton Superseding Indictment

Commercial Financial

•US v. Jay Lowell Jones Information , September 13, 2002 •US v. William R. Bartmann Indictment , December 12, 2002

Countrymark

•US v. David Heath Swanson Superseding Indictment

Critical Path

•US v. Jonathan A. Beck Information •US v. Kevin P. Clark Information •US v. Timothy J. Ganley Indictment •US v. David A. Thatcher Information 276

Indictments

eConnect

•US v. Thomas S. Hughes First Superseding Indictment • Complaint Affidavit

Enron

•US v. Jeffrey S. Richter Information

FLP Capital Group

•US v. Frank L. Peitz, Daniel B. Benson, Peter A. Loutos, Sr., Robert D. Paladino, Randall W. Law, and Monica M. Iles Indictment

FPA Medical Management

•US v. Steven Mark Lash Indictment

Health Maintenance

•US v. Clifford G. Baird Information, July 29, 2002 •US v. Donavon C. Claflin Information, July 29, 2002 •US v. Kevin L. Lawrence Indictment, July 31, 2002 •US v. Kevin McCarthy Information, July 19, 2002 •US v. James N. Wuensche Information, November 26, 2002

HealthSouth

•US v. Angela C. Ayers, Cathy C. Edwards, Rebecca Kay Morgan, Virginia B. Valentine Information •US v. Aaron Beam Information •US v. Emery Harris Information •US v. Kenneth K. Livesay Information •US v. Michael Martin Information •US v. Malcolm McVay Information 277

Just Say No

© D.L. Crumbley James Comey (U.S. Attorney): “Just following orders is not an excuse for breaking the law.” • Betty Vinson, accountant for WorldCom, was asked by her bosses to make false accounting entries;

initially she refused

but eventually caved.

• “Over the course of six quarters she continued to make the illegal entries transferring expenses to capital accounts to bolster WorldCom’s profits at the request of her superiors. At the end of 18 months, she had

helped falsify at least $3.7 billion in profits

.” • She eventually confessed, hoping to be a witness. A more aggressive prosecutor made her a target. She and another accountant, Troy Normand, pleaded guilty to two criminal counts, carrying a maximum charge of

15 years in prison

• “When an employee’s livelihood is on the line, it’s tough to say no to a powerful boss.”

Source:

Susan Pulliam, “A Staffer Ordered to Commit Fraud Balked, Then Caved,”

Wall Street Journal

, June 23, 2003, p. A-1.

278

© D.L. Crumbley Fraud Identifiers to Spot Fraudsters • Large ego • Substance abuse problems or gambling addiction • Living beyond apparent means • Self-absorption • Hardworking/taking few vacations • Under financial pressure (e.g., heavy borrowings) • Sudden mood changes.

Source: G.E. Moulton, “Profile of a Fraudster,” Deloitte Touche Tohatsu, www.deloitte.com

, 1994. 279

Audit Procedures

Audit evidence is gathered in two fieldwork stages: 1. internal control testing phase 2. account balance testing phase 280

Definitions

• • • •

Materiality

is the measure of whether something is significant enough to change an investor’s investment decision.

Control risk

is risk that a material error in the balance or transaction class will not be prevented or detected.

Inherent risk

is risk that an account or transactions contain material misstatements before the effects of the controls.

Detection risk

is risk that audit procedures will not turn up material error when it exists.

281

External Auditors and Fraud Detection

•Although auditors have previously had the responsibility to detect material misstatement caused by fraud, SAS No. 82

details more precisely what is required to fulfill those responsibilities

. •Now, auditors must specifically assess and respond to the risk of material misstatement due to fraud and must assess that risk from the perspective of the broad categories in the SAS.

•External auditors have to satisfy new documentation and communication requirements. Superseded by SAS No. 99.

282

Statement of Financial Accounting Concepts No. 2

Provides nine qualities and characteristics that make financial information useful for investors, creditors, analysts, and other users of financial information • Relevance.

• Timeliness.

• Reliability.

• Verifiability.

• Representational faithfulness.

• Neutrality.

• Comparability and Consistency.

• Materiality.

• Feasibility or Costs or Benefits.

•Transparency.

283

© D.L. Crumbley Types of Financial Statement Fraud Schemes Three professors have broken financial statement fraud schemes into these ten types: 1. Fictitious and/or overstated revenues and assets (e.g., nonordered or cancelled goods). Sunbeam created revenues by contingent sales, a bill-and-hold strategy, and accelerated sales. Digital Lightware, Inc. recognized fraudulent billings. Computer Associates double-booked revenues when it renewed long-term contracts.

2. Premature Revenue Recognition (e.g., holding books open). Computer Associates used a “35 day month” to inflated revenues.

3. Misclassified Revenues and Assets (e.g., combining restricted cash accounts with unrestricted cash accounts). School districts and universities may engage in this strategy with dedicated funds .

Source: S.E. Bonner, Z. Palmrose, and S.M. Young, “Fraud Types and Auditor Litigation,”

The Accounting Review

, October 1998, pp. 503-532.

284

© D.L. Crumbley Types of Financial Statement Fraud Schemes (contd …) 4. Fictitious Assets and/or Reductions of Expenses/Liabilities (e.g., recording consigned inventory as inventory). Cendant Corporation created fictitious revenues, and Knowledge Ware inflated revenues with phony software sales.

5. Overvalued

Assets or Undervalued Expenses/Liabilities (e.g., insufficient allowance for bad debts).

6. Omitted or

Under

valued Liabilities (e.g., understated pension expenses).

7. Omitted or Improper Disclosures (e.g., stock option expense estimates).

285

9. Related-Party Transactions (e.g., fictitious sales to related parties). Enron had many related-party transactions.

10. Financial Fraud Going the

Wrong Way

(e.g., for tax purposes reducing income or increasing expenses). 286

Wrong Way Earnings Management

    Freddie Mac

understated

past earnings as much as $5 billion.

Certain transactions and accounting policies were “implemented with a view to their effect on earnings” (e.g., to smooth earnings).

Restatements will result in

higher

earnings in prior periods but

lower

earnings in future periods.

Employees appeared to knowingly violate accounting rules in an effort to manipulate earnings.

Source: Patrick Barta and J.D. McKinnon, “Freddie Mac Profits May Have Been Low By Up to $4.5 Billion,”

Wall Street J.,

June 26, 2003, pp. C-1 and C-11.

287

Tax Issues: Freddie Mac

linked swaps

to shift at least $420 million into the future.

• Internal report said the linked swaps had minimal business justifications other than the

shifting of operating earnings

• Company’s recent disclosure: potential additional tax liability as much as $750 million, plus interest.

Source: Dawn Kopecki and J.D. Mckinnon, “IRS Probes Tax Issues at Freddie Mac,”

Wall Street Journal

, October 22, 2003, p.A-6. 288

AICPA Indicia of Fraud

• Lack of written corporate policies and standard operating procedures • Lack of interest in or compliance with internal control policies, especially division of duties • Disorganized operations in such areas as bookkeeping, purchasing, receiving, and warehousing • Unrecorded transactions or missing records • Bank accounts not reconciled on a timely basis • Continuous out of balance subsidiary ledgers • Continuous unexplained differences between physical inventory counts and perpetual inventory records 289

© D.L. Crumbley AICPA Indicia of Fraud (contd …) • Bank checks written to cash in large amounts • Handwritten checks in a computer environment • Continual or unusual fund transfers among company bank accounts • Fund transfers to offshore banks (Enron had more

than 880

offshore accounts) • Transactions not consistent with the entity’s business • Deficient screening procedures for new employees • Reluctance by management to report criminal wrongdoing • Unusual transfers of personal assets • Employees living beyond their means 290

© D.L. Crumbley AICPA Indicia of Fraud (contd …) • Vacations not taken • Frequent or unusual related-party transactions (e.g., the Enron special purpose entities) • Employees in close association with suppliers • Expense account abuse • • Business assets dissipating without explanation • Inadequate explanations to investors about losses

A few other indicia of fraud are:

• Heavy selling of stock by insiders (e.g., Enron) • Sudden resigning of an officer (e.g., Jeffrey Shilling at Enron) 291

© D.L. Crumbley AICPA Indicia of Fraud (contd …) • Unconsolidated special purpose entities (Enron had more than 3,500 subsidiary companies, some hiding billion-dollars of debts and others used as tax shelters).

• Greater than 5% of “other revenue” • Large loans to executives (Baptist Foundation of Arizona loaned companies controlled by one director and two former directors almost $140 million which they invested in real estate) • Negative cash flow from operations • Recurring nonrecurring charges • Off-balance sheet financing • Related Parties – SFAS 57 says a related party is any party that controls or can significantly influence the management or operating policies of the company to the extent that the company may be prevented from fully pursuing its own interests. Source: http://aicpa.org/members/div/mcs/fraudin.htm

. 292

Seven Investigative Techniques

1. Public document review and background investigation (non financial documents).

2. Interviews of knowledgeable persons.

3. Confidential sources.

4. Laboratory analysis of physical and electronic evidence.

5. Physical and electronic surveillance.

6. Undercover operations.

7. Analysis of financial transactions.

Source: R.A. Nossen,

The Detection, Investigation and Prosecution of Financial Crimes

, Thoth Books, 1993.

293

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 294

Investigative

Activities

not

misrepresen

t either the identity or the purpose of the contact with a questionable party.   Surveillance is

not

an activity which accountants normally perform (e.g., may need a private investigator’s license).

Typical

state statute

requires

a PI license for: “the investigation by a person or persons for the purpose of obtaining information with reference to any of the following: the causes and origin of, or responsibility for, … damage or injuries to real or personal property; the business of securing evidence to be used before investigating committees or boards of award or arbitration or in the trial of civil or criminal cases and the preparation therefore….”  In Florida, Legal Opinion 97-9 provides that any person who holds a professional license under the laws of this state, and when such person is providing services or expert advice in the profession or occupation in which that person is so licensed, is

exempt

from private investigator licensing requirements. Thus, a licensed accountant (e.g., CPA)

would be permitted

to perform forensic accounting without a private investigator’s license.

295

Investigative

Techniques Public Document Review

• Real and personal property records.

• Corporate and partnership records.

• Civil and criminal records.

• Stock trading activities.

Laboratory Analysis

• Analyzing fingerprints.

• Forged signatures.

• Fictitious or altered documents.

• Mirror imaging or copying hard drives/company servers.

• Use clear cellophane bags for paper documents.

296

The Magic of the Double Entry System The double entry method of accounting possesses a peculiar elegance; results of operations are presented from two differing points of view – an income statement, presenting results over time, from period A through period B; the second point-of-view presented is always a balance sheet, which is nothing more than a “Kodak moment,” simple snapshot of things remaining on hand at the end of period B.

Part of the perverse and peculiar elegance of the double-entry system is that distortion of one point-of view requires distortion in the other. Sooner or later, the distortion of a balance sheet, that Kodak snapshot, becomes visible to the naked eye. The distortion becomes discernable through various tests and measures – and audit procedures.

In other words, you can put off the inevitable, but only for so long. Six months. A year maybe. In really egregious situations, perhaps longer. If there are many parties in collusion, or if the fraud is very complex, perhaps it can be put off far longer. In time, though, the balance sheet puffery bursts of its own accord.

Even a tick can swell only so far .

Source: Joe Anastasi,

The New Forensics

, John Wiley & Sons, 2003, p. 91 297

So Get Two, Three, Four Ticks

•

Enron’s management figured an ingenious method of overriding the double-entry of accounting. They simply ignored it.

•

It remains the simplest, most elegant financial fraud. Enron created special purpose entities (SPEs) and pledged Enron stock – just pieces of paper.

• •

If the SPE was successful, they recognized income.

When the SPE had huge losses they issued more paper. Debts were filed off-balance sheet in the partnerships.

Source: Joe Anastasi,

The New Forensics

, John Wiley & Sons, 2003, p. 92-93.

298

© D.L. Crumbley Analytical Procedures Analytical procedures involve the study or comparison of the relationship between two or more measures for the purpose of establishing the reasonableness of each one compared.

Five types

of analytical procedures help find unusual trends or relationships, errors, or fraud: •

Horizontal or Percentage Analysis

•

Vertical Analysis

•

Variance Analysis

•

Ratio Analysis or Benchmarking

•

Comparison with other operating information

Source: D.L. Crumbley, J.J. O’Shaughnessy, and D.E. Ziegenfuss,

2002 U.S. Master Auditing Guide

, Chicago: Commerce Clearing House, 2002, p. 592.

299

Sales v. 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.

300

Horizontal Analysis

© D.L. Crumbley Suppose advertising in the base year was $100,000 and advertising in the next three years was $120,000, $140,000, and $180,000. A horizontal comparison expressed as a percentage of the base year amount of $100,000 would appear as follows:

Year 4 Year 3 Year 2 Year 1 Dollar Amount Horizontal Comparison

$180,000 $140,000 $120,000 $100,000 180% 140% 120% 100% 301

rise sharply

, a company may be having trouble delivering its products as promised (Cendant Corp.).

• 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 accounts receivable falsely boosts income (

cookie jar accounting

). 302

• Beware of the ever-present nonrecurring charges (e.g., Kodak for past 12 years).

• Check for regular changes to reserves, depreciation, amortization, or comprehensive income policy.

• Related-party transactions (e.g., Enron).

• Complex financial products (e.g., derivatives).

• Unsupported top-side entries (e.g., WorldCom).

• Under-funded defined pension plans.

• Unreasonable management compensation.

Source: Scott Green, “Fighting Financial Reporting Fraud,”

Internal Auditor

, December 2003, pp. 58-63.

303

• Win per table.

• Drop per table • Comparison to statistical probability curves (regression analysis).

Slot Machines (by denomination) • Win-to-handle percent.

• Comparison of theoretical win to actual win.

• Win per machine.

• Handle per machine.

Keno • Win-to-write percent.

Race and Sports Book • Win-to-write percent.

Source: AICPA Audit and Accounting Guides, Audits of Casinos, 1995, 28, 051.

304

Relationships With Other Departments • Hotel.

• Conventions.

• Entertainment.

Relationships With Outside Conditions • Traffic flow.

• Weather.

• Special events.

5.03 The following are some common factors that may affect such comparisons: Overall Factors • Economic conditions.

• Variations from industry statistics - Types of clientele - Size of operations - Wager limits Source: AICPA Audit and Accounting Guides, Audits of Casinos, 1995, 28, 051.

305

Casino Analytics (cont).

• Lack of sufficient volume.

• Promotional programs.

• Turnover of personnel.

• Changes in competition.

• Change in clientele.

Table Games • Changes in rules of the games.

• Use of more decks or dealing devices.

• Change in volume of credit play.

Slot Machines • Large jackpots • Reliability of meters and readings taken.

• Changes in machines or theoretical percentages.

• Mechanical failures.

Source: AICPA Audit and Accounting Guides, Audits of Casinos, 1995, 28, 051.

306

Casino Analytics (cont).

• Large payouts.

Race and Sports Book • Layoff of bets.

• Adjustments of point spreads.

• Limits on odds.

Source: AICPA Audit and Accounting Guides, Audits of Casinos, 1995, 28, 051.

307

Analytics Procedures © D.L. Crumbley Statistical information for the gaming industry may fluctuate more than some other industries because games are based on chance. Short-term fluctuations are not unusual, but variations over a longer term generally will not deviate from an expected range unless there have been changes in the nature or policies of the casino. Variations from an expected range should be investigated .

Source: AICPA Audit and Accounting Guides, Audits of Casinos, 1995, 28, 051.

308

• Convert into indexes for benchmarking.

• All indexes should be close to one.

Day’s Sales in Receivable Index : (Accounts Receivable t / Sales t ) (Accounts Receivable t-1 / Sales t-1 ) Index for manipulators: 1.5 to 1 ------------------------------------------------------- Gross Margin Index: [(Sales t-1 - Cost of Sales t-1 ) / Sales t-1 ] [(Sales t-1 - Cost of Sales t-1 ) / Sales t-1 ] Index for manipulators = 1.2 to 1 ------------------------------------------------------- Source: M.D. Beneish, “The Detection of Earnings Manipulation,”

Financial Analysts Journal

, September/October, 1999. t-1 = prior year.

309

© D.L. Crumbley Five Statistically Significant Ratios Asset Quality Index = 1 ( Current Assets t + Net Fixed Assets t ) Total Assets t 1 ( Current Assets t-1 + Net Fixed Assets t-1 Total Assets t-1 ) Index for manipulators = 1.25 to 1 ---------------------------------------------------------------- Sales Growth Index : Sales t / Sales t-1 Manipulators: 60% Non manipulators 10% Source: M.D. Beneish, “The Detection of Earnings Manipulation,”

Financial Analysts Journal

, September/October, 1999. t-1 = prior year.

310

© D.L. Crumbley Five Statistically Significant Ratios Total Accruals to Total Assets = Δ Working Capital t - Δ Cash t - Δ Current Taxes Payable t - Δ Current Portion of LTD t - Δ Accumulated depreciation and amortization t Total Assets t TATA for manipulators: .031

TATA for non manipulators: .018

Source: M.D. Beneish, “The Detection of Earnings Manipulation,”

Financial Analysts Journal

, September/October, 1999. LTD = Long-term debt.

311

GMI AQI SGI TATA 2.00

1.50

0.10

Peer group 1.03

1.10

1.23 1.04

1.20

0.05

% over peers 51% 82% 18% 25% 100% Source: C.R. Lundelius,

Financial Reporting Fraud

, AICPA, 2003, p. 129.

312

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 4. Inventory turnover = Cost of goods sold Average inventory The number of days inventory is on hand can be calculated as 365 Inventory turnover 5. Receivables turnover = Net credit sales Average receivables 6. Gross Margin = 1 – Cost of goods sold Sales www.smartmoney.com

313

© D.L. Crumbley 7. Expense ratio = Selling general and administrative expenses Sales 8. Operating margin = Operating income Sales 9. Profit margin = Net income before extraordinary items Sales 10. Interest coverage ratio = Income before interest and taxes Fixed charges 11. Margin of safety = Income after fixed charges before income taxes Sales 314

© D.L. Crumbley 12. Debt-to-equity ratio = Total current and long-term + capitalized leases Total stockholder’s equity Or Total debt at book value Total debt and preferred stock + common stock at market 13. Return on assets (ROA) = Net income Average total assets Or Earnings before interest and taxes Average total assets 14. Return on equity (ROE) = Net income Average common equity 15. Return on invested capital = Earnings before interest and taxes Average invested capital 16. Number of years to pay off debt by application of internally generated cash flows = Total fixed obligations Operating cash flows 17. Ratio of senior debt to capital = Total senior debt Subordinated debt + net worth 315

Problems The following information is taken from the accounting records of Donald Company:

Average receivables Cost of goods sold Sales Average inventory Net credit sales Operating income $700,000 2,900,000 8,000,000 1,100,000 1,200,000 900,000

The inventory turnover is

• 1.81

• 2.2

• 2.64

• 2.92

• None of the above.

Using the facts above, the operating margin is

• .1125

• .32

• 1.1

• 1.6

• None of the above. 316

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 317

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.

318

One way to detect fraud is to interview company personnel. The AICPA Fraud Task Force provides an interviewing template of 13 questions for CEOs, CFOs, and Controllers.

1. Explain the purpose of interview- need to assess risk and comply with audit responsibilities 2. Inquire whether they are aware of any instances of fraud within their organization- Do they have reason to believe that fraud may have occurred or is occurring?

3. Has the CEO or CFO ever approved an accounting treatment for transactions that were not appropriate?

4. Have there been any instances where someone has attempted to inflate assets or revenue or deliberately understate liabilities and expenses?

5. Is there any member of management that has a direct interest or indirect interest in any customer, vendor, competitor, supplier or lender?

6. Is any member of management related to any other member of management?

7. Does anyone in the company have any personal, financial or other problems that might affect their job performance?

8. If there was an area within the company that might be vulnerable to fraud, what would that be?

9. Has anyone within the accounting department been let go or resigned within the past year?

10.Is there anyone in management that appears to be living a lifestyle beyond their means? – expensive cars, trips, jewelry, vices 11.Has anyone been involved in civil or criminal proceedings or filed bankruptcy 12.Does the company have a strong ethics policy?

13.Has anyone ever been fired for committing fraud against the company?

Source:

Ronald L. Durkin et. al, “Incorporating Forensic Procedures in an Audit Environment,”

Litigation and Dispute Resolution Services Subcommittee

, New York: AICPA, 2003.

319

Selecting the Right Interviewees

“Someone knows what is going on. If you tune in, you will get a feel for it.”

Lorraine Horton, Kingston, R.I.

------------------------------------------------------------- “It is important that you select the right person to interview, and be conversant in interviewing techniques. For instances, pick someone from customer complaints or an employee who didn’t get a raise for two years, as they would be likely to provide the needed information.”

R.J. DiPasquale, Parsippany, N.J.

Source: H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical Accountant, February 2004, pp. 23-28 ---------------------------------------------------------------------------------------------

Listen to rouges and whistle blowers who complain

320

Interview vs. Interrogation

• Interview-non-accusatory process where person asks questions to develop factual information (e.g., who, what, when, where, how).

• Interrogation-accusatory interview to obtain an admission of guilt.

321

Advantage and Disadvantages



Advantages of an interview (non accusatory)

• Facilitates the development of cooperation.

• Easier to develop rapport.

• More effective way of developing usable information.



Disadvantages of Interrogation

• Interviewee may be alienated and refuse to speak to anyone later.

• If interviewee will not speak to anyone, ability to obtain information or admission is diminished .

Source: John E.Reed Associates, Inc.

322

Verbal and Nonverbal Behavior

Verbal behavior

includes not only words, but timing, pitch, rate, and clarity of the responses.

Nonverbal behavior

expressions.

includes body movement, position changes gestures, eye contact, and facial See “Interviewing & Interrogation,” The Reid Technique, John E.Reid Associates, Inc., L.E.R.C Law Enforcements.

323

Nonverbal Language

•

60%

of communication is

nonverbal

• Previous contact with person helpful.

• During President Bill Clinton’s testimony he touched his nose several times when he was lying, but did

not

touch his nose during truthful testimony.

• Two-thirds of truthful interviewees cross their legs.

Source:

“Lying 101: There May Be Nonverbal Indicators of Lying,” http://members.tripod.com/nwacc_communication/id25.htm

. 324

Posture Language

 Truthful • Frontally aligned.

• Upright or forward.

• Open (perhaps crossed legs).

• Dynamic, comfortable changes .

 Deceptive • Non-frontally aligned.

• Slouched, retracted or leaning.

• Barriers (crossed arms, purse in lap).

• Frozen and rigid.

Source: John E. Reid Associates, Inc.

325

Some Lying Signs

• • • • • • • • • • • • • • • • • • • •

Covering mouth with hand.

Rubbing nose.

Frequent blinking.

Biting lip.

Moving or tapping foot.

Crossing arms.

Leaning forward.

Handling objects (e.g., pencil, pen).

Avoiding eye contact or averting eyes.

Clearing the throat.

Closing and opening coat.

Picking at lint on clothing.

Playing with collar.

Moving away.

Shrug gestures.

Slow response.

Higher pitch.

Long answer.

Gap between words becomes longer.

Non-words such as uh.

Source:

“Lying 101: There May Be Nonverbal Indicators of Lying,” http://members.tripod.com/nwacc_communication/id25.htm

326

Interviewing Techniques

was quiet

, the person he needed information from would eventually

fill the silence

.” (pp. 5-6).

------------------------------------------- “Just listen. You are a detective.

Detectives are supposed to listen.

You once told me that solving murders are getting people to talk and just listening to them.” (pp. 92 93).

------------------------------------------------- Source: Michael Connelly, 1993.

The Black Ice

, St. Martin’s Paperback, 327

Progression of Interpersonal Communication

Investigative Communication Type Investigative Conversation Structured Investigative Interviewing Basic Forensic Interrogation Advanced Forensic Interrogation Time Requirements Flexible Thirty minutes to one hour Three to six hours Three to six hours Required Environment Flexible Private setting Intimate setting Intimate setting 328

Progression of Interpersonal Communication

Skill/Training Requirements Minimal training required. Preferable to have training in active listening skills, question formulation and basic behavior analysis as well as psychology of investigative discourse.

Minimum fifteen hours training in structured interview formats and behavior analysis.

Minimum fifteen hours interviewing training plus thirty hours of training in Reid Nine Steps.* Minimum standards for structured formats and basic interrogation as well as minimum ten hours of advanced training.

Inbau, F.E., Reid, J. E. & Budkley, J.P. (1986) Criminal Interrogation and Confessions, third edition (Baltimore, Williams and Wilkins).

Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I. 02911.

329

Progression of Interpersonal Communication

Appropriate Use and Restrictions When you are looking for direction in an investigation. Result is a gamble rather than a predictable outcome When you have established the need for a formal investigation and are interacting with witnesses, victims, complainants or suspects. Must accept information as it is presented without confrontation .

When you are interacting with an uncooperative suspect and require a truthful account of that person’s guilt. Make use of perception manipulation and as such requires comprehensive quality control.

Most desirous form for uncooperative suspects of severe offences or suspects who may be emotionally unstable. Does not use perception manipulation and therefore beneficial when you need to identify true motivation for the offence.

Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I. 02911.

330

Chance of Confession

“Police Interviewing Techniques,” British

Journal of Criminology

, Vol. 33, 1993.

William Morrisette Believes that “an investigator who properly identifies and implements the appropriate investigative communication type should be able to achieve an 85 percent confession rate through basic interrogation and a 95 percent rate by way of advanced interrogation.” 331

Some Financial Outlaws

Andrew S. Fastow

(Enron)

Dennis Kozlowski

(Tyco)

Crazy Eddie Antar

(Electronics)

Robert E. Brennan

(New Era Philanthropy)

Barry Minkow

(ZZZZ Best)

Robert Vesco

(Investors Overseas)

Charles K. Ponzi John Bennett Michael Milken

(junk bonds)

Scott Sullivan

(WorldCom)

John D. Apfelbaum

(stamps)

John Rigas

(Adelphia)

Frank W. Abagnale

(great imposter)

Richard Scrushy

(HealthSouth)

Calisto Tanzi

(Parmalat) Narcissistic personality disorder: a pervasive pattern of grandiosity (in fantasy or behavior), need for admiration, and lack of empathy.

332

HealthSouth’s Richard Scrushy

• The beauty of acquisition accounting – perfectly legal - - was the room it allowed for all sorts of gimmicks and restatements,

masking true operating performance.

• Enter Richard Scrushy (HealthSouth). Allegedly King Richard and 11 other co-conspirators were called the “family.” From 1997 through mid-2002, the SEC says HealthSouth overstated its earnings by $2.5 billion -

- 2,500% higher than true earnings.

[By 1/21/04, $2.5 to $4.6 billion.] • • Scrushy allegedly

met monthly

with company financial executives, and he would say, “If we are not making the numbers, go figure it out.”

Lower-level

bean counters then

inflated

assets and used other creative accounting to plug the difference. They overstated profits by at least $1.4 billion by billing Medicare for physical-therapy services the company never performed. They submitted falsified documents to Medicare to verify the claims.

Source

: John Helyar, “The Insatiable King Richard,”

Fortune

, July 7, 2003, p. 84.

333

Non-Audit Fees

• E&Y classified $1.3 million as an audit related fee for HealthSouth in 2001, which was called pristine audit janitorial inspections.

• These “audits” included checking toilets, parking lots, and other parts of HealthSouth facilities for cleanliness (50-point questionnaire).

•

Fortune

said E&Y missed billions in financial fraud, but they were great at finding dust bunnies in their white-glove tests.

Source

: John Helyar, “The Insatiable King Richard,”

Fortune

, July 7, 2003, p. 82.

334

Look For Fraud Symptoms

•Source Documents.

•Journal Entries.

•Accounting Ledgers.

335

Source Documents

• Checks.

• Employee time cards.

• Sales invoices.

• Shipping documents.

• Expense invoices.

• Purchase documents.

• Credit card receipts.

• Register tapes.

Source Documents Fraud Symptoms

•Photocopies of missing documents.

•Counterfeit/false documents.

•Excessive voids/credits.

•Second endorsements.

•Duplicate payments.

•Large numbers of reconciling items.

•Older items on bank reconciliations.

•Ghost employees.

•Lost register tapes.

337

Journal Entries Fraud Symptoms

•Out-of-balance.

•Lacking supporting documents.

•Unexplained adjustments.

•Unusual/numerous entries at end of period.

•Written entries in computer environment.

338

Ledger Fraud Symptoms

•Underlying assets disagree.

•Subsidiary ledger different than general ledger.

339

AICPA Top 10 Technologies Task Force

The task force found the following top ten technologies for

2004

in descending order of importance:

Information Security

. The hardware, software, processes and procedures in place to protect an organization’s systems. It includes firewalls, anti-virus, password management, patches and locked facilities, among others.

Spam Technology (new)

. The use of technology to reduce or eliminate unwanted e-mail. Technologies range from confirmation of the sender via ISP lookup to methods where the recipient accepts e-mail only from specific senders.

340

AICPA Top 10 Technologies Task Force

Digital Optimization (new)

. Also known as “The Paperless Office.” The process of capturing and managing documents electronically (i.e., PDF and other formats).

Database and Application Integration (new)

. The ability to update one field and have it automatically synchronize between databases. An example would be the transfer of data between disparate systems.

Wireless Technologies

. The transfer of voice of data from one machine to another via the airwaves without physical connectivity.

341

AICPA Top 10 Technologies Task Force

Disaster Recovery

. The development, monitoring and updating of the process by which organizations plan for continuity of their business in the event of a loss of business information resources due to theft, weather damage, accidents or malicious destruction.

Data Mining (new)

. The methods by which a user can sift through volumes of data to find specific answers.

Virtual Office (new)

. The technologies, processes and procedures that allow personnel to work effectively, either individually or with others, regardless of physical location.

342

AICPA Top 10 Technologies Task Force

Business Exchange Technology (new)

. The natural evolution from EDI to greater business transaction and data exchange via the Internet using datasets that are transported easily between programs and databases (e.g., XBRL).

10.

Messaging Applications (new)

. Application that permit users to communicate electronically, including e mail, voicemail and instant messaging.

343

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 344

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.”

Bret 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. 23-28 345

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.

346

Wiz Rule Data Auditing Tool

• Based upon date 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.

347

Technology Commits Fraud

“Technology was used to

commit fraud

selling pools of credit card debt. A cooked formula was embedded in software by the seller of the debt to in analyze the quality of debt for the purchaser, so no matter what debt came out, it had a good collection ratio, and the purchaser was willing to pay more. Only by analyzing the software coding was the fraud discovered,” Cal Klausner, Bethesda Md.

----------------------------------------------------------- The trend toward

paperless systems

hinders a CPA’s ability to find fraud. For example, many banks are no longer sending out checks Roberts J. DiPasquale H.W. Wolosky, “Forensic Accounting to the Forefront, “

Practical Accountant

, February 2004, pp. 23-28 348

Computer-Assisted Audit Techniques

Parallel simulation

– actual company data are processed using auditor – controlled software program. Does

not

contaminate data.

Test data

– dummy transactions are prepared by the auditor and processed under auditor control by the client’s computer program. Simple, quick, and inexpensive.

Integrated test facility

– creates a small subsystem within the regular IT system. Can create errors in clients files.

Continuous monitoring of online real time systems

– use test data to test controls. Contamination can occur.

Tagging Transactions

– place indicators or tags on selected transactions and trace through the system.

Source: Boynton et.al,

Modern Auditing

, 7 th Edition., 396-398.

349

Types of Misappropriations

Embezzlement Cash and check schemes

– Larceny of cash – Skimming – Swapping checks for cash – Check tampering – Kiting – Credit card refund and cancellation schemes

Accounts receivable fraud

– Lapping – Fictitious receivables – Borrowing against accounts receivable • •

Inventory fraud

– Stealing inventory – Short shipments with full prices

Fictitious disbursements

– Doctored sales figures – Sham payments – Price manipulations: land flipping, pump and dump, and cybersmearing – Money laundering – Bid rigging 350

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.

351

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.” 352

Preventive Measures

• 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.

353

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].

354

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.

355

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.

356

Kickback Example

Paul J. Silvester, former state treasurer for Connecticut, admitted accepting cash

kickbacks

in return for placing

millions

of dollars in state pension investments with certain equity funds.

Mr. Silvester was

sentenced

to 51 months in prison for taking bribes in return for investing $527.5 million from the state pension fund in five investment funds.

Source: Marc Santora, “After Help in Corruption Cases, Central Figure Gets 51 Months,”

N.Y. Times

, November 21, 2003, p. C-12.

357

Parmalat Kickback Scheme

Former Bank of America executive Luca Sala told investigators that over 7 years he took $27 million in a kickback scheme involving Parmalat.

He obtained the monies by a kickback arrangement with an outside broker who helped organize bond issues from Parmalat.

Mr. Sala (corporate finance head) helped organize several bond placements for Parmalat for which the bank regularly received fees.

Source: A. Galloni and C. Mollenkamp, “Ex-Parmalat Banker Admits Stealing $27 Million,”

WSJ,

February 27, 2004, p. A-3.

358

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.

359

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.

360

Lapping

Lapping

• Recording of payment on a customer’s account some time after receipt of payment. Later covered with receipt from another customer (robbing Peter to pay Paul).

• Lapping is more successful where one employee has both custody of cash and record keeping responsibility.

Audit Steps

• Independently verifying customers who do not pay.

• Reviewing write-offs.

• Reviewing customers’ complaints .

361

Lapping (cont.)

•

Compare the checks on a sample of deposit slips to the details of the customers’ credits that are listed on the day’s posting to the customer’s account receivable

362

Reducing Bad Debts

 Eventually MCI had to write-off $650 million in bad debt.

•  His schemes: Allow a customer to sign a promissory note to turn the receivable into a short-term asset.

• Redacting invoices.

• Developing interpretations to explain why some items are aged so long.

• Using questionable codes.

• Used unapplied cash to cover.

 Arthur Andersen did not audit the smaller bad debt accounts where the questionable accounts occurred (e.g., the third tier).

 Paulo said that the AA auditors were young, inexperienced, and fresh out of college.

Source: J.M. Jacka, “An Environment for Fraud,”

Internal Auditor

, April 2004, pp. 49-52 363

Inventory

Inventory Fraud

• Stealing inventory/supplies for personal use or for sale at flea markets/garage sales.

• Kickback schemes (vendor/supplier and an employee). Sale of unreported inventory or at inflated prices.

• Use renumbered inventory tags matched to count sheets; use count procedures for work-in progress items; separate duties between purchasing and logging receipts of shipments

Audit Steps for Inventory Fraud

• Check for same vendors.

• Prices higher than other vendors.

• Purchasing agent does not take vacation.

• Only photocopies of invoices are available.

• Age of inventory.

• Inventory turnover • There is data-mining software.

364

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.

365

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.

366

Some Employee Schemes (contd …) Fictitious Disbursements

• Multiple payments to same payee.

• Multiple payees for the same product or service.

• Ghosts on the payroll.

• Inflated invoices.

• Shell companies and/or fictitious persons.

• Bogus claims (e.g., health care fraud and insurance claims).

• Overstate refunds or bogus refunds at cash register.

• Many fictitious expense schemes (e.g., meals, mileage, sharing taxi, claiming business expenses never taken).

• Duplicate reimbursements.

• Overpayment of wages. 367

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. 368

Some Employee Schemes (contd …)

•

Other Fraud Schemes (contd …)

• A

ponzi scheme

is a pyramid-type technique where early investors are paid with new money collected from future investors, who lose their investments.

Bid rigging

occurs when a vendor is given an unfair advantage in an open competition for a certain contract. 369

Ponzi Scheme Example

• Women Helping Women group hosted invitation – only “birthday parties” that promised $40,000 in the future to each woman who invested $5,000.

• Some of the women received the pay-off, but most lost out.

• $12 million pyramid schemes.

• Cheryl Bean, the leader, given 3 years probation, ordered to pay $15,000 in restitution, and $10,000 to a charity fund.

Source: AP, “Pyramid Scheme Leader Pleads No Contest,”

Las Vegas Sun

, November 8, 2003.

370

Hammersmith Trust Ponzi Scheme

• Hundreds of sophisticated investors put $100 million in this

prime banking scheme

that promised as much as 1,600% annual return.

• The scheme revolved around the so-called international prime banking instruments (e.g., high-yield commercial paper or secret bank debenture programs).

There is no market for prime bank instruments.

•

“

Not a single dime is invested in anything – save the fraudulent pyramid itself, with some money going from one investor to the other in the form of purported “interest” and “return of principal “payments – while most of it sticks to the pyramid or rather, to the people running the pyramid.” Source: John Anderson, “Take The Money & Run,”

Smart Money

, December 2003, pp. 122-130.

371

Bid Rigging or Bid Pooling

• Sherman Antitrust Act – illegal restraint of trade. Felony. Substantial fines and up to three years.

• Group of dealers choose one dealer to bid on items. Later the dealers themselves bid on the items bought and they, therefore, share the profits.

372

Bid Rigging Red Flags

• Winking, hand signals or other similar signs among dealers after the bidding is opened.

• A uniformity to the bidding. For example, Dealer One bids on a particular lot and buys it with little or no activity, and then Dealer Two buys another lot, again with little or no competition.

• Difficulty getting things going.

• A lot of handshaking and other signs of recognition among several dealers before or after the auction takes place.

• An air of silence throughout the auction since auctions are generally noisy – or conversely, a lot of conversation among bidders during the sale of lots they normally should be bidding on.

• Low competition among known dealers who normally bid strongly against one another.

Source: www.harryrinker.com/bidrigging :

The Official Government Auction Guide

373

Forensic Auditing Steps

Count

the Petty Cash

Twice

in a Day • • •

Investigate Investigate

Suppliers (Vendors) Customers’ Complaints.

Examine

Endorsements on Canceled Checks •

Add

Up the Accounts Receivable Subsidiary

Audit Match

General Journal Entries 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.

374

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.

375

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,” 9 th

International Anti-Corruption Conference

, October 13, 1999. PowerPoint presentation slide 56. http:// www.transparency.org/iacc/9 th _iacc/papers/day3/ws1/dnld/d3ws1_djherling.ppt

376

Anti-fraud Checklist Business policy

• Is there a published ethics policy with definitions of fraud?

• Is fraud included in the company’s overall business risk assessment?

• Is there a plan in place to respond to risk and to limit damage to the business?

Staff

• Does the company check job applicants’ references and get certificates for qualifications for appointments at all levels?

• Are staff trained to notice signs of all types of fraud?

• Are whistle blowers encouraged to come forward?

Source: Adapted from Moody, M., “Fraud – enemies within” in Director (April 2000), p. 16. 377

Anti-fraud Checklist (contd …) Commercial activities

• Does the company follow strict credit management practice and enforce credit limits?

• Does the company follow good practices on credit cards and counterfeit money?

• Are goods received and their prices checked against delivery notes and invoices?

• Is ownership checked on product refund requests?

Security

• Have physical security arrangements been reviewed recently?

• Are visitors identified (e.g., name tags) and accompanied? Source: Adapted from Moody, M., “Fraud – enemies within” in Director (April 2000), p. 16. 378

Red Flags or Fraud Identifiers

• • • • • • •

Earnings problem:

earnings downward trend in

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 receivable 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. 379

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. 380

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.

381

Barter Deals

AOL

created ad revenues out of thin air.

With an obsession to get advertising revenue in the door, “nobody there appears to have paid much attention to whether the business deals at issue were really producing ad ‘revenues’ by any acceptable definition….” At least $90 million of revenues were expunged by mid-2003, with another $400 million contested.

Source:

C.J. Loomis, “Why AOL’s Accounting Problems Keep Popping Up,”

Fortune

, April 28, 2003, p. 86.

382

IRS’s Forensic Analysis

•

IRS Commissioner Mark W. Everson said that the role of the IRS in the HealthSouth matter was to trace the flow of money . “IRS agents in this case used the same comprehensive financial analysis that we use in criminal tax investigations to document million of dollars in transactions through dozens of financial institutions, including banks and brokerage firms,” Everson said.

•

“The IRS will use its financial expertise to help the government hold accountable those executives who engage in fraud,” Everson said. “Our investigation supports the money-laundering charges as well as the forfeiture counts against Mr. Scrushy involving a staggering sum of money – over a quarter of a billion dollars – which he accumulated during a seven-year period,”

•

“This money went to support a lavish lifestyle, one few Americans could possibly imagine,” the Commissioner continued. “With his ill-gotten gains, Mr. Scrushy purchased multiple estates, racing and leisure boats, fine art by such artists as Picasso, Miro, and Renoir, cars including a Lamborghini and a Rolls-Royce, and extravagant jewelry, such as a 22-carat diamond ring.”

Source: Amy Hamilton, “Everson Publicizes Criminal Charges Against HealthSouth CEO,”

Tax Notes

, November 10, 2003, p. 671.

383

Lifestyle Probes

Lavish residence

–

Expensive cars and boats

–

Vacation home

–

Private schools for children

–

Exotic vacations

384

IRS Financial Status Audits

If someone is spending beyond his or her apparent means, there should be concern. If a forensic accountant suspects fraud or unreported income, a form of

financial audit

may be appropriate that will enable the investigator to check the

lifestyles of the possible perpetrators

385

Forensic Audit Approaches Used by the IRS

Direct methods

involve probing missing income by pointing to specific items of income that do not appear on the tax return. In direct methods, the agents use conventional auditing techniques such as looking for canceled checks of customers, deed records of real estate transactions, public records and other direct evidence of unreported income.

Indirect methods

use economic reality and financial status techniques in which the taxpayer’s finances are reconstructed through circumstantial evidence.

386

Indirect Methods

inadequate

records books and • The books do

not

income clearly reflect taxable • There is a reason to believe that the taxpayer has

omitted

taxable income • There is a significant increase in year-to year net worth • Gross profit percentages change significantly for that particular business • The taxpayer’s expenses (both business and personal) exceed reported income and there is no obvious cause for the difference 387

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

388

Minimum Income

Probes

• For

nonbusiness returns

, an agent question the taxpayer or representative about possible sources of income other than reported on the return. If there is no other information in the file indicating potential unreported income, the minimum income probe is met.

• For taxpayers who are

self-employed

and file a Schedule C or F, an analysis is made of tax return information to determine if reported income is sufficient to support the taxpayer’s financial activities.

389

Cash T

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

possible fraud

390

Preliminary Cash-T

Gross Receipts: Business Expenses:

Schedule C Preliminary Understatement $120,000 Schedule C Personal Living Expenses $95,000 $60,000 $155,000 $35,000 391

Preliminary Cash-T (contd …)

The cash hoard defense is illustrated in the Edwin Edwards’ gambling corruption trial in 2000. An IRS agent testified that Edwards spent hundreds of thousands of dollars more in cash than he reported in earnings. On Monday, jurors got another avalanche of numbers as prosecutors tried to prove their charge that Edwards hid money he extorted from riverboat casino owners.

A financial analyst testified for the prosecution about how the former governor spent his cash, testimony the defense challenged every step of the way.

Don Semesky, a special agent for the Internal Revenue Service, used a chart to show that Edwards spent $872,000 more in cash than he reported receiving from 1986 to 1997.

Source: C. Baughman, “Prosecution Concludes Case In Edwards’ Trial,”

The Advocate Online

, April 4, 2000.

392

Preliminary Cash-T (contd …)

Semesky said Edwards started 1986 with $82,000 in cash. He based that figure on Edwards’ own testimony in an unrelated trial in 1985.

In the current trial, Edwards testified he always had between $250,000 and $500,000 in cash during the mid 1980s. Using $250,000 as a starting point, Semesky said, Edwards still spent $704,000 more in that period than he reported receiving.

“I believe the evidence in this case is that Mr. Edwards received cash from other, unreported sources,” Semesky told prosecutor Mike Magner.

In either calculation, Edwards started spending more cash in 1996, Semesky said. He agreed with Magner’s allegation that the increase in spending coincided with Edwards getting extortion payments from Robert Guidry.

393

Preliminary Cash-T (contd …)

Guidry, the former owner of the Treasure Chest casino in Kenner, testified he paid Edwards and his son along with Edwards’ former, aide Andrew Martin, $100,000 a month from early 1996 until August 1997.

Like he did with Laura East, Small wasted little time attacking Semesky’s numbers, which were displayed for the jury on a chart.

Semesky’s total for cash spent by Edwards included $383,500 the FBI seized from his safe-deposit box on April 29, 1997.

Edwards testified that cash was left over from $400,000 Eddie DeBartolo Jr. had given him in a legitimate business deal on March 12, 1997. He said it was primarily to prepare for a gambling election in Bossier City, where DeBartolo was applying to put in a casino boat.

394

Preliminary Cash-T (contd …)

DeBartolo, who has pleaded guilty in the case, testified for the prosecution that Edwards extorted the $400,000 from him.

But while Semesky showed the $383,500 as cash spent, he did not show the $400,000 from DeBartolo as cash received, Small said.

“Isn’t it a fact that you screwed up and you missed the $400,000?” Small asked Semesky.

“Mr. Small, you’re not understanding the concept of this chart,” Semesky said. “The government’s contention in this case is that it (the $400,000) came from extorted payments.” The purpose of the chart was to show legal sources of cash, Semesky said. That included $1,586,800 in net gambling winnings Edwards had from 1986 until 1997, he said.

395

Preliminary Cash-T (contd …)

But Small said the cash shortfall that Semesky found - about $872,000 - - could be made up by starting with $500,000 in cash in 1986, as Edwards testified he might have had.

Add the $400,000 from DeBartolo and the shortfall disappears, Small said.

Later in 1997, DeBartolo reported to the IRS he had given Edwards the money, Small said.

But Semesky maintained that the $400,000 could not be counted as a legitimate source of cash.

“It doesn’t belong on that schedule,” he said.

396

Source and Application of Funds Method (Expenditure Approach)

This technique is a variation of the net worth method that shows

increases

and

decreases

in a taxpayer’s accounts at the end of the year. The format of this method is to list the applications of funds first and then subtract the sources. If the taxpayer’s applications exceed his or her known cash receipts (including cash on hand at the beginning of the year), any difference may be unreported income.

397

Source/Application of Funds

Application of funds:

Bank balance increase Down payment on home Closing costs on home Purchase of SUV Rent payment (4 months) Mortgage payment Down payment on boat Credit card payments Miscellaneous (living) Balance

Known sources of funds:

Cash on hand Salary Consulting Dividends and interest Loan proceeds Balance Net unreported funds

2002

$7,300 15,000 3,700 17,600 2,000 4,200 14,000 11,500 75,300 $3,600 49,500 7,000 3,000 0 $63,100 $12,200

2003

$29,500 8,400 10,000 38,800 37,000 $123,700 $1,700 53,000 13,000 3,000 7,000 $77,700 $46,000 398

Net Worth Method

© D.L. Crumbley The net worth method is a common indirect balance sheet approach to estimating income. To use the net worth method, an IRS agent or forensic accountant must: 1. Calculate the person’s net worth (the known assets less known liabilities) at the beginning and ending of a period 2. Add nondeductible living expenses to the increase in net worth 3. Account for any difference between reported income and the increase in net worth during the year as (a) nontaxable income and (b) unidentified differences

Hollard v. U.S., 348 U.S. 121 (1954).

399

Net Worth Example

© D.L. Crumbley Total assets (at cost) Less: Total liabilities Net worth, end of the year Net worth at beginning of year Increase or decrease in net worth Add: living expenditures Estimated Income Less: Known sources of income Unexplained income $1,200,000 (550,000) 650,000 530,000 120,000 145,000 265,000 (130,000) $135,000 400

Unexplained

net worth increase

2003 2004

$225,000 225,000 0 11,000 $421,000 310,000 $111,000 21,000 $

90,000 2005

$610,000 420,000 $190,000 23,000 $

167,000

Income Expenses Net asset increase $62,000 51,000 $

11,000

$81,000 60,000 $

21,000

$87,000 64,000 $

23,000

1 Actual Net Worth recalculated based upon actual assets less liabilities.

2 Net Worth based upon reported income

less

expenses.

401

Non-Tax Net Worth Use

In a narcotics conspiracy trial, defendant argued that the expert auditor

should have worth method

to followed the

net

to prove that defendant’s wealth is disproportionate to his reported income.

Holland

need

not

be followed in non-tax cases. Unlike tax prosecutions, narcotics conspiracy charges do

not

involve financial gain as necessary elements of offense, so less stringent standards are allowable.

U.S. v. Cuervo, No. 02-2898 (CA-8, 2004).

402

Bank Deposit Method

The bank deposit method looks at the funds deposited during the year. This method attempts to reconstruct gross taxable receipts rather than adjusted.

Gleckman v. U.S., 80 F.2d 394(CA-8, 1935).

403

Formula for Bank Deposit Method

Total deposits to all accounts Less: Transfers and re-deposits = Net deposits plus: Cash Expenditures = All total receipts less: = Funds from known sources Funds from unknown sources $195,000 21,000 174,000 68,000 242,000 119,000 123,000 404

Formula for Expenditure Method

Expenditures less: = Known sources of income Unknown sources of income $210,000 115,000 $95,000 405

Percentage of Markup Method

Gross Profit on Sales Formula

Sales per books Gross profit percentage Gross profit as recomputed $100,000 25% $25,000

Sales on Cost of Sales Formula Cost of Sales Percentage of Sales Price

Cost of Product A Cost of Product B Product A Product B Sales as recomputed $40,000 $40,000 $80,000 $10,000 $20,000 Cost of Sales – Percent of Selling Price Product A Product B Recompiled Sales of products A and B 25% 50% (10,000/.25) (20,000/.5)

Ratio Analysis Formula

Restaurant Sales Number of waiters Average sales per waiter Customer’s tip percentage Waitress tip income as recomputed $90,000 3 30,000 10% $3,000 406

Unit and Volume of Sales Method

Average sales price per machine Number of machines manufactured Total sales as recomputed Total sales per return Unreported sales: $900 1,100 $990,000 720,000 $270,000 Suppose: Beginning inventory Ending inventory $220,000 $250,000 407

Some Exercises

30) Given the following facts about Sammie Bright, calculate his preliminary understatement using the Cash-T method.

Schedule C expenses Personal living expenses Schedule C receipts $102,000 59,000 112,000 31) Based upon the following facts about Phil Tizzard, in Sour Lakes, Texas, calculate any unexplained net worth increase (if any): Computed Net worth (reported income less expenses) Calculated Net worth (actual net worth $520,000 recalculated upon actual assets less liabilities) $618,000 Income $93,000 Expenses $67,000 32) Ben Lautenberg is a waiter in Las Vegas, and reports tip income of $4,200 for the year. The restaurant sales where he works were $360,000 and there were 5 waiters. Assume that the waiters have about the same amount of sales. Compute Ben’s tip income recomputed if customers’ tip percentage is approximately 11% 408

Some Exercises

Other Techniques

check spread

deals with disbursements and may be used when a target uses checking accounts. George A. Manning says the following information is needed to perform a check spread: date, payee, check number, amount, bank from, bank to, first endorsement, second endorsement, and second signatory. Check spreads show patterns of activities and can gather data for the net worth method.

deposit spread

deals with the receipts into a checking account, and shows patterns of activities and gathers data for the net worth and expenditures methods.

Credit card spreads

may be used for legal and stolen credit cards to show where a target has been geographically over time. Source: G.A. Manning,

Financial Investigation and Forensic Accounting

, Boca Raton, FL: CRC Press, 1999, pp. 196-198.

410

Witness and Attorneys Have Testy Session

On cross examination, Edwards’ defense attorney, Dan Small, attacked Ms. East’s testimony. Below is the exchange between Laura East and Dan Small, taken from a reporter’s version: Laura East was on the stand eight hours Wednesday. Dan Small used much of that time to attack the numbers she came up with for prosecutors.

East had testified Edwards had about $98,000 in cash at the beginning of 1994 that was not deposited in banks.

She used a financial statement from January 1994 that said Edwards had $200,000 in cash. East said she subtracted about $102,000 Edwards had in a bank to come up with the $98,000 cash on hand.

Source: B. Barrouquere, “Appeal Questions Edwards Case Money Trail,”

The Advocate Online

, April 10, 2002.

411

Witness and Attorneys Have Testy Session

But East agreed with Small that cash on hand in financial statements can “be all screwed up.” Using the $98,000 as a starting point, East concluded that Edwards had a total of $855,652 in undeposited cash from 1994 to 1996.

She said he spent $1,597,853. East concluded that Edwards had another, unreported source of income totaling $742,301.

But Small suggested that East had underestimated Edwards’ cash on hand by starting at $98,000.

Small focused attention on financial disclosure forms public officials must file with the state. Officials report their holdings in ranges.

412

Witness and Attorneys Have Testy Session

Except for 1993, Edwards had consistently reported having $200,000 or more in cash, Small said. In 1993, Edwards checked the $150,000-$199,999 range for cash.

And Small used tax returns to show Edwards won $1,104,000 gambling between 1987 and 1993.

Although some of the winnings came in the form of checks, East agreed most probably was cash.

But East said she only looked at Edwards’ finances between 1994 and 1996.

“I didn’t review his tax returns from 1987,” said East, a former FBI financial analyst. “It was beyond the scope of my assignment.” Small also attacked other calculations East made, pointing out the vast differences between some numbers in her draft report

Witness and Attorneys Have Testy Session

A draft report East prepared in December showed Edwards had spent $231,000 in cash on improvements on his Double E ranch in Mississippi.

East based some of her report on a handwritten list FBI agents seized from Edwards during a 1997 raid.

But Small contended the list did not denote cash spent. It was a tally of improvements Edwards made in anticipation of selling the ranch, such as siding and roofing, he said.

East said that in her final report, she revised the cash expenditures for the ranch down to $70,560, using what she could confirm as cash spent from 1994 to 1996.

And she defended her calculations of what Edwards spent building a home in the Country Club of Louisiana.

414

Witness and Attorneys Have Testy Session

East calculated the home cost about $1.3 million. Of that, Edwards had spent $733,567 in cash, she said.

Small said East had overestimated by almost $200,000 how much Edwards actually spent in cash.

For example, Small said, East figured Edwards spent about $76,000 in cash buying lumber and supplies from his mother-in-law, Pat Picou, who owns Picou Builders’ Supply.

Picou testified Edwards had given her about $47,000 in cash.

East said she found a lot of Edwards’ transactions to be “suspicious,” and had made some assumptions based on those suspicions.

“So the jury needs to believe your assumptions, and not the testimony in front of it?” Small asked. Source: C. Baughman and A. Angelette, “Witness and Attorneys Have Testy Session,”

The Advocate Online

, March 2, 2000, pp. 3 and 4.

415

Tax Fraud

Tax fraud is somewhat different than legal fraud. The Supreme Court in

Spies v. U.S.

provides some badges of tax fraud: • Abnormal cash dealings.

• False entries in records or creation of false documents such as invoices.

• Duplicate set of books.

• Concealing assets or sources of income.

• Fictitious transactions.

• Expenses not deducted to divert attention from unreported income.

• Destruction of books or records.

Source: 317 U.S. 492 (1943).

416

Tax Fraud

Bradford v. Commissioner

provides other badges of fraud: • Understatement of income.

• Inadequate records.

• Failure to file tax returns.

• Implausible or inconsistent explanations of behavior.

• Concealing assets.

• Failure to cooperate with tax authorities.

• Engaging in illegal activities.

• Attempting to conceal illegal activities.

• Dealing in cash.

• Failing to make estimated tax payments.

• Many of these badges and others may be found in the

Internal Revenue Manual

. Source: 796 F. 2d 303 (CA-9, 1986).

417

Tax Fraud Schemes

• • •

Slavery Reparation Credit

– 80,000 claims in 2001, totaling $2.7 billion. IRS paid out $30 million.

Social Security Refund

– promoters tell taxpayers they can recover all of their FICA and Medicare taxes paid. Typical charge: $100 plus 10% of the refund.

Home – based businesses

– claim deductions for home – based businesses (i.e., hobby losses).

• Domestic and foreign

trust

schemes charges range from $5,000 to $70,000 • Many

frivolous

protestor theories.

See: S.F. Holub, “Tax Fraud and Tax Protesters,”

The Tax Adviser,

December 2002, pp. 790-792.

418

Venue for Tax Fraud

Criminal Tax Fraud: Federal District Court Civil Tax Fraud: • Federal District Court.

• U.S. Tax Court.

• Federal Claims.

419

Fraud vs. Avoidance

Chevron Texaco 50% 50% Caltex (Indonesian companies)

•

U.S. companies paid Caltex excessive amounts for Indonesian Crude Oil ($4.55 per barrel).

•

Therefore, excessive dividend income, with foreign tax credits and cost of sales deductions on U.S. income tax returns.

•

To compensate Caltex for the extra taxes it paid, Indonesian Government provided Caltex with oil in excess of the amount called for under the formal production sharing contract.

•

Total Federal and State taxes avoidance of $8.6 billion and $433 million.

Source: J.D. Gramlich and J.E. Wheeler, “How Chevron, Texaco, and Indonesian Government Structured Transactions to Avoid Billions in U.S. Income Taxes,”

Accounting Horizons

, June 2003, pp. 107-122.

420

Financial Statement Fraud May Serve Many Purposes:

Obtaining credit, long-term financing, or additional capital investment based on misleading financial statements; Maintaining or creating favorable stock value; Concealing deficiencies in performance; 4.

Hiding improper business transactions (e.g., fictitious sales or misrepresented assets); and 5.

Resolving temporary financial difficulties (e.g., insufficient cash flow, unfavorable business decisions, defense control in maintaining prestige).

Source: Zab Rezaee,

Financial Statement Fraud

, New York: John Wiley & Sons, 2002.

421

Management may also engage in financial statement fraud to obtain personal benefits of:

1. Increasing compensation through higher reported earnings; 2. Enhancing value of personal holding of company stock such as stock-based compensation; 3. Converting the company’s assets for personal use; and 4. Obtaining a promotion or maintaining the current position within the company.

Source: Zab Rezaee,

Financial Statement Fraud

, New York: John Wiley & Sons, 2002.

422

KPMG provides 10 steps to follow when an organization finds or suspects fraud:

1. Shut the door!

Keep assets secure until you can provide appropriate long-term security.

2. Safeguard the evidence.

Ensure that all records and documents necessary for an investigation remain intact and are not altered by you or anyone else.

3. Notify your insurer.

Failure to notify may negate your coverage.

4. Call a professional.

Do not confront or terminate the employment of a suspected perpetrator without first consulting your legal advisor.

5. Prioritize your objectives.

What’s most important: punishment, loss recovery, prevention, detection of future occurrences?

423

KPMG’s 10 steps to follow contd..

6. Consider prosecution.

Before you make the call, weigh the plusses and minuses and determine if your insurance company requires prosecution.

7. Terminate business relations.

If the fraud is external, business relations with the suspect individual or organization should be terminated.

8. Seek advice and assistance.

An important consideration is whether you have the knowledge and resources necessary to effectively manage the process.

9. Prepare a witness list.

that statements be taken before a “party line” can develop.

It is important

10. Consider the message.

Whatever you do will affect future situations. Now may be the time to change the way your business operates.

424

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.

425

The Rest Of The Story: Fraudsters Should Be Prosecuted

Although large frauds may be reported to law enforcement agencies, smaller frauds are often

not reported

This failure to report fraud incidents and the reluctance of police to aggressively tackle the issue only empowers the perps and diminishes the victims. Ultimately, these unreported incidents are precursors to

larger and larger acts of violence

. If we do not deal with simple crimes, we will eventually have to deal with homicide.

Source:

Stephen Doherty, “How Can Workplace Violence Be Deterred,”

Security Management

, April 2002, p. 134.

426

State and Local Government Susceptibility

Government bankruptcy is an important issue for fraud prevention and detection because likes business corporations and organizations, governments facing severe financial difficulties can be fertile ground for fraud. Government bankruptcy also may trigger an investigation in order to determine if fraud has contributed to such financial distress.

427

Governmental Frauds

20 billion

in erroneous payments.

On June 19, 2003: We analyzed a portion of the programs and already know that erroneous payments exceeded

$35 billion

a year.” Office of Mgt. And Budget 428

Governmental Frauds

The Internet site of Ashcraft & Gerel indicates that

10 percent

of the U.S. annual budget is paid to companies or persons who are defrauding the government.* •Ashcraft & Gerel, “Whistle Blower Litigation Under The Federal False Claims Act - - Qui Tam Claims,” www.ashcraftandgerel.com/whistleb.html#History ------------------------------------------------------------- 2002 Wells Report: 25% of fraud incidents occurred in government agencies, with a $48,000 median loss (.25 times $600 billion = $150 billion).

429

New Zealand Government Fraud

•The Ministry of Social Development was defrauded of $1.1 million by a trusted employee.

•The employee created 67 fictitious invoices for payment over 28 months, at a time when there had been changes in management

at the time of the month when there was pressure to approve payment of accounts payable.

•Another employee noticed his own signature apparently forged on a document.

Source: Helen Bishop and Ashley Burrows, “Fraud in New Zealand Government Despite Auditor General’s Warning,”

Journal of Government Financial Management

, Winter 2003, Vol. 52, No. 4, pp. 42-46.

430

Government Quiz 101

The ________ in 2002, improperly recorded some expenses, kept “inappropriate balances” in some accounts, and failed to verify how much money it was collecting in transaction fees.

While this government agency’s overall internal controls were “effective,” their financial reports are not presented in accordance with applicable federal accounting requirements.

This agency did not properly record capital leases for computer hardware and did not properly account for its software licensing fees and other in-house expenses. They need to do a better job of tracking transaction fees.

Source:

Deborah Soloman, “SEC’s Own Accounting Requires Tightening, Internal Audit Says,”

Wall Street J.

, July 3, 2003, A-2.

431

Top-Side Entries: Smoking Gun

An Oct. 14, 2002,

New York Times

article by Joel Brinkley stated that “auditors studying the financial records of federal government departments find may of them so disorganized, even chaotic, that the agencies cannot account for tens of billion of dollars.” So how did the agencies make their books balance? Through the magic of top-side balancing entries.

The Forest Services, a division of the U.S. Department of Agriculture, tried to balance its books at the end of the 2001 fiscal year. It booked more than 15,337 adjusting entries, debits, and credits totaling more than $11 billion gross. Auditors determined that 73 percent of these adjustments, totaling $7.9 billion, were unsupported. The U.S. Department of Defense alone entered an unsubstantiated balance adjustment totaling $1.1 trillion in 2000, down from $2.3 trillion the prior year.

Source: Scott Green, “Fighting Financial Reporting Fraud,”

Internal Auditor

, December 2003, pp. 58-65.

432

GASB Statement No. 34

•Although GASB has no authority to set law, many public agencies follow its standards.

•Statement No. 34 retains the fund accounting focus (good for budgeting and short-term focus), but adds government-wide financial statements (e.g., account for all assets and liabilities).

•Requires capitalization and depreciation of infrastructure assets.

•Goes from the Governmental Funds Statements to the Statement of Net Assets and Statement of Activities.

•Goes from the modified accrual statements to the full accrual statements.

•New Management Discussion and Analysis (MD & A) Statement – a narrative discussion of any significant changes in the overall financial picture of a given agency.

Source: K. Middaugh, “The Great GASB,”

Government Technology

, October 2003, pp. 50-52.

433

Qui Tam Suits

• The Qui Tam suit allows any

concerned citizen

to seek relief in the name of the government.

• Many whistle-blowers initially file qui tam suits to get a dispute on the books and started.

• Once a qui tam suit is initiated, the U.S. Department of Justice evaluates the case to see whether the DOJ believes there are sound reasons to pursue the conflict.

• Whatever parts of the qui tam suit the U.S. DOJ does not take, a whistle blower and his or attorney can

continue to litigate

434

Taxpayers Against Fraud

The Taxpayers Against Fraud has an Internet site called “The False Claims Act Legal Center.” Their Qui Tam Attorney Network assists attorneys in their efforts to provide effective representation to qui tam plaintiffs. This group disseminates information about the False Claims Act and qui tam provision. An attorney may request an

amicus

brief submission. They state that enforcement of the False Claims Act and its qui tam provisions have returned more than $12 billion to the U.S. Treasury over the past 17 years ($2.1 billion in 2003 fiscal year).

Whistle-blowers paid $319 million in 2003 fiscal year (up to 25% of judgment).

435

Ratio Assess Financial Health

Financial Position: Unrestricted Net Assets Expenses Financial Performa nce: Change in Net Assets Total Net Assets

Purpose

Measures a government’s ability to provide basic government services Measures a government’s financial performance during the current fiscal year by comparing the change in the Net Assets derived from the Statement of Activities to the total net assets.

Negative Indicator

Decreasing Decreasing (General Revenues + Transfers) / Expenses Liquidity: (Cash + Current Investments + Receivables) / Current Liabilities Measures the extent to which the cost of services are paid for out of general revenues. Measures the extent to which current liabilities are covered by the more liquid current assets.

Decreasing Decreasing Solvency: Long-term Debt / Assets Measures a government’s long-term financial viability by comparing the extent to which assets are financed by incurring long-term debt.

Increasing (Change in Net Assets + Interest Expense) / Interest Expense Measures the government’s ability to generate a stream of inflows sufficient to make interest payments.

Decreasing Source: B.A. Chaney, D.M. Mead, and K.R. Schermann, “The New Governmental Reporting Model,”

Journal of Governmental Management

, Spring 2002, p. 29. 436

© D.L. Crumbley Early Warning Signals of Possible Trouble for Municipal Entities 1. Current year operating deficit 2. Two consecutive years of Operating Fund deficit 3. Current year operating deficit that is larger than the previous year’s deficit 4. A General Fund deficit in the current year – balance sheet – current position 5. A current General Fund deficit (two or more years in the last five) 6. Short-term debt outstanding at the end of the fiscal year, greater than five percent of main Operating Fund Revenues 7. A two-year trend of increasing short-term debt outstanding at fiscal year end 8. Short-term interest and current year-end service greater than 20 percent of total revenues 9. Property taxes greater than

90 percent

of the tax limit 10.Debt outstanding greater than

90 percent

of the debt limit 11.Total property tax collections less than 92 percent of total levy 12.A trend of decreasing tax collections – two consecutive years in a three-year trend 13.Declining market valuations – two consecutive years – three-year trend 14.Expanding annual unfunded pension obligations Source: H.C. Grossman and T.E. Wilson, “Assessing Financial Health,”

Handbook of Governmental Accounting & Finance

, Somerset, N.J.: John Wiley & Sons, 1992, pp. 38-1 to 38-13.

437

Ratios

Assess Financial Health of Governmental Units Negative Indicator Credit Industry Benchmark

Less than 1% Cash and investments/current liabilities Operating surplus (deficit)/total revenue Decreasing Decreasing Elastic revenue (sales, utilities, other elastic taxes)/total revenue Decreasing Increasing State and federal aid / total revenue Current liabilities/total revenue Uncollected property taxes/ current tax levy Fixed costs/ total expenditures Increasing Increasing Increasing 5% or consecutive Varies Varies 5% Greater than 8% Varies Debt service/total revenue Tax levy/tax limit Increasing Increasing Greater than 20% Greater than 90% Debt outstanding/debt limit Increasing Greater than 90% Source: S.M. Winckler and Dewey Ward, “Can City Hall Go Broke? The Going Concern Issue,”

Journal of Accountancy

, May 1984.

438

Office of New York State Comptroller

Indicator 1: Revenue and Expenditures Per Capita Recurring Revenues Per Capita

a. Gross Revenues Population b. Gross Expenditures Population c. Recurring Revenues (Gross Revenues – One-Time Revenues) Population

Negative Trend

: Indicator 1b increasing faster than indicator 1a or 1c.

Indicator 2: Real Property Taxes Receivable

Real Property Taxes Receivable Real Property Tax Revenue

Negative Trend

: The percentage increases over time.

Indicator 3: Fixed Costs – Personal Services and Debt Service

a. Salaries and Fringe Benefits Gross Expenditures b. Debt Service Expenditures Gross Expenditures c. Salaries and Fringe Benefits + Debt Service Gross Expenditures

Negative Trend

: Percentages increasing over time.

Some analysts use a variation of the 3b ratio based upon debt service expenditures as a percentage of revenues. A ratio of 25% for debt service expenditures to “own source” revenues is considered a danger signal.* * J.R. Razek

et. al

, Introduction to Governmental and Not-For-Profit Accounting, Prentice-Hall, 2000, p. 412.

439

Office of New York State Comptroller

Indicator 4: Operating Surplus/Deficit

a. Gross Revenues – Gross Expenditures Gross Expenditures b. Gross Revenues – Gross Expenditures – One-Time Revenues Gross Expenditures

Negative Trend

: Percentages decreasing over time.

Indicator 5: Unreserved Fund Balance and Appropriated Fund Balance

a. Unreserved Fund Balance Gross Expenditures b. Appropriated Fund Balance Gross Expenditures

Negative Trend

: Percentages decreasing over time.

Deficits in major funds in excess of 1.5% of fund expenditures or $50,000 (whichever is greater) are generally causes for concern. Some analysts use a variation of this ratio: the budgetary cushion. Here the fund balance is compared to revenues. The greater the fund balance as a percentage of revenues, the more likely a local government may weather hard times. A good rule of thumb is that a fund balance should be at least 5% of revenues.

[1] [1] J.R. Razek et. al, op. cit., p. 411.

440

Office of New York State Comptroller

Indicator 6: Liquidity

Cash and Investment as a Percentage of Current Liabilities Cash and Investments as a Percentage of Gross Monthly Expenditures a.

Cash and Investments Current Liabilities b.

Cash and Investments Gross Expenditures/12

Negative Trend

: Percentages decreasing over time.

A government should generally have year-end cash equal to about 50% of current liabilities and 75% of average monthly expenditures. A governmental accounting textbook states that this quick ratio (or acid test) omits receivables and amounts due from other funds because of difficulties converting them into cash. They suggest that a large state government

should

consider a quick ratio of less than 50 percent as an indicator of financial stress.

Indicator 7: Long-Term Debt

Long-Term Debt Population

Negative Trend

: Percentage increase over time Note: An increase in #7 would likely trigger a future increase in #3 formula as well as a decrease in #8.

Indicator 8: Capital Outlay

Capital Outlay Gross Expenditures

Negative Trend

: Percentage decreasing over time Note: This eighth indicator is an early warning sign of financial stress. * Razek and Hosch,

ibid

.411.

441

Office of New York State Comptroller Indicator 9: Current Liabilities

Current Liabilities Gross Revenues

Negative Trend

: Percentage increasing over time

Indicator 10: Intergovernmental Revenues

Intergovernmental Revenues Gross Revenues

Negative Trend

: Percentage increasing over time.

Indicator 11: Economic Assistance Costs

Economic Assistance Cost Gross Expenditures

Negative Trend

: Percentage increasing over time.

442

Office of New York State Comptroller Indicator 12: Public Safety

Public Safety Cost Gross Expenditures

Negative Trend

: Percentage increasing over time

Indicator 13: Tax Limit Exhausted

Tax Levy Tax Limit

Negative Trend

: Percentage increasing over time The tax limit is the maximum amount of taxes that can be levied based upon some statutory authority.

Indicator 14: Debt Limit Exhausted

Total Debt Subject to Limit Debt Limit

Negative Trend

: Percentage increasing over time Debt limit is the maximum amount of debt that can be issued under applicable statutory authority. Compare this ratio with indicators 3 and 7.

443

Some Exercises

1. You have the following data for a city in the southwest. Calculate the quick ratio. Is this ratio favorable or unfavorable?

Current Liabilities Cash $28 million $27 million Investments (current) Accounts Receivable $36 million $12 million Due from other funds $2.5 million 2. You have the following information about a mid-west city. Calculate the ratios of fund balance to revenues and determine if they are favorable or unfavorable.

General Fund Unreserved Fund $62 million $54 million General Fund Revenues $401 million 3. You determine the following data about a local government in the southeast. Determine the ratios of unreserved fund balance and reserved fund balance to total revenues. Are these ratios favorable?

Revenues from Property Taxes Unreserved Fund Balance $36 million $5 million Reserved Fund Balance $3.5 million 4. Assume the following facts about a local government. Determine the Tax Limit Exhausted and the Debt Limit Exhausted ratios.

Tax Limit Debt Limit Tax Levy Total Debt subject to Limit $11 million $13 million $8.5 million $9 million 5. Assume that Debt Service Expenditures is $16.2 million and Total Revenues is $70.1 million. Calculate the Debt Service/total revenue ratio. Is the ratio favorable?

444

negative

indicators of the financial health of a government unit.

a. Cash and investments divided by current liabilities ratio is

decreasing

over several years.

b. Current liabilities divided by total revenues ratio is

decreasing

c. Fixed costs divided by total expenditures ratio is

increasing

d. Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is

increasing

over time.

e. Debt Service expenditures as a percentage of revenues is greater than 25%.

f. Debt Service Expenditures divided by Gross Expenditures ratio is

decreasing

over time.

g. Gross Revenues – Gross Expenditures : Decreasing over time.

Gross Expenditures h. The debt service expenditures as a percentage of revenues is 25% or larger.

i. A fund balance is greater than 10% of revenues.

j. Unreserved fund balance divided by gross expenditures ratio is

decreasing

over time.

k. The quick ratio of a large state government is 2.2 to 1.

l. Long-Term Debt divided by population ratio is

decreasing

over time.

m.Current Liabilities divided by Gross Revenues ratio is

increasing

over time.

n. Tax Levy divided by Tax Limit ratio is

decreasing

over time. 445

negative

financial health of a government unit.

indicators of the a. Cash and investments divided by current liabilities ratio is decreasing over several years.

Negative

b. Current liabilities divided by total revenues ratio is decreasing.

Positive

c. Fixed costs divided by total expenditures ratio is increasing.

Negative

d. Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is increasing over time.

Negative

e. Debt Service expenditures as a percentage of revenues is greater than 25%.

Negative

f. Debt Service Expenditures divided by Gross Expenditures ratio is decreasing over time.

Positive

g. Gross Revenues – Gross Expenditures : Decreasing over time.

Gross Expenditures

Negative

h. The debt service expenditures as a percentage of revenues is 25% or larger.

Negative

i. A fund balance is greater than 10% of revenues.

Favorable

j. Unreserved fund balance divided by gross expenditures ratio is decreasing over time.

Negative

k. The quick ratio of a large state government is 2.2 to 1.

Favorable

l. Long-Term Debt divided by population ratio is decreasing over time.

Favorable

m.Current Liabilities divided by Gross Revenues ratio is increasing over time.

Negative

n. Tax Levy divided by Tax Limit ratio is decreasing over time.

Favorable

447

Not-For-Profits

• There are more than

1 million

not-for profits in the U.S.

• Often there

is little

segregation of duties.

• They often deal in an atmosphere of trust, with employees having little accounting and business experience.

• Difficult to estimate and control the cash contributions and revenues (e.g., Salvation Army’s Christmas kettles take in $1,000 $1,500 per day).

• Fountains at charitable organizations may take in several thousand dollars in coins.

• The Non Profit Times ( www.nptimes.com

• Some people believe the Sarbanes-Oxley Act will be

imposed

on large not-for profits.

• Moral: Do

not

go to a hospital that you are giving away money to in your will.

448

Fraud in Not-for-Profit Organizations

The website of Clark, Schaefer, Hackett & Company states the following reasons not-for-profit organizations become targets of fraud: Many smaller not-for-profits just don’t have the personnel size required for a real segregation of duties. They often don’t require much approval for disbursements. And, when fraud is discovered, they frequently don’t prosecute it very aggressively because of the perceived negative publicity.

449

Blue Cross Overcharged

•Two men supplied hundreds of

phony invoices

to Blue Cross from 1996-2001 in a scheme to defraud more than $14 million.

•Prosecutors said V.J. Croce and Joseph Quattrone

overcharged

Blue Cross for building maintenance supplies and repairs.

•Two men convicted, receiving eight years in jail and $9.2 in restitution.

Source: AP, “Men in Blue Cross Fraud Case Sentenced,”

Las Vegas Sun

, January 17, 2004.

450

Red Flags of Fraud for NPOs

•

Budget cutbacks.

•

High turnover.

•

Refusal to take legitimate perks (e.g., vacations).

•

Overemphasis on short-term fund-raising goals.

•

Poorly monitored remote event or promotional locations.

•

Bounced checks.

•

Things don’t add up.

•

Anonymous tips.

•

Lifestyle or behavior changes.

•

Inattention to details.

•

Not conducting background checks on anyone handling money.

•

Keeping problems a secret.

•

Failing to investigate and then prosecute to the fullest extent of the law.

K. Anne Midkiff, “Catching the Warning Signs of Fraud in NPOs,”

Journal of Accountancy

, January 2004, p. 28.

451

Industry Specific Investigations: IRS’s Audit Technique Guides (ATGs)

• • • • • • • Market Segment Specialization Program produces ATGs.

At least 74 different ATGs.

Length: 13 to 237 pages.

ATGs on IRS website.

See CCH Internet Tax Research Network.

more under study.

Usually contain:   Common and unique practices.

Industry terminology.

  Examination techniques (e.g. interview questions).

Other information.

452

Some ATGs

• • • • • • • • • • • • Attorneys.

Auto Dealerships.

Bars and Restaurants.

Child Care Providers.

Construction Industry.

Oil and Gas Industry Pizza Restaurants.

Retail Gift Shops.

Scrap Metal.

Taxicabs.

Trucking Industry.

Wine Industry.

Computer Forensics

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. 91 454

The End Is Here