Transcript Forensic Accounting Update Exam II Copyrighted 2002 D

© D.L. Crumbley
New Strategies for Detecting &
Preventing Fraud
D. Larry Crumbley, CPA, Cr.FA, CFD
KPMG Endowed Professor
Department of Accounting
Louisiana State University
Baton Rouge, LA 70803
225-578-6231
225-578-6201 Fax
[email protected]
Dr. Crumbley is the
Editor of the Journal of Forensic Accounting: Auditing,
Fraud, and Risk,
Former chair of the Executive Board of Accounting
Advisors of the American Board of Forensic Accountants,
Member of the NACVA’s Fraud Deterrence Board, and
On the AICPA’s Fraud Task Force (2003-2004).
A frequent contributor to the Forensic Examiner, Professor
Crumbley is a co-author of CCH Master Auditing Guide,
along with more than 50 other books and 350 articles. His
latest book entitled Forensic and Investigative Accounting is
published by Commerce Clearing House (800-224-7477).
Some of his 12 educational novels have as the main character
a forensic accountant. His goal is to create a television series
based upon the exciting life of a forensic accountant and
litigation consultant.
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© D.L. Crumbley
Definition of Forensic Auditor
Someone who can look behind the
facade--not accept the records at
their face value--someone who has a
suspicious mind that the documents
he or she is looking at may not be
what they purport to be and someone
who has the expertise to go out and
conduct very detailed interviews of
individuals to develop the truth,
especially if some are presumed to
be lying.
Robert G. Roche, a retired chief of the IRS Criminal Investigation
Division of the IRS
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Definition of Forensic Accounting
Forensic accounting is the application of
accounting, tax, auditing, finance,
quantitative analysis, investigative and
research skills, and an understanding of
the legal process for the purpose of
identifying, collecting, analyzing, and
interpreting financial or other data or
issues in connection with:
1) Litigation services: providing assistance
for actual, pending or potential legal or
regulatory proceedings before a trier of
fact in connection with the resolution of
disputes between parties, or
2) Non-litigation
services:
performing
analyses or investigations that may require
the same skills used in 1, above, but may
not involve the litigation process.
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© D.L. Crumbley
Definition of Forensic Accounting
Non-Litigation Services
Forensic
accounting
non-litigation
services are the professional assistance
accountants provide not related to the
litigation process. These services may
involve accounting, financial, auditing, tax,
quantitative analysis, and investigative and
research skill as well as an understanding of
the legal process to provide assistance in
connection with matter or issues not
involving the litigation process.
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The Bubble Deception
There are 14,000 publicly traded companies
in the United States. Expecting all of them to
be honest is unrealistic. Like any town of
14,000, the market is bound to have its share
of grifters and shoplifters. But the deception
at Computer Associates was dangerous
precisely because it wasn’t an aberration.
By January 2001, all manner of companies
were abusing accounting rules to mislead
their investors, seemingly without fear of
being caught. A strange madness had gripped
the market. Even its most solid citizens were
running red lights and breaking windows.
And the police were nowhere in sight.
Alex Berenson, The Number, Random House, 2003, p. xxiii.
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Enriching Insiders
I know that sounds crazy, but the stock market has
gone from a place where investors actually own part
of a company and have a say in their management to
a market designed to enrich insiders by allowing
them to sell shares they buy cheaply through options.
Companies continuously issue new shares to their
managers without asking their existing shareholders.
Those managers then leak that stock to the market a
little at a time. It’s unlimited dilution of existing
shareholders’ stakes, dilution by a thousand cuts. If
that isn’t a scam, I don’t know what is.
Individual shareholders have nothing but the
chance to sell their shares to the next sucker . A
mutual fund buys one million shares of a company
with your and your coworkers’ money. You own 1
percent of the company. Six weeks later you own
less, and that money went to insiders, not to the
company.
Alex Berenson, The Number, Random House, 2003, p. xviii.
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Forensic Accounting Factors
• Time: Forensic accounting focuses on
the past, although it may do so in
order to look forward (e.g., damages,
valuations).
• Purpose: Forensic accounting is
performed for a specific legal forum
or in anticipation of appearing before
a legal forum.
• Peremptory: Forensic accountants
may be employed in a wide variety of
risk management engagements within
business enterprises as a matter of
right, without the necessity of
allegations (e.g., proactive).
----------------------------------------------With a single clue a forensic
accountant can solve a fraudulent
mystery.
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One Small Clue
© D.L. Crumbley
A former Scotland Yard scientist tried to
create the world’s biggest fraud by
authenticating $2.5 trillion worth of fake U.S.
Treasury bonds.
When two men tried to pass off $25 million
worth of the bonds in Toronto in 2001, a
Mountie noticed the bonds bore the word
“dollar” rather “dollars.”
Police later raided a London bank vault and
discovered that the bonds had been printed
with an ink jet printer that had not been
invented when the bonds were allegedly
produced.
Zip codes were used even though they were
not introduced until 1963.
Sue Clough, “Bungling Scientist Is Jailed for Plotting World's
Biggest Fraud,” News.telegraph.co.uk, January 11, 2003.
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Forensic Accounting
Defined
Forensic accounting is the action of
identifying, recording, settling, extracting,
sorting, reporting, and verifying past financial
data or other accounting activities for settling
current or prospective legal disputes or using
such past financial data for projecting future
financial data to settle legal disputes.
Source: Forensic and Investigative Accounting
(CCH)
-------------------------------------------------------When the death of a company occurs
under mysterious circumstances, forensic
accountants are essential. Other accountants
look at the charts but forensic accountants
actually dig into the body.
Douglas Carmichael
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Forensic Accounting Areas
Investigative Auditing
Litigation Support
Forensic: Latin for “forum,”
referring to a public place or court.
Black’s Law Dictionary: Forensic,
belonging to the courts of justice.
Note: Corporate spooks are used to check on
competitors.
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Forensic Auditing
Forensic auditing is a type of auditing that
specifically looks for financial misconduct, and
abusive or wasteful activity.
It is most commonly associated with
gathering evidence that will be presented in a
court of law as part of a financial crime or a fraud
investigation.
Source: B.L. Derby, “Data Mining for Improper Payments,” Journal of Government Financial
Management, Winter, 2003, pp. 10-13
----------------------------------------------------------------
“ Forget the stuffed white shirt, forensic
accountants are more parts Philip
Marlowe than Casper Milquetoast. They
open the books and crack the code,
transforming a dull science of numbers
into a suspenseful mystery with a logical,
even riveting resolution.”
Cory Johnson
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Top Niche Services
1. Litigation Support
2. Business Valuations
3. Estate Planning
4. SOX Compliance
5. Forensics/fraud
6. Nonprofits
73%
72%
65%
63%
60%
60%
7. Attest services
8. Business mgt. for the wealthy
55%
55%
Source: Accounting Today.
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Forensic Accounting vs.
Fraud Auditing
Fraud Auditor: An accountant especially
skilled in auditing who is generally
engaged in auditing with a view toward
fraud discovery, documentation, and
prevention.
-------------------------------------------------“Economic crimes and fraud often do not
involve obvious evidence like the smoking
gun. Forensic accountants look behind the
deals and handshakes and probe beyond the
numbers to uncover the reality of financial
situations.”
Source: D.W. Squires, “Problems Solved with Forensic Accounting:
A Legal Perspective,” Journal of Forensic Accounting., Vol. IV
(2003),. P. 131.
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Forensic vs. Fraud Audit
Google result, May 4, 2004
– Forensic Audit, 19,800 hits
– Fraud Audit, 4,470 hits
– Fraud Examination, 11,400 hits
– Fraud Accounting, 3,790 hits
– Forensic Accounting, 225,000
hits
---------------------------------------------I don’t care what they say, but
[forensic accounting] is here to stay.
Danny & the Juniors
-----------------------------------------------------------------------------------
I see skies of blue and clouds of white, and
I think to myself, what a wonderful
world.
Louis Armstrong
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Specialties Within Forensic
and
Investigative Accounting
• Employee Crime Specialist.
• Asset Tracing Specialist.
• Litigation Services Specialist
and Expert Witness.
• Insurance Claims.
• Valuation Analysis.
• False Claims Act Violations.
• Due diligence investigations.
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Asset Tracing
© D.L. Crumbley
Three Italian lawyers said in a filing to be presented
to a bankruptcy court that they had traced $7.7 billion
in missing Parmalat funds.
“We are preparing a filing in which we are asking for
the insolvency status to be revoked because the
money was robbed and not lost,” lawyer Carlo Zauli
told Reuters.
But he said it would be an illusion to believe proof of
electronic transfers of the funds could be found and
the lawyers representing the Parmalat Creditors
Committee did not say where the money was being
held or if it was recoverable.
An Italian website, TGfin (www.tgfin.it), said a
company linked to Parmalat founder Tanzi was
holding the funds in the form of U.S. bonds in an
account with Bank of America.
Source: Emilio Parodi and Stefano Bernabei, “Wrap-up 2: Paramalat Fraud
Probe Widens to Auditors, Ex-Banker, “forbes.com, January 8, 2004.
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Gross Profit Comparison
•
In a divorce situation, a business owner
claimed only about $75,000 annual
income.
•
He claimed he had borrowed and not
paid back huge sums.
•
Wife said he was spending about
$400,000 per year more than his salary.
Four schedules for the courtroom:
1. What was known and alleged about
husband’s expenditures.
2. Schedule comparing income with
expenditures.
3. Amounts husband claimed he had
borrowed.
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Gross Profit Comparison (cont.)
4.
•
•
Company’s income statements side-byside:
New Gross Profit
His
Per Industry
----------------$75,000
$475,000
Husband had overstated COGS.
Checks issued to vendors, into COGS.
Some of the vendors cashed the checks
and returned the money to husband.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R. T.
Edwards, 2005, pp. 49-57.
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Unreported Beer Sales
• Business owner reports only $50,000 business
income, but has expensive cars, private
schools, buying significant real estate.
• Subpoenaed records of local beer distributors.
Then went to the club and ordered some
drinks, noting the pricing of the beer, etc.
1,000 cases of Miller’s
24 bottles
24,000
x $2
$48,000 per year
• Found that reported sales were underreported
by $500,000.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards,
2005, pp. 49-57.
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© D.L. Crumbley
Home Improvements
• Massive improvements to personal home, not
paid for by personal funds.
• Company showed many corporate payments to
home remodeling contractors/landscapers.
• But the industrial park not owned by company.
• Only photocopies of invoices provided.
• FC demanded original documents.
• Finally, the original documents had white-outs of
job locations and work descriptions.
• Could turn over the originals and read the real
data from the back side.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards,
2005, pp. 49-57.
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© D.L. Crumbley
Finding Unreported
Income/Hidden Assets
1.
2.
3.
4.
Look at the lifestyles.
Look at the expenses.
Look at the cash flow.
Look at the business
operations.
5. Look at the industry ratios.
6. Consider using private
investigators.
7. Use the net worth method.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R.T.
Edwards, 2005, pp.49-57.
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© D.L. Crumbley
Fiction v. Reality
The main difference between fiction and
reality is that instead of using mask and gun,
today’s villains use mouse and keyboard.
Instead of hiding behind a lamppost in a trench
coat and fedora, today’s forensic accountants
are more likely to be hiding behind their own
computers, searching for clues amid
mountains of data.
Source; “Book ‘EM! Forensic Accounting in History and Literature,”
The Kessler Report, Vol.1, No. 2.
------------------------------------------------------------------------------------
“Every investigation I did as a prosecutor, you
have a particular target, but it always branches
off because something else gets your attention.
And that’s what is going to happen with a
forensic accountant.”
Tom Carlucci:
E-library Rueter Library September 20, 2002
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Carmichael`s Position
• Doug Carmichael, Chief Auditor for Peekuh-boo, faults auditors for not adopting
forensic techniques.
• Carmichael wishes more “test of details,” not
relying on test of controls.
• He wishes more shoe-leather work.
• Shoe-leather work is what we do!
Kris Frieswick, “How Audits Must Change,”
CFO, July 2003, p.48
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Forensic Accountants
“Rather than combing torn clothing,”
forensic accountants “comb through
corporate books, looking for oddities
that could signal swindles,” says Bruce
Dubinsky. Investigations can be
extremely complex, with crates and
crates of documents and thousands of
computer files. Investigators look for
flags or patterns that would not
normally occur.
Source: Mark Maremont, “Tyco Is Likely to Report
New Woes,” Wall Street Journal, April 30, 2003, p. C1.
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Auditors Blamed: Deep Pockets
•Trustee for United Companies (UC) said that
Deloitte and Touche was guilty of negligence,
malpractice, misrepresentation, breach of duty,
and fraud.
•D & T failed to warn United Companies of all
of the losses it would absorb if the people who
took out the loans defaulted, because the
accounting firm was making millions and
millions of dollars in fees.
•Loan practice called securitization or bundled
high-interest loans.
•$685 million in liability damages.
•Plaintiff’s Attorney: Role of auditors is to act
as watchdogs for companies. “A good watchdog
barks when somebody comes into the yard. D &
T is supposed to bark when there is a problem.”
•Defendant’s Attorney: “The problem was
much larger than a watchdog could handle. Can
a watchdog stop your house from getting hit by a
hurricane? Of course not.”
Source: Adrian Angelette, “Auditors Blamed, “Baton Rouge Advocate,
October 23, 2003, pp. A-1 and a-8
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Auditors Blamed (cont.)
•As part of the securitization agreement,
UC agreed to pay the principal and
interest on defaulted loans.
•Creditors contend that UC failed to
account for the interest it was paying, and
D&T should have caught the mistake
earlier.
•After UC wrote off $605 million in debt,
the company filed for bankruptcy.
• Confidential mid-court settlement.
Source: Adrian Angelette, “United Companies Settlement Reached,”
Baton Rouge Advocate, October 31, 2003, pp. A-1 and A-12
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Find It, or I’ll Sue
Accountants must be attuned
to detecting fraud at every level of
service, including standard
accounting services, compilations,
reviews, and bank reconciliations. If
there is fraud and you don’t detect
it, you are going to be sued, and
you will likely lose, as the public
perception is the accountant is the
watchdog.
Robert J. DiPasquale, Parsippany, N.J.
Source: H.W. Wolosky, “Forensic Accounting to the Forefront,”
Practical Accountant, February 2004, pp. 23-28.
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Forensic Accounting Knowledge Base
LAW
Criminology
Investigative
auditing
Accounting
Forensic Accountant
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© D.L. Crumbley
Threads of Forensic
Accounting
Forensic accounting (or at least
accounting expert witnessing) can be
traced as far back as 1817 to a court
decision. [Meyer v. Sefton]
In 1824, a young accountant by the name
of James McCleland started business in
Glasgow, Scotland and issued a circular
that advertised various classes of expert
witness engagements he was prepared to
undertake.
In 1856 in England, the audit of
corporations became required.
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Investigative Accountants
Initially called investigative
accounting, many of the forensic
techniques, such as the net worth
method, were developed by IRS agents
to detect tax evaders.
Infamous mobster, Al Capone, was
caught when Special Agents of the IRS
stepped in and charged him with tax
evasion.
Accountants caused the crime czar’s
career to come to an end.
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Investigative Techniques
“You know how it goes,” I said. “You get a case. You
just keep poking around, see what scurries out.” p.
144.
-----------------------------------------------------------“How,” Susan said, “on earth are you going to
unravel all of that?”
“Same way you do therapy,” I said.
“Which is?”
“Find a thread, follow it where it leads, and keep on
doing it.”
“Sometimes it leads to another thread.”
“Often,” I said.
“And then you follow that thread.”
“Yep.”
“Like a game,” Susan said.
“For both of us,” I said.
Susan nodded. “Yes,” she said, “tracking down of a
person or an idea or an evasion.”
pp. 270 – 271.
-------------------------------------------------------------------------------Source: R.B. Parker, Widow’s Walk, Berkley Books, 2002.
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Al Capone Caper
“Perhaps the most celebrated case of
an accountant nailing a famous criminal was
the case of Al Capone. For all of Capone’s
colorful history of violent crime, the FBI
could never gather enough evidence to
convict him until FBI agent Eliot Ness had
an idea.
He gathered special agents of the IRS
to track the flow of cash from Capone’s illicit
activities. When the mobster failed to pay
taxes on those earnings, the IRS nailed him
for tax evasion.
Capone went to jail and was never a
factor again. IRS recruitment posters boast
till this day: ‘Only an accountant could catch
Al Capone.’”
Source: “Book ‘Em! Forensic Accounting History and Literature,” The Kessler
Report, Vol. 1, No. 2.
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© D.L. Crumbley
Father of Forensic
Accounting:
Maurice E. Peloubet (1946)
Pretenders:
– Max Lourie (1953)
– Robert Lindquist (1986)*
* Repeated, First sentence in N. Brennan and J.
Hennessy, Forensic Accounting, 2001, p. 5.
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The Essence of Forensic Accounting
by Maurice Peloubet (1946):
“The preparation of data for and the
appearance before government agencies as a
witness to facts, to accounting principles, or to
the application of accounting principles is
essentially forensic accounting practice rather
than advocacy.”
Modern Version
“Let’s face it, we in the forensic profession
labor in an obscure corner of the vineyard. We
are the carefully selected, trusted, highly trained
guardians of one of the last great secrets
remaining on the face of the earth - - the $600
billion[now $660], more or less annual problem
nobody knows about.”
Joseph W. Koletar, Fraud Exposed, John Wiley & Sons,
Inc 2003, p. 228.
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Fictional Hero
“Forensic accounting is turning up more
frequently in the world of fiction, too. The
financial intrigue of fraud and the investigative
process of forensic accounting are a natural fit with
mystery of suspense novels. Add exotic locations,
colorful characters and a murder or two, and you
have all the elements of a classic thriller.
There is a selection of books featuring
forensic accountants as the heroes of their own
stories, as well. Lenny Cramer, perhaps the most
prominent of this fictional group, is the star of a
series of novels written by I.W. Collett and various
co-authors.
In one of these novels, Cramer tracks forged
receipts to uncover a plot to steal Burmese religion
treasures. Another features Cramer, while
conducting an audit at Coca-Coca, uncovering a
scheme to steal the company’s secret formula. In
yet another, Cramer uses his forensic accounting
skills to solve a series of murders in the New York
art world.”
Source: “Book ‘em! Forensic Accounting in History and Literature,”The
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Panel on Audit Effectiveness
• In 1998, the Public Oversight Board
appointed the Panel on Audit
Effectiveness to review and evaluate how
independent audits of the financial
statements of public companies are
performed and to assess whether recent
trends in audit practices serve the public
interest.
• In 2000, the Panel issues a 200-page
report, Report and Recommendations,
which includes a recommendation that
auditors should perform forensic-type
procedures during every audit to enhance
the prospects of detecting material
financial statement fraud.
• Did not believe a GAAS audit should
become a fraud audit.
• In all audits the degree of audit effort in
forensic- type steps should be more than
inconsequential [p. 24].
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AICPA Fraud Task Force
Report
In 2003, the AICPA’s Litigation and
Dispute Resolution Services
Subcommittee issued a report of its
Fraud Task Force entitled,
“Incorporating Forensic Procedures in
an Audit Environment.”
The report covers the professional
standards that apply when forensic
procedures are employed in an audit and
explains the various means of gathering
evidence through the use of forensic
procedures and investigative techniques.
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Forensic-Type Organizations
•
•
•
•
•
•
•
•
•
American College of Forensic Examiners (2750 E. Sunshine,
Springfield, MO 65804; 800-423-9737; www.acfei.com. DABFA
and Cr.FA; 2000)
Certified Fraud Examiners (Association of CFEs, The Gregor
Bldg., 716 West Avenue Austin, TX 78701; 800-245-3321;
www.cfenet.com).
Certified Insolvency and Reorganization Accountant (CIRAs).
Accountants, lawyers, consultants included in insolvency and
bankruptcy matters. 3-part exam. 4,000 hours. 541.858.1665.
AIRA, 221Stewart Avenue, Suite 207, Medford, Or. 97501.
[email protected]
Society of Financial Examiners. Financial examiners of insurance
companies, banks, savings & loans, and credit unions. About
1,600. 174 Grace Blvd., Altamonte Springs, Fl. 32714.
www.sofe.org.
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 antifraud corporation located in Sacramento, Calif., for those dealing
in white-collar crime, fraud, and abuse issues. Association of
Certified Fraud Specialists. http://acfsnet.org.
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Ink Analysis
 Martha Stewart was undone by a blue
ballpoint pen.
 Stockbroker belatedly inserted a note to
help cover up Ms. Stewart’s improper stock
trading. Blue ballpoint ink used is different
from ink elsewhere on the trading
worksheet.
 Prosecutors used forensic ink analysis in
Rite Aid case to show that certain
documents were backdated (ink used to
sign letter was not commercially available
until 3 months after the letter was dated).
 Xerox laser printers now encode the serial
number of each machine in tiny yellow dots
in every printout, nestled within the printed
words and margins. It tracks back to you
like a license plate.
 Advice for fraudsters: use pencils.
Source: Mark Maremont, “In Corporate Crimes, Paper Trail Often
Leads to Ink Analysts’ Door,” Wall Street J., July 1, 2003, p. A-1.
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Deductive vs. Inductive
 Deductive: one goes from general to
specific; fairly simple and economical.
 Inductive: one starts with specific
experiences and then draws inferences.
Deductive Approach
Inductive Approach
Generic data mining
Custom data mining
Digital analysis
Analysis of all data
Discovery sampling
Generic software
Custom software
For smaller organizations
For larger organizations
Basic features
Sophisticated features
Easy to learn
Requires advanced skills
Relatively inexpensive
More expensive
Source: W.S. Albrecht and C.C. Albrecht, “Root Out Financial
Deception,” Journal of Accountancy (April 2002), p. 33.
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Benford’s Law
•
•
Distribution of initial digits in natural numbers is not random
Predictable patterns:
0= ----1= 30.1%
2= 17.6%
3= 12.5%
4= 9.7%
5= 7.9%
6= 6.7%
7= 5.8%
8= 5.1%
9= 4.6%
12%
11.4%
10.9%
10.4%
10%
9.7%
9.3%
9%
8.8%
8.5%
10.2%
10.1%
10.1%
10.1%
10%
10%
9.9%
9.9%
9.9%
9.8%
There is software to detect potentially invented numbers in many situations.
Compare actual frequency with Benford’s frequency.
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Benford’s Law Uses
•
•
•
•
•
•
•
•
•
•
Investments sales/purchases
Check register.
Sales history/Price history.
401 contributions.
Inventory unit costs.
Expenses accounts.
Wire transfer information.
Life insurance policy values.
Bad debt expenses.
Asset/liability accounts.
Source: Richard Lanza, “Digital Analysis- Real World
Example,” IT Audit, July 1, 1999,pp. 1-9.
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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).
-------------------------------------------------------------------------------
The U.S. Supreme Court has overturned some of
these concepts. Look for Congress to take
action.
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Fraud
© D.L. Crumbley
Some accountants believe that
ethics is a place in England.
Essex, U.K.
-----------------------------------------------------A statement made by Mark Twain about
New England weather applies to fraud
and corruption:
“It’s hard to predict, but everyone agrees
there’s plenty of it.”
----------------------------------------------As Sherlock Holmes said, “the game is
afoot.”
------------------------------------------------------Read My Lips; It’s The Fraud, Stupid.
44
© D.L. Crumbley
Termites, Rust, and Fraud
• Just as termites never sleep, fraud
never sleeps.
• Just like termites, fraud can destroy
the foundation of an entity.
-------------------------------------------------Like rust, fraud never sleeps.
--------------------------------------------------
Auditing without forensic techniques is
like trying to live without water.
45
© D.L. Crumbley
Sarbanes-Oxley Act (7-30-2002)
• Most significant change since 1934
Securities Exchange Act
• New five-member Public Company
Accounting Oversight Board (PCAOB)
• Authority to set and enforce auditing,
attestation, quality control and ethics
(including independencies) standards for
auditors of public companies.
• Empowered to inspect the auditing
operations of public accounting firms that
audit public companies as well as impose
disciplinary and remedial sanctions for
violations of the board’s rules, securities
laws and professional auditing and
accounting standards.
• Rotation of lead audit partner every five
years.
• For now no requirement to rotate auditing
firm
46
© D.L. Crumbley
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.
• http://www.pcaob.us, to get free
subscription to PCAOB Update.
47
© D.L. Crumbley
Sarbanes-Oxley Act of 2002
• If you are going to be an auditor, you have to be an
auditor, not an auditor and a consultant [Senator Jack
Reed].
• In order to be independent, an accounting firm should not
– Audit ones own work.
– Function as part of management or an employee.
– Act as an advocate.
• No limitations are placed upon accounting firms in
providing non-audit services to public companies they do
not audit or any private companies.
• Audit services and non-audit services (e.g., tax) must be
pre-approved by the audit committee, if not prohibited by
the Act (before the non-audit service commences).
• Auditor must report to the audit committee on a timely
basis.
• Cooling off period of one year for hiring an auditor if CEO
and other senior officers worked for the auditor.
• There is no requirement to rotate the auditors.
• There is discussion of requiring a forensic audit
irregularly. Harvey Pitt suggested this proposal.
48
© D.L. Crumbley
Sarbanes-Oxley (contd.)
• Many of the Sarbanes-Oxley’s provisions became
effective July 30, 2002.
• www.tnwinc.com
The Network
• Thus, SEC will control the accounting standards, not
the AICPA.
• Auditors to report to audit committee, and audit
committee must approve all services.
• Crime to corruptly alter, destroy, mutilate, or conceal
any document with the intent to impair the object’s
integrity or availability (up to 20 years).
• Statute of limitations for the discovery of fraud is now
two years from the date of discovery and 5 years after
the act.
• Maximum penalty for mail and wire fraud is
increased from 5 to 10 years.
• Financial statement filed with SEC: certified by CEO
and CFO. Maximum penalties for willful and
knowingly violation: fined not more than $5 million
and/or imprisonment of up to 20 years.
• Sense of Congress: CEO should sign the Federal
income tax return.
49
© D.L. Crumbley
Sarbanes-Oxley Act Creates Need For
Forensic Accounting
1. To assist corporations in their quest to
ensure compliance with the mandates
of S-O.
2. Public accounting firms must introduce
forensic techniques into audits, and
they may request help from forensic
experts.
------------------------------------------------Robbers do not need guns. Pencil and
paper will do. Opportunity and greed
are thievery’s driving forces. Put
enough zeroes behind a number, and
it’s amazing how flexible morals
become. How many years in prison
would you do to accumulate a half a
billion dollars in your bank account?
John H. Bolt
50
© D.L. Crumbley
Section 404-Sarbanes-Oxley
• Beginning June 2004, large
companies must have in place
tight internal controls, assess the
effectiveness of these controls
annually (and issue a report of
their effectiveness), and pay for
an independent assessment by
external auditors.
• Need an internal control
framework (e.g., COSO or
similar).
• Companies are paying steep fees
to fund the PCAOB.
• Audit fees have increased by as
much as 30% since S/O.
51
© D.L. Crumbley
Six-Legged Table of Financial Statements
External Auditors
Audit Committee
Top
Board of Directors
Management
Internal
PCAOB and SEC
External
Auditor
Auditors
In a baseball analogy, think of the pitcher as
the auditee, the catcher as the internal auditor,
the manager as top management, the
scorekeeper as the external auditor, and the
umpire would be PCAOB(SEC). The
scoreboard could be the general ledger.
The Big “R”
52
© D.L. Crumbley
COSO CUBE
(5 components of internal controls)
53
© D.L. Crumbley
HIERARCHY OF
INTERNAL CONTROL
NEEDS
54
© D.L. Crumbley
The COSO Model
1.
2.
3.
4.
5.
Control environment – management’s
attitude toward controls, or the “tone at the
top.”
Risk assessment – management’s
assessment of the factors that could prevent
the organization from meeting its objectives.
Control activities – specific policies and
procedures that provide a reasonable
assurance that the organization will meet its
objectives. The control activities should
address the risks identified by management
in its risk assessment.
Information and communication – system
that allows management to evaluate progress
toward meeting the organization’s objectives.
Monitoring – continuous monitoring of the
internal control process with appropriate
modification made as deemed necessary.
www.erm.cosous.org
55
© D.L. Crumbley
COSO New Cube: Enterprise Risk
Management
Source: erm.coso.org. See Apostolou and Crumbley, “ Sarbanes-Oxley Fall-out
Leads to Auditing Standards No. 2: Importance of Internal Controls,” The Value
56
Examiner, November/December 2004, pp. 55-60.
© D.L. Crumbley
Management Control Philosophy
Fraudulent Financial Reporting more
likely to occur if
• Firm has a poor management control philosophy.
• Weak control structures.
• Strong motive for engaging in financial statement
fraud.
Poor management philosophy:
• Large numbers of related party transactions.
• Continuing presence of the firm’s founder.
• Absence of a long-term institutional investor.
Source: Paul Dunn “Aspect of Management Control Philosophy that
contributes to fraudulent Financial Reporting,” Journal of Forensic
Accounting, Vol. IV (2003), pp. 35-60
57
Risk Assessment
Benefits
© D.L. Crumbley
A major step in a forensic audit is to
conduct a risk assessment, which entails a
comprehensive review and analysis of program
operations in order to determine where risks
exists and what those risks are.
Any operation developed during the risk
assessment process provides the foundation or
basis upon which management can determine
the nature and type of corrective actions needed.
A risk assessment helps an auditor to
target high-risk areas where the greatest
vulnerabilities exist and develop
recommendations to strength internal controls
Source: B.l. Derby, “Data Mining for Improper Payments,”
Journal of Government Management, Winter 2003, Vol.52, No.
4, pp. 10-13.
58
© D.L. Crumbley
Fraud Risk-Assessment Process
1. Organize the assessment – integrate into
organization’s existing business cycle or
establish a separate cycle.
2. Determine areas to assess – conduct at
company wide, business-unit, and significantaccount 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.
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Fraud Risk-Assessment Process
4. Assess likelihood of fraud
•Remote (1 out of 20)
•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.
60
Source: Financial Executive Institute
© D.L. Crumbley
FEI’s Costs of Compliance
Revenue
First-Year Costs
First-Year Hours
Less than $25 million
$.28 million
1,996
$25 to $99 million
$.74 million
3,080
$100 to $499 million
$.78 million
5,118
$500 to $999 million
$1.04 million
6,950
$1 to $4.9 billion
$1.83 million
13,355
Over 5 billion
$4.67 million
41,201
Source: Financial Executive Institute
• Audit fees have increased about 50%.
• First year spending around $10 billion. Steve Watkins,
“For Some, SOX Is No Hassle at All,” IBD, January 14, 2005, p. A6.
• About $100,000 each year for insuring Board
members.
• Bob Ross: Section 404 of SOX, which requires companies
to document their controls, cost his company (Urban
Outfitters) at least a penny per share in 2004, turning his job
into a “struggle to explain common sense.”
Tim Reason, “Feeling the Pain,” CFO, May 2005, p. 51.
61
© D.L. Crumbley
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.
62
© D.L. Crumbley
Fraud is Possible
The motto of a fraudster:
Anything is possible. The
impossibility simply takes longer.
--------------------------------------------Biggleman’s Safe – a safe builder
wrote blueprints of a unbreakable
safe and locked the blueprints
inside the safe.
-----------------------------------------------Internal controls can be broken, often
by top executives.
-----------------------------------------------Just as a pitcher tries to fool
batters, financial statements may
be misleading or wrong.
63
© D.L. Crumbley
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.
64
© D.L. Crumbley
The McKesson’s Massive
Fraud
In 1938, police discovered a massive fraud
at McKesson & Robbins, a big drug company
traded on the New York Stock Exchange and
audited by Price Waterhouse. Executives at
McKesson embezzled more than $18 million,
hiding their theft by creating a fake division.
The fictitious unit represented almost onefifth of McKesson’s total assets, but Price
Waterhouse somehow had managed to miss the
fact that it didn’t exist.
(Clues to the fraud included a shipment
that supposedly had been sent from Canada to
Australia – by truck.)
Alex Berenson, The Number, Random House, 2003, p.33
65
© D.L. Crumbley
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.
66
© D.L. Crumbley
The Cost of Fraud
 Organizations lose 6 percent of
annual revenue to fraud and
abuse.
 Fraud and abuse costs U.S.
organizations more than $660
billion annually ($4,500 per
employee).
 The average organization loses
more than $12 a day per
employee due to fraud and abuse.
Source: 2004 Wells Report
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© D.L. Crumbley
The Cost of Fraud (cont.)
 Over 90% 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 way, internal audit.
 Third most common detection:
accident.
 The most targeted asset is cash.
Source: 2004 Wells Report
68
© D.L. Crumbley
Ernst & Young 2002 Survey
• More than 20 percent of the respondents were aware
of fraud in their workplace.
• Nearly 80 percent would be willing to turn in a
colleague thought to be committing a fraudulent act.
• Employers lose a staggering 20 percent of every
dollar earned to some type of workplace fraud.
• More frequently committed frauds are theft of office
items, claiming extra hours worked, inflating expense
accounts, and taking kickbacks from suppliers.
• Women are more likely than men to report fraudulent
activities.
• Older employees were more likely to report
fraudulent activities than younger employees.
Ernst & Young. “American Works: Employers Lose 20 Percent of Every
Dollar to Work Place Fraud.” (2002) Available at
http://www.ey.com/global/Content.nsf/US/Media_Release_-_08-05-02DC
69
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Undiscovered Fraud
Howard R. Davia believes there
are three groups of fraud:
Group 1: 20% of fraud
discovered.
Group 2: Fraud discovered, but
not made public (40%).
Group 3: Fraud not yet detected
(40%).
Source: H.R. Davia, Fraud 101, John Wiley, 2000, pp. 5-12.
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The Trillion Dollar Gorilla
(in Billions)
U.S. Business1
$ 256.32
Federal Government2
239.75
State Government3
354.21
Tax-exempts4
134.5
Local Government5
Annual Fraud (trillion)
68.4
$ 1.053
1. 2002 Statistics of Income, $1,281.6 trillion time 20%.
2. $2.3975 trillion budget times 10%
3. $3,542.1 million times 10%
4. $897 billion in revenue times 15%.
5. $684.6 billion times 10%.
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© D.L. Crumbley
Fraud Multiplier
Employee Fraud = $ for $ reduction in
net income
Suppose $100,000 bottom line reduction.
Suppose 20% profit margin
How much new revenue needed to offset
the lost income?
$100,000 = $500,000
20%
So ACFE says $660 billion lost per year.
$660 billion = $3.3 trillion needed revenue
20%.
----------------------------------------------------This amount lost to fraud and abuses is
twice the size of the U.S. military budget.
72
© D.L. Crumbley
Put Fraud In Perspective
The Iraq War may cost as much as
$200 billion. Since fraud and abuse reduce
the bottom lines of businesses as much as
$660 billion per year (assuming a tax rate
of 30%), the federal government loses in
taxes each year $198 billion.
So in less than 13 months, stopping
fraud and abuse would pay for the Iraqi
war.
73
© D.L. Crumbley
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.
74
© D.L. Crumbley
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.
75
© D.L. Crumbley
Scienter Necessary
• To prove any type of fraud, prosecutors
must show that scienter was present.
• That is, the fraudster must have known
that his or her actions were intended to
deceive.
------------------------------------------------Important to know that fraud is not limited
by amount but rather by intent. If
someone’s intent was to defraud someone of
$10 or $10 million, it is still fraud.
Staff Accounting Bulletin No. 99
If someone makes an incorrect entity of
$10,000 (against GAAP) to give a company
the one cent to meet its earnings target, such
an entry is a material misrepresentation.
76
Fraud
© D.L. Crumbley
Legally, Black’s Law Dictionary defines fraud
as:
All multifarious means which human ingenuity
can devise, and which are resorted to by one
individual to get an advantage over another by
false suggestions or suppression of the truth,
and includes all surprise, trick, cunning or
dissembling, and any unfair way by which
another is cheated.
The four legal elements to fraud are
 A false representation or willful omission regarding a
material fact.
 The fraudster knew the representation was false.
 The target relied on this misappropriation.
 The victim suffered damages or incurred a loss.
----------------------------------------------------------------------
Institute of Internal Auditors definition:
Any illegal acts characterized by deceit,
concealment, or violation of trust. These acts
are not dependent upon the applications to
obtain money, property, or services; to avoid
payment or loss of services; or to secure
personal or business advantage.
77
© D.L. Crumbley
Superseded SAS No. 82
Accounting Fraud Referred To As
“Misstatement”
Misstatements arising from fraudulent
financial reporting are intentional
misstatements or omissions of amounts or
disclosures in financial statements to
deceive financial statement users.
---------------------------------------------------------Three most important red flags according to
external/internal auditors (total of 40.1%):
1) Known history of securities law violations
(14.6%)
2) Significant compensation tied to aggressive
accounting practices (12.9%)
3) Management’s failure to display appropriate
attitude about internal controls (12.6%)
Source: B.A Apostolou et.al, “The Relative Importance of
Management Risk Factors,” Behavioral Research in
Accounting, January 1, 2001, pp. 1-24.
78
© D.L. Crumbley
Engagement Letters Are Important
•For claims to Continental Casualty Company the
national provider of CPA malpractice insurance, in
2003:
Tax, 48%
Compilation and bookkeeping, 15%
Consulting, 11% Audit, 10%
Fiduciary, 6% All Others, 5%
• Most accounting malpractices claims involve
inadequate documentation.
• In claims re business tax, 54% of the time no
engagement letter.
• For individual tax claims, no engagement letters
78% of the time.
• Estate-related tax services, none, 63%.
• The most costly malpractice claims area is audit
practice.
• Almost 40% of all audit claims allege that an auditor
either failed to detect fraud or failed to inform the
client of internal control weakness to reduce the risk of
fraud.
Source: Joseph Wolfe, “Accounting for Malpractice,” AICPA,
79
© D.L. Crumbley
COSO’s Most Common Fraud Methods
1.
2.
3.
4.
5.
Overstatement of earnings.
Fictitious earnings
Understatement of expenses.
Overstatement of assets.
Understatement of allowances for
accounts receivables.
6. Overstatements of the value of
inventories by not writing down the
value of obsolete goods.
7. Overstatement of property values and
creation of fictitious assets.
80
© D.L. Crumbley
COSO’s Major Motives for Fraud
1. Cover up assets misappropriated for
personal gain.
2. Increase the stock price to increase the
benefits of insider traders and to
receive higher cash proceeds when
issuing new securities.
3. Obtain national stock exchange listing
status or maintain minimum exchange
listing requirements to avoid de-listing.
4. Avoiding a pretax loss and bolstering
other financial results.
81
COSO Survey (1999)
© D.L. Crumbley
• Financial pressures were important contributory
factors for the commitment of financial statement
fraud (FSF).
• Top executives (e.g., CEOs, CFOs) were commonly
involved in FSF.
• The majority of alleged FSF were committed by
small companies.
• Board of directors and audit committees of the fraud
companies were weak and ineffective.
• Adverse consequences for fraud companies were
bankruptcy, significant changes in ownership, and
delisting by national stock exchanges.
• Cumulative amounts of FSF were relatively
significant and large.
• More than half of the alleged FSF involved
overstatement of revenues.
• Most FSF were not isolated to a single fiscal period.
• Fifty-five percent of the audit reports issued in the
last year of the fraud period contained unqualified
opinions.
•The majority of the sample fraud companies (56
percent) were audited by Big Eight/Big Five auditing
82
firms.
© D.L. Crumbley
Business Fraud Survey (1999)
1. Nearly 15 percent reported management
misappropriation as the greatest fraud risk to their
organization.
2. Sixty percent of the respondent reported their
department’s fraud risk analysis process as being
reactive in nature.
3. The majority of respondents (72 percent) reported
that their organization did not have fraud detection
and deterrence programs in place.
4. The majority of respondents (68 percent) reported
that they never felt pressured to compromise the
adherence to their organization’s standard of
ethical conduct.
5. The majority of the respondents reported their
organization’s external auditors as being
ineffective in preventing and detecting fraud.
6. The majority of the respondents believed that more
budgets should be devoted to fraud-related
activities and training in department.
The Institute of Management and Administration (IOMA) and the Institute of Internal
Auditors(IIA). “Business Fraud Survey.” (1999). Available at http://www.theiia.org 83
© D.L. Crumbley
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.
84
© D.L. Crumbley
The Methods
 Asset misappropriation accounted
for more than four out of five
offenses (92.7%). $93,000
 Bribery and corruption constituted
about 30.1 % of offenses.
($250,000)
 Fraudulent statements were the
smallest category of offense 7.9%
(most costly). $1 million per
scheme.
Source: 2004 Wells Report
85
© D.L. Crumbley
Restatements of Financial Statements
2004
414
2003
323
2002
270
2001
270
1999
216
1998
158
Reasons for 2004 restatements:
1. Revenue recognition.
2. Equity accounting.
3. Revenues, accruals, contingencies.
• 15% were repeat filers.
• Arthur Andersen had averaged 11 restatements
before 2002. In 2002, they had 40, with 26 after
new auditors were retained.
Source: “An Analysis of Restatement Matters,” Huron Consulting
Group, www.huronconsultinggroup.com.
86
© D.L. Crumbley
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.
87
Rite Aid Fraud Case
© D.L. Crumbley
 Former CEO Martin Glass bragged that the
computer used to generate backdated letters had
disappeared at sea. “They have no computer.
The letters that were done on the computer…they
do not have and never will have, unless they use
a Trident submarine.”
 Wrong. President Timothy Noonan was wearing
a wire. He recorded 6 meetings over 10 weeks.
Federal investigators heard everything.
 CFO Franklyn Bergonzi:
 Obtained $30 million in extra profits by dunning Rite
Aid’s suppliers for merchandise that was supposedly
outdated or damaged (but not so).
 Another $75.6 million came from rebates from
pharmaceutical firms that had yet to be earned.
 Failed to report certain expenses properly.
 Increased the useful life of some assets.
 The financial restatements wiped out $1.6 billion
in profits.
 Martin L. Glass was sentenced to 8 years, and his
CFO was sentenced to 2 years and 4 months.
Source: Mark Maremont, “Call To Account: Rite Aid Case
Gives Early View of Fraud on Trial,” Wall Street J., June 11,
88
2003, p. A-6.
© D.L. Crumbley
One Piece at a Time
89
One Piece At A Time
© D.L. Crumbley
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.
90
© D.L. Crumbley
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."
.
91
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.
92
© D.L. Crumbley
Missing Fraud
Auditors will continue to miss fraud
because much of their work is predicted on
the assumption that separation of duties
prevents fraud (i.e., one person hold the
money and another person keeps track of it).
The Equity Funding case shakes the
foundations of auditing in that so much is
based on the assumption that people don’t
collude very long.
These people work together as an
efficient team for a very long time [9 years].
Lee Seidler
93
© D.L. Crumbley
The Perpetrators
 First-time offenders.
 Losses from fraud caused by managers
and executives were 3.5 times greater
than those caused by non-managerial
employees.
 Losses caused by men were 3 times
those caused by women. [53% males;
47% females]
 Losses caused by perpetrators 60 and
older were 27 times those caused by
perpetrators 25 or younger.
 Losses caused by perpetrators with
post-graduate degrees were more than
3.5 times greater than those caused by
high school graduates.
Source: 2002 ACFE Report
94
White-collar criminals have these
characteristics:
© D.L. Crumbley







Likely to be married.
Member of a church.
Educated beyond high school.
No arrest record.
Age range from teens to over 60.
Socially conforming.
Employment tenure from 1 to 20
years.
 Acts alone 70% of the time.
Source: Jack Robertson, Fraud Examination for
Managers and Auditors (1997).
95
© D.L. Crumbley
Other Characteristics of Occupational
Fraudsters:
 Egotistical
 Inquisitive
 Risk taker
 Rule breaker
 Hard Worker
 Under stress
 Greedy
 Financial need
 Disgruntled or a
complainer
 Big spender
 Close relationship
 Overwhelming
with vendors /
desire for personal
suppliers
gain
 Pressured to
perform
Source: Lisa Eversole, “Profile of a Fraudster,” Some Fraud Stuff,
http://www.bus.lsu.edu/accounting/faculty/lcrumbley/fraudster.html
96
Quotes
© D.L. Crumbley
To be a forensic auditor, you have to have
a knowledge of fraud, what fraud looks
like, how it works, and how and why
people steal.
Source: Robert J. Lindquist
"Finding fraud is like using a metal
detector at a city dump to find rare coins.
You're going to have a lot of false hits."
- D. Larry Crumbley
“Fraud can be best prevented by good
people asking the right questions at the
right time.”
- Michael J. Comer
97
© D.L. Crumbley
“Finding fraud is like trying to
load frogs on to a wheelbarrow.”
Larry Crumbley
98
© D.L. Crumbley
Fraud Catching
Finding fraud is like trying to
herd cats and chickens.
There is a chicken catching
machine (150 chickens per
minute),* but there is no perfect
fraud catching machine.
D. Larry Crumbley
* PH2000 mechanical chicken harvester. Scott
Kilman, “Poultry in Motion: Chicken Catching
Goes High Tech,” Wall Street Journal, June 4,
2003, p. A-1. Human can catch about 1,000 an
hour. $200,000 cost.
99
© D.L. Crumbley
How Fraud Is Detected
1. Tips (39.6%).
2. Internal audit (23.8%).
3. By accident (21.3%)
4. Internal controls (18.4%).
5. External audits (10.9%).
6. Notification by police (0.9%)
Source: 2004 Wells Report.
100
© D.L. Crumbley
Finding Fraud In The Midst of a Conspiracy
When speaking about the fraud of HealthSouth, a
spokesman for Ernst & Young emphasized the
difficulty of detecting accounting fraud in the
midst of a conspiracy of senior executives and
false documentation.
An accountant testified that HealthSouth employees
would move expenses of $500 to $4,999 from the
income statement to the balance sheet throughout
the year. Overall the SEC said about $1 billion in
fixed assets were falsely entered. The employees
moved only those expenses less than $5,000,
because Ernst & Young automatically looked at
those expenses over $5,000.
An ex-bookkeeper even sent Ernst & Young an email flagging one area of the fraud, but E & Y still
did not catch it. Employees actually produced false
invoices when the accounting firm asked for backup.
Source: Charles Mollenkamp, “Accountant Tried in Vain to Expose
HealthSouth Fraud,” Wall Street Journal, May 20, 2003, pp. A-1 and
A-13.
101
Quotes
© D.L. Crumbley
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
102
© D.L. Crumbley
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. 3034.
www.investigation.com/artilces/library/2002Articles/15.htm.
103
© D.L. Crumbley
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 Columboesque investigative style. “We don’t wear
special windbreakers that say ‘forensic
accountant.’”
Source: Eric Krell, “Will Forensic Accounting Go
Mainstream?” Business Finance Journal, October 2002, pp. 3034. www.investigation.com/articles/library/2002Articles/15.htm
104
© D.L. Crumbley
D.R. Cressey’s Fraud Pyramid
Don’t think you’re the only ones
Who bend it, break it, stretch it some.
We learn from you.
Girls lie, too
Terri Clark
105
© D.L. Crumbley
Kessler Survey (2001)
• About 13% of employees are
fundamentally dishonest.
• Employees out-steal shoplifters.
• About 21% of employees are honest.
• But 66% are encouraged to steal if
they see others doing it without
repercussion.
Source: “Studies Show 13% of employees are fundamentally dishonest,”
KesslerNews, November 1, 2001,
www.investigation.com/articles/library/2001articles.
---------------------------------------------------------------------------------------
• 30% of people in U.S. are dishonest.
• 30% situational dishonest.
• 40% are honest all of the time.
Source: R.C. Hollinger, Dishonesty in the Workplace, Park Rider, N.Y.:
London House Press, 1989, pp. 1-5.
106
© D.L. Crumbley
Little Has Changed: CFO Survey
• Nearly half of CFOs – 47 percent – report
they still feel pressure from their superiors to
use aggressive accounting to make results
look better.
• What is worrisome is that the pressure to
make the numbers hasn’t abated much. Of
these who have felt pressure in the past, only
38 percent think there is less pressure today
than there was three years ago, and 20
percent say there is more.
• Few finance executives have much
confidence in the numbers their colleagues
are reporting. Only 27 percent say that if they
were investing their own money, they would
feel “very confident” about the quality and
completeness of information available about
public companies.
Source: Don Durfee, “It’s Better (and Worse) Than You Think,” CFO Magazine, May 3, 2004.
107
CFO
© D.L. Crumbley
108
© D.L. Crumbley
SAS No. 99 Characteristics of Fraud
Incentives / pressures
Attitude /
Rationalization
Opportunity
109
© D.L. Crumbley
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.”)
110
© D.L. Crumbley
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.
------------------------------------------------“It was definitely the perfect fraud……..
unfortunately they hired the perfect
investigator.”
Cartoon in M.J. Comer’s book
111
© 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.
112
© D.L. Crumbley
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.
113
© D.L. Crumbley
Which of these statements are false?
a. A high degree of competition accompanied by
declining margins would be an example of an
opportunity for fraudulent financial reporting. F
(I/P)
b. Personal guarantees of debt of a company that are
significant to one’s personal net worth is an
example of a pressure/incentive for fraudulent
financial reporting. T
c. A heavy concentration of one’s wealth in a
particular company would be an example of a
rationalization condition for fraudulent financial
reporting. F (I/P)
d. An excessive interest by management in
maintaining a company’s stock price is an
example of rationalization for fraudulent financial
reporting. T
e. Anticipated future layoff would be an example of
an incentive to misappropriate assets. T
f. A large amount of cash on hand would be an
example of a rationalization to misappropriate
assets. F (O)
g. Inadequate internal controls is an example of an
opportunity to misappropriate assets. T
114
© D.L. Crumbley
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
115
© D.L. Crumbley
Rationalization
Sherron Watkins provides an
excellent comment about
rationalization with respect to
Enron’s Jeff Skilling and Andy
Fastow.
At what point did they turn
crooked? “But there is not a defining
point where they became corrupt. It
was one small step after another,
with more and more rationalizations.
There was a slow erosion of values
over time.”
Source: Pamela Colloff, “The WhistleBlower,” Texas Monthly, April 2003, p. 141.
116
© D.L. Crumbley
Fraud’s Fatal Failings
 85% of fraud victims never get
their money or property back.
 Most investigations flounder,
leaving the victims to defend for
themselves against counterattacks by hostile parties.
 30% of companies that fail do so
because of fraud.
Source: Michael J. Comer, Investigating
Corporate Fraud, Burlington, VT: Gower
Publishing, 2003, p. 9.
117
© D.L. Crumbley
Anti-Fraud Strategy
•
•
•
•
•
The company’s stance on fraud
and other breaches of the
ethical code.
What will be done and by
whom in the case that frauds
or other breaches are
suspected.
The key initiatives which the
company proposes;
Who will lead these initiatives.
Clear deadlines and measures
for monitoring effectiveness of
implementation.
Source: David Davies, Fraud Watch, 2nd Edition., London, ABG
Professional Information, 2000, p. 77.
118
Several Strategies
© D.L. Crumbley
1. Establishment of responsible corporate
governance, a vigilant board of directors and audit
committees, diligent management, and adequate and
effective internal audit functions.
2. Utilization of an alert, skeptical external audit
function, responsible legal counsel, adequate and
effective internal control structure, and external
regulatory procedures.
3. Implementation of appropriate corporate strategies
for correction of the committed financial statement
fraud, elimination of the probability of its future
occurrences, and restoration of confidence in the
financial reporting process.
-------------------------------------------------------------Financial statement fraud occurs when one or a
combination of these strategies are relaxed due to
self-interest, lack of due diligence, pressure, overreliance, or lack of dedication.
Source: Crumbley, Razaee, Ziegenfuss, U.S. Master Auditing Guide,
Chicago, CCH, pp. 689-690.
119
© D.L. Crumbley
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.
120
© D.L. Crumbley
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
121
© D.L. Crumbley
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.
122
© D.L. Crumbley
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. 3334.
123
© D.L. Crumbley
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.
124
© D.L. Crumbley
Bias Assumptions
•
•
•
•
•
There are almost as many oil/gas
reserve definitions as there are
countries.
During the first week of January 2004,
Royal Dutch/Shell Group slashed its
estimates of oil reserves by 20% or
about 3.9 billion barrels of oil.
Stock fell 9%.
Shell, Exxon/Mobil, and
Chevron/Texaco make the estimates
themselves.
By the end of 2002, a total of 4.47
billion barrels cut; another 1.4 billion
barrel cut in 2003.
Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil Reserves
Prove Unrefined,” Wall Street Journal, January 14, 2004, p. C-4.
Chip Cummins, “Shell Slashes Oil Reserves Again, News
Overshadows Profit Surge,” WSJ, February 4, 2005, p. A-3
125
© D.L. Crumbley
Shell Board Kept In the Dark
•
•
•
•
•
One memo drafted on February 11,
2002, warned that about one billion
barrels of oil-equivalent reserves
appeared not to be in compliance with
SEC guidelines.
Board learned of information only in
early January 2004.
Chairman Sir Philip was ousted in
early March 2004.
Most of the misstated reserves were
recorded from 1997 to 2000, when Sir
Philip was in change of exploration
and production.
Oil/gas reserves were increased (not by
discovery) by changing its accounting.
Source: Stephen Labaton and Jeff Gerth, “At Shell, New Accounting and
Rosier Oil Outlook,” New York Times, March 12, 2004, pp. A-1 and
C-4.
126
© D.L. Crumbley
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.
127
© D.L. Crumbley
Journal Entries at Year End: Those
Magic Changes
Apparently, Arthur Andersen was given
limited access to the general ledger at
WorldCom, which had a $11 billion fraud
(largest accounting fraud in history). Most of
the original entries for online costs were
properly placed into expense accounts.
However, near the end of the period these
entries were reversed. One such entry was as
follows:
Other Long-term Assets
$629,000,000
Construction in Progress
$142,000,000
Operating Line Costs
$771,000,000
The support for this entry was a yellow postit note.
WorldCom’s outside auditors refused to
respond to some of Cynthia Cooper’s
questions and told her that the firm had
approved of some of the accounting methods
she questioned.
128
© D.L. Crumbley
Those Magic Changes: Yellow Peril
• Fourth Quarter of 1999: "The $239 million
[international line cost accrual release] was entered
in WorldCom's general ledger ... The only support
recorded for the entry was '$239,000,000,' written
on a Post-it Note and attached to a printout of the
entry."
• Third Quarter of 2001: "Myers gave Sethi a Postit Note that said 'Assume $742 million.' Later,
Myers and Sethi had a conversation confirming that
$742 million identified on the Post-it Note was the
line cost capitalization entry for the quarter.”
http://thestreet.com/pf/markets/dumbestgm/10093441.html
----------------------------------------------------Those Magic Changes
“Oh my heart arranges, oh those magic changes,
oooh yeah.”
Grease
129
© D.L. Crumbley
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
130
© D.L. Crumbley
WorldCom Fraud Massive
 At least 40 people knew about the fraud.
 They were afraid to talk.
 Scott Sullivan handed out $10,000 checks
to 7 involved individuals.
 Altered key documents and denied
Andersen access to the database where
most of the sensitive numbers were stored.
 Andersen did not complain about denied
access.
 Company officials decided what tax rates
they wanted and then used the reserves to
arrive at the tax rates.
Source: Rebecca Blumenstein and Susan Pullian,
“WorldCom Fraud Was Widespread,” Wall Street
J., June 10, 2003, p. 3.
131
Computer Forensics
© D.L. Crumbley
“ Today’s Sergeant Joe Friday does
not write in a small notebook in the
course of solving crimes; he now
reconstructs the data from imaging hard
drives.”
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003.
--------------------------------------------------------
“Corporate criminals don’t always
tell the truth. Their computers usually
do.”
Thomas Talleur, KPMG
132
© D.L. Crumbley
Computer Forensics
“I need you to step away from your
computer please,” Lee Altschuler said.
Morgan Fay’s chief financial officer glanced up
from her computer screen. She regarded the man
standing at her office doorway for a moment.
“Excuse me?” Cindy Shalott asked.
“We’d like you to please conclude your
business for the day.” Lee Altschuler said. “I’d
appreciate it if you could complete whatever
you’re doing as quickly as you can. Please leave
your computer in the way that it is now. Don’t
turn it off.”
The chief financial officer swung her desk
chair around.
“Just move away from your computer
please,” Altschuler repeated.
“Who are you?” Cindy Shalott asked.
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91
133
© D.L. Crumbley
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.
134
© D.L. Crumbley
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
135
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Falsification
Enron’s crude oil trading operation based in
Valhalla, New York was fictitious, according
to one auditor. “It was pretend. It was a
playhouse. There were a lot of expensive
people working there, and it was impressive
looking, but it wasn’t legitimate work.
The traders were keeping two sets of
books, one for legitimate purposes – to show
Enron and auditors from Arthur Andersen –
one other set in which to record their illgotten gains.
Source: Mimi Swartz and Sherron Watkins, Power Failure, New York:
Doubleday, 2003, p.31.
136
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SAS No. 99 Ways to Overcome the
Risk of Management Override of
Controls
 Examining journal entries
and other adjustments.
 Reviewing accounting
estimates for bias, including a
retrospective review of
significant management
estimates.
 Evaluating the business
rationale for significant
unusual transactions.
137
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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
138
repurchased had not really been bought.
Examples
© D.L. Crumbley
 Enron issued $1.2 billion of stock to special
purpose entities and recorded a $1.2 billion
notes receivable (rather than a contra
account to stockholders equity). Both assets
and owners equity were overstated by $1.2
billion.
 HealthSouth allegedly overstated profits
by at least $14 billion by billing Medicare
for physical – therapy services the company
never performed. The company submitted
falsified documents to Medicare to verify
the claims over 10 years.
 E&Y collected $2.6 million from
HealthSouth (as audit-related fees) to check
the cleanliness and physical appearances of
1,800 facilities. A 50- point checklist was
used by dozens of junior-level accountants
in unannounced visits. For 2000, E&Y
audit fee, $1.03 million; other fees, $2.65
million.
139
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TRUTH
Given the right pressures, opportunities, and
rationalizations, many employees are capable of
committing fraud.
Bev Harris says that fraudsters and embezzlers
are the nicest people in the world:
Wide-eyed mothers of preschoolers. Your best
friend. CPAs with impeccable resumes. People
who profess deep religious commitments. Your
partner. Loyal business managers who arrive
early, stay late, and never take a vacation. And
sometimes, even FAMILY MEMBERS. So if
you’re looking for a sinister waxed mustache
and shifty eyes, you’re in for a surprise –
scoundrels come in every description.
Source: “How to Unbezzle A Fortune,” www.talion.com/embezzle.htm,
p. 1.
140
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Comparison of Auditing and Forensic Examination
Issue
Audit
Forensic Examination
Timing
Recurring: audits are
conducted on a regular
basis
Nonrecurring: fraud
examinations are
nonrecurring. They are
conducted only with sufficient
predication.
Scope
General: collection of
sufficient, competent
data to support the
opinion rendered.
Specific: the fraud
examination is conducted to
resolve specific allegations.
Objective
Opinion: express
opinion on financial
statements
Affix blame: determine if
fraud occurred and who is
responsible. Adversarial in
nature.
Methodology
Audit techniques
applied primarily to
financial data.
Fraud examination techniques
include document
examination, public record
searches, and interviews.
Presumption
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.
141
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Financial Audit v. Forensic Audit
The typical financial audit is a
sampling activity that doesn’t look at every
transaction and can therefore be exploited by
someone who knows how to rig the books.
Forensic accounting focuses on a
specific aspect of the books and examines
every digit. While the average accountant is
trying to make everything add up, a forensic
accountant is performing a detailed financial
analysis to find out why everything doesn’t or
shouldn’t add up.
It’s a far more time-consuming
enterprise and can be significantly more
expensive than regular auditing work.
Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004,
http://www.phoenix.edu/students/future/oldissues/Winter2004/fraud.ht
m
142
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Financial Audit v. Forensic Audit
“
During one investigation, we found in the auditing
working papers written in the margin of the
internal audit working papers by the internal audit
manager: ‘Conceal from bankers,’ says Nicholas L.
Feakins, CPA, partner at San Mataeo, Calif based
forensic accounting firm Feakins & Feakins. “ It
sounds amazing, but the [third-party] auditors has
put B-level staff on the project who simply didn’t
read the documents and missed it.”
----------------------------------------------------------------MiniScribe, one of the world’s largest disk-drive
makers, which in the late 1980s was surreptitiously
shipping bricks instead of disk drives to the Far
East and receiving credit from the bank for the
amount of the shipments. “After all,” he says “it’s
going to be 90 days until they ship the brick back to
you. “MiniScribe’s public accounting firm, Coopers
& Lybrand, didn’t catch the false-revenue scam
during its regular audits-but a forensic accountant
did.”
Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004,
http://www.phoenix.edu/students/future/oldissues/Winter2004/fraud.htm
143
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Bridging the Gap
Forensic accountants play a key role in bridging
the gap between an audit and an investigation.
Every audit cannot, and should not be conducted
as a full-fledged forensic investigation. GAAS
states, “An auditor typically works within
economic limits; the auditor’s opinion, to be
economically useful, must be formed within a
reasonable length of time and at reasonable
cost.” [SAS No. 31]
Forensic investigations also may be subject
to such constraints, but the parameters are often
vastly different. As a result, a forensic
investigation might represent a large multiple, in
both cost and elapsed time, of what an audit
would normally entail. This approach will
undoubtedly reduce the likelihood of undetected
fraud. However, such an approach also might
reduce the likelihood of completing the
engagement in time for meeting the filing
deadline for an SEC Form 10-K. [SAS No. 99]
144
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Pre SAS 99
Consulting
Standards
Auditing
Standards
Traditional
Investigation
Traditional
Audit
Post SAS 99
Auditing
Standards
Consulting
Standards
Traditional
Investigation
Forensic
Procedures in
the Audit
Environment
SAS 99
Source:AICPA, “Forensic Services, Audits, and Corporate
Governance: Bridging the Gap,” Discussion Memorandum, 2004.
145
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Steps Toward Forensic Audit
Traditional audit [forensic
techniques & fraud prevention
program].
If suspect fraud, bring in-house
forensic talent into the audit.
If no in-house talent or fraud
complex, engage an outside
forensic accountant (e.g., Cr.FA,
CFFA, or CDF).
As audit moves toward forensic
investigation, auditor must comply
with litigation services standards
(consulting).
146
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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.
147
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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.
148
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Poster Child For Overregulation?
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).
[p. A-6]
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.” Both require the
same level of work.
PCAOB 2004 Budget: $103 million.
PCAOB 2005 Budget: $152.8 million
Source: PCAOB Release 2004-001, March 9, 2004
149
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Internal Controls Not Perfect
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).” [p. A12].
Source: PCAOB Release 2004-001, March 9, 2004
150
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Auditing Internal Controls
a) Planning the engagement;
b) Evaluating management’s assessment
process;
c) Obtaining an understanding of internal
control over financial reporting;
d) Testing and evaluating design
effectiveness of internal control over
financial reporting;
e) Testing and evaluating operating
effectiveness of internal control over
financial reporting;
f) Forming an opinion on the effectiveness
of internal control over financial
reporting.
Source: PCAOB Release 2004-001, A-17.
151
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Anti-Fraud Program
An auditor must perform
“company-wide anti-fraud programs and
controls and work related to other
controls that have a pervasive effect on
the company, such as general controls
over the company’s electronic data
processing.”
Further, the auditor must “obtain
directly the ‘principal evidence’ about the
effectiveness of internal controls.”
PCAOB endorses the COSO
Cube [pp. 24-26 and A-25 and A-26]
Source: PCAOB Release 2004-001.
152
Walkthroughs
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An auditor must perform a walkthrough
of a company’s significant processes (each
major class of transactions).
Can not be achieved secondhand.
According to PCAOB, in a walkthrough
an auditor traces “company transactions and
events – both those that are routine and
recurring and those that are unusual – from
origination, through the company’s accounting
and information systems and financial report
preparation processes, to their being reported in
the company’s financial statements.”
Auditors should perform their own
walkthroughs which provides auditors with
appropriate evidence to make an intelligent
assessment of internal controls.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
153
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New Terms in Financial Reports:
Deficiencies Have No Bright Lines
Control deficiency – one that might allow a
bad number to get into the financial
reports (e.g., the likelihood that a
company misstates reports is remote– 1
out of 20).
Example: company does not check
changes made by a salesman in a minor
contract.
Significant deficiency – more serious flaw
or a number of flaws that increase the
chances that wrong numbers will
significantly distort financial statements
(e.g., more than remote).
Example: company not checking for
changes to terms of several key contracts.
Need only to report to BOD, but some
companies are making them public.
154
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Deficiencies Have No Bright Lines
Material weakness – deficiencies are
so bad that there is more than a remote
change of a material misstatement in
financial statements.
Example: a bank does not regularly
check for errors in estimating loan-loss
expenses (i.e., Fannie Mae reported a
$1.3 billion error from its computer
model, many in an uncontrolled
environment).
They must be reported.
David Henry, “How Clean Are the Books?” Business Week,
March 7, 2005, pp. 108-109.
155
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Numerous Material Weaknesses
Of 233 companies reporting
material weaknesses, 88
companies (38%) cited tax as the
area of deficiency.
Bob Ross, Urban Outfitters, says
with a 40% effective rate, if there
is an error in tax it will have a
material effect of the financials.
Tim Reason, “Feeling the Pain,” CFO, May, 2005, p. 55.
156
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Material Weaknesses: Adverse Opinion
•
•
•
•
PCAOB provides several strong
indicators that material weaknesses exist
in internal controls:
Ineffective oversight of the company’s
external financial reporting and internal
control over financial reporting by the
company’s Board of Directors.
Board of Directors must be responsible for
evaluating the performance and
effectiveness of the audit committee.
Material misstatement in the financial
statements not initially identified by the
company’s internal controls.
Significant deficiencies that have been
communicated to Board of Directors and
the audit committee but that remain
uncorrected after a reasonable period of
time.
Source: PCAOB Release 2004-001, pp. 21-22..
157
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Parallel Universe: Two Opinions
External auditors must do a regular
audit of a company (e.g., financial
statements are fairly stated) and must also
audit the internal controls that are to ensure
that the financial statements are accurate
(e.g., issue two opinions).
Prior to the external auditors’ arrival, the
company itself must review its internal
controls and issue a report on the
effectiveness of these controls.
There will be two external opinions: on
management’s assessment of the internal
controls over financial reporting and another
one on the effectiveness of the internal
controls themselves (e.g., statements are
fairly stated).
PCAOB Release 2004-001.
158
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Financial Statement Assertions
For each significant account, an auditor should
determine the relevance of each of these
financial statement assertions:
• Existence or occurrence
•Completeness
•Valuation or allocation
•Rights and obligations
•Presentations and disclosure.
Source: PCAOB Release 2004-001, A-33
159
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Slot Machine Example
160
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Revenue Flows
161
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Wandering Around
•Informal observations while in the casino.
•Especially valuable when assessing the
internal controls.
•Observe employees while entering and
leaving work and while on lunch break.
•Observe posted material, instructions, job
postings.
•Observe information security and
confidentiality.
•Observe the compliance with procedures.
162
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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.
163
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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
164
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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
165
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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.
166
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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.
---------------------------------------------Moral: Reduce external audit fees
by beefing up the internal auditing
department.
167
Test of Detail
© D.L. Crumbley
• Because of management overriding controls,
substantive analytical procedures alone are not well
suited to detecting fraud.
• The auditor’s substantive procedures must include
reconciling the financial statements to the accounting
records. The auditor’s substantive procedures must also
include reconciling the financial statements to the
accounting records. The auditor’s substantive procedures
also should include examining material adjustments
made during the course of preparing the financial
statements. Also, other auditing standards require
auditors to perform specific tests of detail in the
financial statement audit.
• For instance, AU sec. 316, Consideration of Fraud in
Financial Statement Audit, require the auditor to
perform certain tests of detail to further address the
risk of management override, whether or not a
specific risk of fraud has been identified.
• Paragraph .34 of AU Sec 330, The Confirmation
Process, states that there is a presumption that the
auditor will request the confirmation of accounts
receivable.
•Similarly, paragraph .01 of AU Sec. 331, Inventories,
states that observation of inventories is a generally
accepted auditing procedure and that the auditor who
issues an opinion without this procedure ‘has the burden
of justifying the opinion expressed.”
PCAOB Release 2004-001, A-66.
168
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Law Suits Few So Far
• Companies reporting problems with internal controls have
not seen a big increase in class-action lawsuits, according
to a study by Deloitte & Touche between November 2003
and August 2004.
• Deloitte said only 6% of the 290 companies reporting
internal-control flaws were sued.
• 52% of the firms had material weakness in their internal
controls.
• These internal control announcements did not seem to
send prices downward.
• Highest incidence of internal controls:
-computer-software firms
-manufacturers
-health-care and pharmaceutical companies.
- financial-services firms
-telecommunication companies.
•The newsletter Compliance Week said that 582 companies
acknowledged problems in 2004.
Source: Judith Burns, “Few Firms Are Sued Over Flaws in Internal Controls,
169
Study Finds, WSJ, December 29, 2004, p. B-5.
© D.L. Crumbley
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.”
170
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Types of Forensic Engagements
 Determine if fraud is occurring.
 Support criminal or civil action against
dishonest individuals.
 Form a basis for terminating a dishonest
employee.
 Support an insurance claim.
 Support defense of an accused
employee.
 Determine whether assets or income
were hidden by a party to a legal
proceeding (such as a bankruptcy or
divorce).
 Identify internal controls to prevent it
from happening again.
Source: D.R. Carmichael, et. al, Fraud Detection, 5th, Fort
Worth: Practitioners Publishing, 2002, p. 2 – 4.
171
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Two Major Types of Fraud
Investigations
• Reactive: Some reason to suspect
fraud, or occurs after a significant
loss.
• Proactive: First, preventive
approach as a result of normal
operations (e.g., review of internal
controls or identify areas of fraud
exposure). There is no reason to
suspect fraud. Second, to detect
indicia of fraud.
Source: H.R. Davia, “ Fraud Specific Auditing,” Journal of
Forensic Accounting, Vol. 111, 2002, pp. 111-120
172
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Proactive vs. Reactive Approaches
Proactive approaches include
Effective internal controls,
Financial and operational audits,
Intelligence gathering,
Logging of exceptions, and
Reviewing variances.
Reactive detection techniques
include
Investigating complaints and
allegations,
Intuition, and
Suspicion.
Jack Bologna and Robert Lindquist, Fraud Auditing and Forensic Accounting, 2d
Edition, New York: John Wiley, 1995, p. 137.
173
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Fraud Deterrence Review
•Analysis of selected records and
operating statistics.
•Identify operating and control
weaknesses.
•Proactively identify the control structure
in place to help prevent fraud and operate
efficiently.
•Not an audit; does not express an opinion
as to financial statements.
•May not find all fraud especially where
two or more people secretively agree to
purposely deceive with false statements
or by falsifying documents.
[Always get a comprehensive, signed
engagement letter defining objectives.]
174
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Swimming Lanes
Mary Larry Jane
Controls
Cash
X
Entries in
Books
X
Deposits
Checks
Does
Reconciliation
Controls
Account
Receivable
Sam
X
X
X
X
X
X
X
X
X
X
175
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GAP Analysis
Actual Internal Controls
Organization’s Stated Internal
Controls
Best Practices Internal Controls
176
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Inexperienced Forensic Auditors
• Find out who did it. Do not worry
about all the endless details.
• Be creative, think like the fraudster,
and do not be predictable. Lower the
auditing threshold without notice.
• Take into consideration that fraud
often involves conspiracy.
• Internal control lapses often occur
during vacations, sick outages, days off,
and rest breaks, especially when
temporary personnel replace normal
employees.
H. R. Davia, Fraud 101, New York: John Wiley & Sons, 2000, pp.
42-45.
177
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How Fraud Occurs
Source: KPMG Fraud Study
178
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Types of Fraud
Source: KPMG Fraud Study
179
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Certain Fraud is Increasing
Source: KPMG Fraud Study
180
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Measures Helpful in Preventing Fraud
1. Strong Internal Controls (3.66)
2. Willingness of companies to prosecute
(3.44)
3. Regular fraud audit (3.40)
4. Fraud training for auditors (3.33)
5. Anonymous fraud reporting
mechanisms (3.27)
6. Background checks of new employees
(3.25)
7. Established fraud policies (3.12)
8. Ethical training for employees (2.96)
9. Workplace surveillance (2.89)
Source: 2004 Wells Report
181
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Executions for Fraud?
• In September 2004, Wang
Liming, a onetime accounting
officer at China Construction, and
two other bank employees were
executed for defrauding the bank
of $2.4 million.
• In an unrelated corruption case,
an officer at the Zhuhai branch of
the Bank of China was put to
death.
•
John Goff, “Bank Fraud Brings Executions,” CFO,
November 2004, p.20.
182
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Auditors Must be Alert for:
Concealment
Collusion
Evidence
Confirmations
Forgery
Analytical relationships
Source: Gary Zeune, “The Pros and Cons.”
----------------------------------------------“Things are not what you think they
are.” Al Pacino, “The Recruit.”
183
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SAS No. 99
Recommendations
• Brainstorming.
• Increased emphasis on professional
skepticism.
• Discussions with management.
• Unpredictable audit tests.
• Responding to management
override of controls.
184
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Internal Auditors and Fraud
Detection
The Institute of Internal Auditors’ Due
Professional Care Standard (Section 280)
assigns the internal auditor the task of
assisting in the control of fraud by
examining and evaluating the adequacy
and effectiveness of the internal control
system.
However, Section 280 says that
management has the primary
responsibility for the deterrence of fraud,
and management is responsible for
establishing and maintaining the control
systems. In general, internal auditors are
more concerned with employee fraud than
with management and other external
fraud.
185
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When Fraud Is Discovered
1.
2.
3.
4.
Notify management or the board when the
incidence of significant fraud has been
established to a reasonable certainty.
If the results of a fraud investigation
indicate that previously undiscovered fraud
materially adversely affected previous
financial statements, for one or more years,
the internal auditor should inform
appropriate management and the audit
committee of the board of directors of the
discovery.
A written report should include all findings,
conclusions, recommendations, and
corrective actions taken.
A draft of the written report should be
submitted to legal counsel for review,
especially where the internal auditor
chooses to invoke client privilege.
186
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Audit Committee
The audit committee is the subcommittee of an
organization’s board of director’s charged with
overseeing the organization’s financial reporting
and internal control processes. The audit
committee’s biggest responsibility is monitoring
the component parts of the audit process.
------------------------------------------------------------The board of directors and its representative audit
committee should oversee (1) the integrity, quality,
transparency, and reliability of the financial
reporting process; (2) the adequacy and
effectiveness of internal control structure in
preventing, detecting, and correcting material
misstatements in the financial statements; and (3)
the effectiveness, efficacy, and objectivity of audit
functions.
187
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Audit Committee Red Flags
• Independence of audit committee from
management.
• The clarity with which the audit committee’s
responsibilities are articulated, such as in the
charter, and how well the audit committee and
management understand those responsibilities;
• The audit committee’s interactions and
involvement with the independent and internal
auditor; and
• Whether the audit committee raises and
pursues with management and the independent
auditor the appropriate questions, including
questions that indicate an understanding of the
critical accounting policies and judgmental
accounting estimates.
188
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Management’s Role
The Sarbanes-Oxley Act of 2002 mandates
that CEOs and CFOs certify in periodic
reports containing financial statements filed
with the SEC the appropriateness of financial
statements and disclosures.
-------------------------------------------------------In March 2005, the SEC said that
executives are gatekeepers. Thus, an
executive can be in trouble if in a position to
detect wrongdoing below them and do not
move forcefully to prevent the fraud. It does
not matter if the executive has been lied to.
An executive has the responsibility to cut
through the lies and try to root out the truth.
Carol. J. Loomis, “The SEC Turns the Screws on
Gatekeepers,” Fortune, April 18, 2005, p. 38.
189
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Pressures On All Sides
CEOs are now being squeezed as a
result of SOX by BODs, auditors, and
lawyers because these watchdogs are
finally facing genuine liability for their
failures. These watchdogs are trying to
protect their hides.
Arthur Andersen is out of business, and
directors at WorldCom and Enron are
paying off fraud claims out of their own
pockets. Hank Greenberg, former
Chairman and CEO of AIG said that the
balance of power in corporate America
has shifted.
Diane Brady and Joseph Weber, “The Boss on the Sidelines,”
Business Week, April 25, 2005, p. 88.
190
CEO Duality
© D.L. Crumbley
Eight of the ten recent scandals had
board chairs who were also CEO:
1.Enron
5. HealthSouth
2.Adelphia
6. Quest
3.Tyco
7. Homestore
4.Waste Management
8. Sunbeam
WorldCom and Global Crossing had different
Chairman and CEO.
-------------------------------------------------------Aging Board of Directors. “Easier for
Management to get away with misdeeds.”
Enron’s Audit Committee chairman was 72.
“They can be hard of hearing.” Nearly 10% of
directors in the S & P’s 500 stock index are 70
or over.
Source: Louis Lavelle, “Directors: Know When to Fold Them, “Business Week, May
24, 2004, p.14.
191
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Audit Tests
The Panel on Audit Effectiveness
recommended that surprise or unpredictable
elements should be incorporated into audit
tests, including:
– Recounts of inventory and
unannounced visits to locations
– Interviews of financial and
nonfinancial client personnel in
different locations
– Requests for written confirmations
from client employees regarding
matters about which they have made
representations to the auditors
– Tests of accounts not normally
preformed annually
– Tests of accounts traditionally or
frequently deemed “low risk”
192
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SAS No. 99: SKEPTICISM
 An attitude that includes a
questioning mind and a critical
assessment of audit evidence.
 An auditor is instructed to
conduct an audit “with a
questioning mind that recognizes
the possibility that a material
misstatement due to fraud could
be present, regardless of any past
experience with the entity and
regardless of the auditor’s belief
about management’s honesty and
integrity.”
193
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SKEPTICISM
Ronald Reagan said with respect
to Russia, “Trust, but verify.”
FA’s motto should be “Trust no one;
question everything; verify.”
-----------------------------------------------------
This ain’t my first rodeo.
I didn’t make it all the way through
school.
But my mama didn’t raise no fool.
I may not be the Einstein of our time.
But honey, I’m not dumb, and I’m
not blind.
Vern Gosdin
194
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SAS No. 99: Questions for Management






Whether management has knowledge of any fraud that
has been perpetrated or any alleged or suspected
fraud.
Whether management is aware of allegations of fraud,
for example, because of communications from
employees, former employees, analysts, short sellers,
or other investors.
Management’s understanding about the risks of fraud
in the entity, including any specific fraud risks the
entity has identified or account balances or classes of
transactions for which a risk of fraud may be likely to
exist.
Programs and controls the entity has established to
mitigate specific fraud risks the entity has identified,
or that otherwise help prevent, deter, and detect fraud,
and how management monitors those programs and
controls.
For an entity with multiple locations, (a) the nature
and extent of monitoring of operating locations or
business segments, and (b) whether there are
particular operating locations or business segments for
which a risk of fraud may be more likely to exist.
Whether and how management communicates to
employees its views on business practices and ethical
behavior.
195
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BE SKEPTICAL
 Assume there may be wrong
doing.
 The person may not be
truthful.
 The document may be altered.
 The document may be a
forgery.
 Officers may override internal
controls.
 Try to think like a crook.
 Think outside
the box.
196
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Think Like A Crook
•
•
•
•
Know your enemy as you know yourself,
and you can fight a hundred battles with no
danger of defeat.” Chinese Proverb.
Military leaders study past battles.
Football and basketball teams study game
films of their opponents.
Chess players try to anticipate the moves of
their opponent.
Examples: If contracts above $40,000 are
normally audited each year, check the
contracts between $30,000-$40,000.
• FAs must learn the tricks of the trade as
well as the trade.
197
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Think Outside the Box
American astronauts returning from
space complained that they could
not write with their pens in zero
gravity. NASA set aside $1 million
to develop a sophisticated pen that
would function in space.
The Russians encountered the same
problem. What did they do?
198
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Fraud Awareness Auditing:
Unrefined Oil
199
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Thinking as a Forensic Auditor
The Iceberg Theory of Fraud
Overt Aspects
Hierarchy
Financial Resources
Goals of the Organization
Skills and Abilities of Personnel
Technological State
Performance Measurement
Structural
Considerations
Water line
Covert Aspects
Attitudes
Feelings (Fear, Anger, etc.)
Values
Norms
Behavioral
Interaction
Considerations
Supportiveness
Satisfaction
Source: G.J. Bologna and R.J. Lindquist,
Fraud Auditing and Forensic Accounting,
2nd Edition, New York: John Wiley, 1995,
pp. 36-37
200
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Behavioral Concepts Important
“Not all fraud schemes can effectively be
detected using data-driven approaches.
Instances of corruption-bribery, kickbacks,
and the like – and collusion consistently involve
circumvention of controls.
Searching relevant transaction data for
patterns and unexplained relationships often fails
to yield results because the information may not
be recorded, per se,by the system.
Behavioral concepts and qualitative
factors frequently allow the auditor to look
beyond the data, both with respect to data that
is there and the data that isn’t.”
Source: S. Ramamoorti and S. Curtis, “Procurement Fraud & Data Analytics, “Journal
of Government Financial Management, Winter 2003, Vol. 52, No. 4, pp. 16-24.
201
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Life Styles
For someone who earned a salary of just
$1,000 a month, Rana Koleilat managed to live
a pretty nice life. She traveled by private jet,
took along her servant and hairdresser, and
stayed at poshest locality in London and Paris.
Back home in Beirut, Lebanon, she lived in
three-story penthouse. To anyone who asked
how she lived so well, she replied that she had a
“rich uncle.”
Actually, Koleilat helped manager a
private bank in Beirut, and thereby hangs a tale.
The chairman of the bank said he lost $1.2
billion, and depositors lost another several
hundred million dollars.
E.T. Pound, “Following the Old Money Trail,” U.S. News & World Report, April
4, 2005, p. 30
202
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Three Major Phases of Fraud
1. The Act itself.
2. The concealment of the fraud (in
financial statements).
3. Conversion of stolen assets to
personal use.
One can study any one of these phases.
Examples:
Things being stolen: conduct surveillance and
catch perp.
If liabilities being hidden, look at financial
statements for concealment.
If perp has unexpected change in financial
status, look for source of wealth.
Source: Cindy Durtschi, “The Tallahassee Bean Counters: A
Problem-Based Learning Case in Forensic Audit,” Issues
in Accounting Education, Vol. 18, No. 2, May 2003, pp.
137-173.
203
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Be Proactive
 Fraud hotline (reduce fraud losses
by 50% re Wells 2002 Report).
 Suggestion boxes.
 Make everyone take vacations.
 People at top must set ethical tone.
 Widely known code of conduct.
 Check those employee references.
 Reconcile all bank statements.
 Count the cash twice in the same
day.
 Unannounced inventory counts.
 Fraud risk assessment (CFD).
204
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Fraud Hypothesis Testing Approach
Here a forensic accountant attempts to proactively detect fraud that is still undiscovered by
formulating and testing null hypotheses. This proactive
technique requires an forensic investigator to
1. Identify the frauds that may exist in a particular
situation.
2.Formulate null hypotheses stating that the frauds do
not exist.
3.Identify the red flags that each of the frauds would
create.
4.Design customized queries to search for the specific
red flags or combination of red flags.
In a refinery, three authors report that after a
formalized pro-active search for red flags, some
unknown frauds were discovered. But applying
generic data mining programs to the company’s
database to detect fraud resulted in a number of Type
II errors. So in order to be useful the red flags had to
be fraud and company specific.
C.C. Albercht, W.S. Albercht, and J.G. Dunn, “Conducting a Pro-Active
Fraud Audit: A Case Study,” Journal of Forensic Accounting, Vol. 11, 2000,
pp. 203-218
205
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Fake Diplomas
 At least 28 high-level federal employees
have degrees from bogus colleges or
unaccredited schools, only a slice of a
problem that ranges from worker quality
to national security, congressional
investigators say.
 Three unaccredited schools investigatedPacific Western University, California
Coast University and Kennedy-Western
University-reported that 463 current or
former students were federal employees.
Most of those listed were in the Defense
Department. The bill to taxpayers at just
two of the schools was $169,471.
 One of those workers paid $5,000 for a
master’s degree from LaSalle University,
an unaccredited school unrelated to
LaSalle University in Pennsylvania. The
worker attended no classes, took no tests
and told the GAO his degree was a joke.
Source: Ben Feller, “GAO: Some U.S. Workers Have Fake Degree,” Las Vegas Sun, May 11, 2004.
206
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Hot Lines – Sarbanes-Oxley
 Audit Committee (AC) must provide a
mechanism for employees to remain
anonymous when reporting concerns
about accounting and auditing problems.
 AC must provide a process for the receipt,
retention, and treatment of complaints
regarding accounting problems.
 Annual report must contain a statement
regarding the effectiveness of internal
controls.
 Employees have the right to sue
companies for whistle-blowing retaliation.
 Managers found guilty of retaliation face
penalties, including up to 10 years in
prison.
See The Network, www.tnwinc.com/hotlines
207
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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
208
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Complaints Increasing
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.
209
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Some Hints
 Need to really understand the
business unit. What they really do.
 Rotation of assignments.
 Have a written/signed ethics policy.
 Do things differently each time you
audit a unit.
 Do not tell client what you are doing.
 Hard to find fraud in the books.
Look/listen. Look for life style
changes.
 Do not rely on internal controls to
deter fraud.
 Auditors must have control of the
confirmation process.
210
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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.
211
More Hints …
© D.L. Crumbley
 Check employee
references/resume.
 Stop giving the employee/client
the answer when you ask a
question.
 Zero tolerance for allowing
employee/executive to get away
with anything.
 Try to think like a criminal.
 Get inside the criminal’s mind.
Be a detective.
 Do not assume you have honest
employees.
 Bond employees.
Source: Gary Zeune
212
Auditing Hints
© D.L. Crumbley
• SAS No. 99 does not require auditors to make
inquiries of “others,” as opposed to management.
Auditors must talk to and interview others below
management level. If asked, employees may be willing
to report suspicious activities.
• Use independent sources for evaluating management
(e.g., financial analysts). Surf the internet.
• Auditors need to follow the performance history of
managers and directors.
• If a company has an anonymous reporting system,
obtain information about the incidents reported and
consider them when assessing fraud risk.
• Be sure to perform analytical procedures, and the
work should be reviewed by senior members of the
audit team.
• Auditors should select sample items below their
normal testing scope.
• Fraud procedures should be more than checklists.
Audits should focus on finding and detecting fraud.
213
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Check References and Resume
Fraud 101: Fraudsters can change
their job and address, but they can
not change who they are.
214
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Run A Criminal-Records
Check
 Federal Bureau of Prisons-since
1982; www.bop.gov Click on
“Inmate Info.”, then “BOP
Inmate Locator,” free.
 Crime Time. www.crimetime
.com. Click on “Sex Offender
Info.,” free.
 Background Check Gateway
www.backgroundcheckgateway.
com Click on “Step 3: Start
Your Investigation,” then
“Criminal History,” free.
215
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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 governanceresearch firm. Hefty pay checks and
perks to current or former chief
executives.
 Poor BODs have in common: an
inability to say no to current or
former chief executives.
Source: Monica Langley, “Big Companies Get Low Marks
for Lavish Executive Pay,” Wall Street J., June 9,
2003, p. C-1.
216
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$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 a 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.”
217
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Compensation Facts
• CEOs compensation components have increased
dramatically in the 1990 [mean of $1.68 million in
1992 to 43.2 million in 2000] even after the passage of
IRC Section 162 (m) in 1993 [$1 million limit].
Balsam, S. 2002. An Introduction to Executive Compensation. San Diego, CA:
The Academic Press.
• Compensation increases when the CEO has influence
over the outside directors, as measured by the
percentage of outside directors appointed by the CEO.
Core, J.E, Holthausen, R and Larcker, D. 1999. Corporate governance, chief
executive officer compensation, and firm performance, Journal of Financial
Economic 51: 371-406
• CEO compensation is higher when the CEO’s tenure
is greater than the chair of the compensation
committee.
Main, B., O’Reilly, C, and Wade, J. 1995. The CEO, the board of directors and
executive compensation: economic and psychological perspectives, Industrial and
Corporate Change 4: 293-332.
• The relation between the change in CEO cash
compensation and stock returns weaken with tenure.
Hill, C. and Phan, P. 1991. CEO tenure as a determinant of CEO pay. Academy of
Management Journal 34: 707-711
• The greater the percentage of outside board members
appointed after the CEO, the more likely the CEO will
have a golden parachute.
Wade, J., O’Reilly, C, and Chandratat, I. 1990 Golden parachutes: CEOs and the
exercise of social influence. Administrative Science Quarterly 35:587-603
218
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To Find Compensation Data






www.monster.com
www.careerjournal.com
www.overseasjobs.com
www.careerbuilder.com
www.salary.com
www.jobsmart.com
219
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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.
220
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Taxes Paid on Fraudulent
Earnings
•
•
27 firms accused by S.E.C.
We estimate that the median firm
sacrificed eight cents in additional income
taxes per dollar of inflated pretax
earnings. In aggregate, we estimate that
the firms in our sample paid $320 million
in taxes on overstated earnings of about
$3.36 billion.
• These results indicate now far managers
of firms are willing to go when allegedly
inflating earnings.
Source: M. Erickson et. al, “How Much Will Firms Pay for Earnings That Do Not
Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings,” Accounting
Review, Vol. 79, No. 2, 2004, pp. 387.
221
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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
222
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Earnings Management
Companies that consist solely of
independent directors and meet at least
four times a year are likely to have lower
non-audit service fees.
L.J. Abbott et.al, “An Empirical Investigation of Audit Fees, NonAudit Fees, and Audit Committees,” Contemporary Accounting
Research, Summer, 2003, p. 230.
An auditor who is also an industry
specialist further enhances the credibility
of accounting information (e.g., less
earnings management).
G.V. Krishnan, “Does Big 6 Auditor Industry Expertise Constrain
Earnings Management?” Accounting Horizons, Vol. 17, Supplement
2003, p. 15.
223
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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.
224
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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
225
© 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.
226
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Types of Financial Statement Fraud
Schemes
Three professors have broken financial
statement fraud schemes into these ten
types:
1. Fictitious and/or overstated revenues and
assets (e.g., nonordered or cancelled
goods). Sunbeam created revenues by
contingent sales, a bill-and-hold strategy,
and accelerated sales. Digital Lightware,
Inc. recognized fraudulent billings.
2. Premature Revenue Recognition (e.g.,
holding books open).
3. Misclassified Revenues and Assets (e.g.,
combining restricted cash accounts with
unrestricted cash accounts). School
districts and universities may engage in
this strategy with dedicated funds.
Source: S.E. Bonner, Z. Palmrose, and S.M. Young, “Fraud Types
and Auditor Litigation,” The Accounting Review, October 1998, pp.
227
503-532.
© D.L. Crumbley
Types of Financial Statement Fraud
Schemes (contd …)
4. Fictitious Assets and/or Reductions of
Expenses/Liabilities (e.g., recording
consigned inventory as inventory).
Cendant Corporation created fictitious
revenues, and Knowledge Ware inflated
revenues with phony software sales.
5. Overvalued Assets or Undervalued
Expenses/Liabilities (e.g., insufficient
allowance for bad debts).
6. Omitted or Undervalued Liabilities (e.g.,
understated pension expenses).
7. Omitted or Improper Disclosures (e.g.,
stock option expense estimates).
228
© D.L. Crumbley
Types of Financial Statement Fraud
Schemes (contd …)
8. Equity fraud (e.g., recording
nonrecurring and unusual income
or expense in equity).
9. Related-Party Transactions (e.g.,
fictitious sales to related parties).
Enron had many related-party
transactions.
10. Financial Fraud Going the Wrong
Way (e.g., for tax purposes
reducing income or increasing
expenses).
229
© D.L. Crumbley
Wrong Way Earnings Management
 Freddie Mac understated past
earnings as much as $5 billion.
 Certain transactions and accounting
policies were “implemented with a
view to their effect on earnings”
(e.g., to smooth earnings).
 Restatements will result in higher
earnings in prior periods but lower
earnings in future periods.
 Employees appeared to knowingly
violate accounting rules in an effort
to manipulate earnings.
Source: Patrick Barta and J.D. McKinnon, “Freddie Mac Profits May Have Been
Low By Up to $4.5 Billion,” Wall Street J., June 26, 2003, pp. C-1 and C11. Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24,
2005, pp. 123-140.
230
© D.L. Crumbley
Tax Issues
• The company used a so-called linked
swaps to shift at least $420 million into
the future.
• Internal report said the linked swaps had
minimal business justifications other than
the shifting of operating earnings.
• CEO Franklin Raines was paid more than
$ 60 million over a 6 year period. On Dec.
21, 2004, Raines took early retirement.
• The Board replaced KPMG as Fannie’s
auditor.
Source: Dawn Kopecki and J.D. Mckinnon, “IRS Probes Tax Issues at
Freddie Mac,” Wall Street Journal, October 22, 2003, p.A-6. Mike
McNamee, “Franklin Raines Lost Gamble,” Business Online,
December 22, 2004.
231
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Fannie Mae’s Problem
• Fannie Mae was ordered by the SEC [2004] to
a restatement of earnings of $ 9 billion
(reducing earnings since 2001). Misuse of
hedge-accounting transactions and improper
accounting for loans.
• CFO J. Timothy Howard resigned with an
annual pension of $400,000 and lifetime access
to Fannie Mae’s Medical benefits. Plus $ 4
million of stock options.
•CEO Franklin Raines was paid more than
$60 million over a 6 year period. On Dec. 21,
2004, Raines took early retirement. $ 1 million
annually for life.
•The Board replaced KPMG as Fannie’s
auditor.
Source: Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24, 2005,
pp. 123-140. Mike McNamee, “Franklin Raines Lost Gamble,” Business
Online, December 22, 2004.
232
Vendor Allowances
© D.L. Crumbley
• In exchange for better shelf space or advertisement
mentioning its products, a merchandise vendor will
pay stores an extra fee--an allowance often based upon
the amount of products sold.
• Employees at OfficeMax “fabricated supporting
documents for approximately 3.3 million in claims
billed to a vendor to its retail business.” Six employees
were fired, and CEO Christopher Milliken resigned.
• The SEC sued three former executives in December
2004 at Kmart Holding Corp. for their role in a $24
million accounting fraud that booked these allowances
early.
•The SEC settled a case in October 2004 with Ahold
NV involving allegations of fraudulent inflation of
promotional allowances at U.S. Foodservice, Inc. unit.
Source: David Armstrong, “OfficeMax Results To Be Restated; CEO Steps
Down,” WSJ, February 15, 2005, p. A-3.
233
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Seven Investigative Techniques
1. Public document review and
background investigation (nonfinancial documents).
2. Interviews of knowledgeable
persons.
3. Confidential sources.
4. Laboratory analysis of physical and
electronic evidence.
5. Physical and electronic
surveillance.
6. Undercover operations.
7. Analysis of financial transactions.
Source: R.A. Nossen, The Detection, Investigation and
Prosecution of Financial Crimes, Thoth Books, 1993.
234
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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
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Investigative Activities
 A forensic accountant must be careful not to
misrepresent either the identity or the purpose of the
contact with a questionable party.
 Surveillance is not an activity which accountants
normally perform (e.g., may need a private
investigator’s license).
 Typical state statute requires a PI license for: “the
investigation by a person or persons for the purpose of
obtaining information with reference to any of the
following: the causes and origin of, or responsibility
for, … damage or injuries to real or personal property;
the business of securing evidence to be used before
investigating committees or boards of award or
arbitration or in the trial of civil or criminal cases and
the preparation therefore….”
 In Florida, Legal Opinion 97-9 provides that any
person who holds a professional license under the
laws of this state, and when such person is providing
services or expert advice in the profession or
occupation in which that person is so licensed, is
exempt from private investigator licensing
requirements. Thus, a licensed accountant (e.g., CPA)
would be permitted to perform forensic accounting
236
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Investigative Techniques
Public Document Review
• Real and personal property records.
• Corporate and partnership records.
• Civil and criminal records.
• Stock trading activities.
• Check vendors.
Laboratory Analysis
• Analyzing fingerprints.
• Forged signatures.
• Fictitious or altered documents.
• Mirror imaging or copying hard
drives/company servers.
• Use clear cellophane bags for paper
documents.
237
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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.
238
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Sales v. Net Income
Forensic accountants should compare the
trend in sales with the trend in net income.
For example, from 1999 to 2001,
HealthSouth’s net income increased nearly
500%, but revenues grew only 5%. On
March 19, 2003, the SEC said that
HealthSouth faked at least $1.4 billion in
profits since 1999 under the auditing eyes of
Ernst & Young.
The SEC said that HealthSouth started
cooking its numbers in 1986, which Ernst &
Young failed to find over 17 years.
HealthSouth also inflated its cash balances.
239
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Horizontal Analysis
Suppose advertising in the base year
was $100,000 and advertising in the
next three years was $120,000,
$140,000, and $180,000. A horizontal
comparison expressed as a percentage
of the base year amount of $100,000
would appear as follows:
Year 4
Dollar
Amount
Horizontal
Comparison
$180,000
180%
Year 3
Year 2
Year 1
$140,000 $120,000 $100,000
140%
120%
100%
240
© D.L. Crumbley
Red Flags with Horizontal Analysis
• When deferred revenues (on the balance sheet) rise
sharply, a company may be having trouble
delivering its products as promised.
• If either accounts receivable or inventory is rising
faster than revenue, the company may not be
selling its goods as fast as needed or may be having
trouble collecting money from customers. For
example, in 1997 Sunbeam’s revenue grew less than
1% but accounts receivable jumped 23 percent and
inventory grew by 40 percent. Six months later in
1998 the company shocked investors by reporting a
$43 million loss.
• If cash from operations is increasing or decreasing
at a different rate than net income, the company
may be being manipulated.
• Falling reserves for bad debts in relation to account
receivables falsely boosts income (cookie jar
accounting).
241
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More Red Flags
• Look for aggressive revenue recognition
policies (Qwest Communication, $1.1 billion
in 1999-2001). Beware of hockey stick
pattern.
• Beware of the ever-present nonrecurring
charges (e.g., Kodak for 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.
242
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Five Statistically Significant Ratios
• Use the ratios for two successive fiscal years.
• Convert into indexes for benchmarking.
Day’s Sales in Receivable Index:
(Accounts Receivable t / Sales t )
(Accounts Receivable t-1 / Sales t-1)
Index for manipulators: 1.5 to 1
-------------------------------------------------------Gross Margin Index:
[(Sales t - Cost of Sales t ) / Sales t]
[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]
Index for manipulators = 1.2 to 1
-------------------------------------------------------Source: M.D. Beneish, “The Detection of Earnings Manipulation,”
Financial Analysts Journal, September/October, 1999. t-1 =
prior year.
243
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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.
244
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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.
245
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A Charles Lundelius Example
Comparison to peer group benchmarks:
Characteristic
DSRI
GMI
AQI
SGI
TATA
MPS Peer group
1.56
1.03
2.00
1.10
1.23
1.04
1.50
1.20
0.10
0.05
% over peers
51%
82%
18%
25%
100%
Source: C.R. Lundelius, Financial Reporting Fraud, AICPA, 2003, p.
129.
246
© D.L. Crumbley
Excel Spreadsheet
Sherron Watkins discovered the Enron fraud in 2001
when she was again working under Andy Fastow,
CFO. She took a simple inventory, using an Excel
spreadsheet to calculate which of the division’s
assets were profitable and which were
unprofitable.
She discovered the special purpose entities
called Raptors, off-the-books partnerships. Enron
had hidden hundreds of millions of losses by
borrowing money from Raptors and promising to
pay the loans back with Enron stock. Enron was
hedging risks in its left pocket with money from its
right pocket.
As the value of Enron stock fell and the
losses in the Raptors mounted, Enron had to add
more and more stock because Enron had risked 97%
of the losses, and Arthur Andersen had agreed to
the accounting.
Source: Mimi Swartz and Sherron Watkins, Power Failure,
New York: Doubleday, 2003, p. 269.
247
© D.L. Crumbley
Look For Fraud Symptoms
•Source Documents.
•Journal Entries.
•Accounting Ledgers.
248
© D.L. Crumbley
Source Documents
•
•
•
•
•
•
•
•
Checks.
Employee time cards.
Sales invoices.
Shipping documents.
Expense invoices.
Purchase documents.
Credit card receipts.
Register tapes.
249
© D.L. Crumbley
Source Documents Fraud Symptoms
•Photocopies of missing documents.
•Counterfeit/false documents.
•Excessive voids/credits.
•Second endorsements.
•Duplicate payments.
•Large numbers of reconciling items.
•Older items on bank reconciliations.
•Ghost employees.
•Lost register tapes.
250
© D.L. Crumbley
Journal Entries Fraud Symptoms
•Out-of-balance.
•Lacking supporting documents.
•Unexplained adjustments.
•Unusual/numerous entries at end
of period.
•Written entries in computer
environment.
--------------------------------------------For example, $400 million passed from
Bertelmann to AOL, but rather than calling
the money a payment to secure amendments in
a contract relating to the ownership of AOL
Europe, AOL labeled it ad revenue.
251
© D.L. Crumbley
Ledger Fraud Symptoms
•Underlying assets disagree.
•Subsidiary ledger different than
general ledger.
252
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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
253
© D.L. Crumbley
Technology is Here
“Extensive knowledge and use of technology is
an absolute necessity. The ability to go into
an electronic image and download
information, and to get information from
systems that don’t talk to each other. All the
accumulated information can then be
reviewed for financial improprieties.”
Bert Lacativo, Southlake, Texas
------------------------------------------------------“We use off-the-shelf software (IDEA) to
import large databases, read different data
files, set up queries, and compare database
files such as addresses, telephone numbers,
and Social Security numbers. This process
will tell us, for example, if a purchase order
was done on Saturday or Sunday when the
company isn’t open.”
Cal Klausner, Bethesda, Md.
H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical
Accountant, February 2004, pp. 23-28
254
© D.L. Crumbley
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.
255
© D.L. Crumbley
Wiz Rule Data Auditing Tool
• Based upon data mining.
• Performs complex analysis of data,
finding errors, inconsistencies, and
situations that require further
investigation.
• WizRule reveals all the if-then rules,
mathematical formula rules, and
spelling irregularities.
• Divides situations deviating from the
rules into data entry errors and
suspicious errors.
• Can be used in auditing, fraud
detection, data scrubbing, and due
diligence reviews.
• Learning curve is short.
• Cost license is $1,395 and yearly
maintenance fee is $279.
Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html.
256
© D.L. Crumbley
Technology Commits Fraud
“Technology was used to commit fraud in
selling pools of credit card debt. A
cooked formula was embedded in
software by the seller of the debt to
analyze the quality of debt for the
purchaser, so no matter what debt came
out, it had a good collection ratio, and the
purchaser was willing to pay more. Only
by analyzing the software coding was the
fraud discovered,”
Cal Klausner, Bethesda Md.
------------------------------------------------------------
The trend toward paperless systems
hinders a CPA’s ability to find fraud. For
example, many banks are no longer
sending out checks
Roberts J. DiPasquale
H.W. Wolosky, “Forensic Accounting to the Forefront, “ Practical Accountant,
February 2004, pp. 23-28
257
© D.L. Crumbley
Types of
Misappropriations
• Embezzlement
• Cash and check
schemes
– Larceny of cash
– Skimming
– Swapping checks
for cash
– Check tampering
– Kiting
– Credit card
refund and
cancellation
schemes
• Accounts
receivable fraud
– Lapping
– Fictitious
receivables
– Borrowing
against accounts
receivable
• Inventory fraud
– Stealing inventory
– Short shipments
with full prices
• Fictitious
disbursements
– Doctored sales
figures
– Sham payments
– Price
manipulations:
land flipping,
pump and dump,
and
cybersmearing
– Money laundering
– Bid rigging
258
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Cash Wheel
Accounts Receivable
Adjusting Entries
Accounts Payable
Depreciation
Accruals
Cash
Source: Fraud Auditing Small Businesses With The Wheel , James A. Goldstine
259
© D.L. Crumbley
Some Employee Schemes
• Embezzlement/skimming involves
converting business receipts to one’s
personal use and benefit, by such
techniques as cash register thefts,
understated/unrecorded sales, theft of
incoming checks etc.
260
© D.L. Crumbley
Some Skimming Schemes (off-book)
• Unrecorded sales.
• Theft of incoming checks.
• Swapping checks for cash.
Auditing Suggestions
• Compare receipts with deposits.
• Surprise Cash Count.
• Investigate customers complaints.
• Gross profit analysis (also for money
laundering).
• Check for reversing transactions, altered cash
counts, and register tapes that are “lost.”
261
Preventive Measures
© D.L. Crumbley
• Segregation of duties, mandatory
vacations, and rotation of duties
help prevent cash larceny.
• Review and analyze each journal
entry to the cash account.
• Two windows at drive-through
restaurants.
• Signs: Free meal if no receipt.
• Blank checks and the automatic
check signing machine should be
kept in a safe place from employees.
• Pre-numbered checks should be
logged and restricted to one
responsible employee. Require two
signatures on cashier checks.
262
Check 21
© D.L. Crumbley
• Check Clearing for the 21st Century Act takes effect
October 28, 2004.
• Authorizes the use of a substitute check where an
original check is converted to an image file and
transmitted electronically in lieu of physically
transporting the original check.
• The substitute check contains images of the front
and back of the original along with the endorsements,
signatures, and magnetic ink character line.
• There is a memo line: “This is a substitute check.
You may use it the same as you would the original
check.”
• Will speed up the check clearing process. May
reduce check kiting and passing of bad checks.
• Banks may incur higher fraud losses (e.g. Bank One
proceeds 11 billion checks per year).
Source: C. Pacini, “Check 21: Fraud Implications of the Check Clearing for the
21st Century, J of FA, July- December, pp. 559-562.
263
© D.L. Crumbley
Some Employee Schemes (contd …)
Kiting: building up balances in bank
accounts based upon floating checks
drawn against similar accounts in
other banks. Wire transferring makes
kiting easier.
Auditing Suggestions
• Look for frequent deposits and
checks in the same amount.
• Large deposits on Fridays.
• Short time lag between
deposits/withdrawals.
• Bank reconciliation audit [cut-off
bank statement].
264
© D.L. Crumbley
Some Employee Schemes (contd …)
Cut-off Bank Statement
• Shorter period of time (10-20 days).
• Bank statement sent directly to fraud
auditors.
• Compare the cancelled checks, etc.
with the cut-off bank statement.
• Helpful for finding kiting and
lapping.
265
© D.L. Crumbley
Cash Schemes
Other Cash Schemes
• Theft of checks (bottom or middle of
checks).
• Checks may be intercepted or payee
altered (washing checks).
• Forged endorsements (disappearing
ink).
• Stolen credit cards.
• Refund schemes.
• Kickback schemes.
266
© D.L. Crumbley
Kickback Example
Paul J. Silvester, former state
treasurer for Connecticut, admitted
accepting cash kickbacks in return for
placing millions of dollars in state
pension investments with certain
equity funds.
Mr. Silvester was sentenced to 51
months in prison for taking bribes in
return for investing $527.5 million
from the state pension fund in five
investment funds.
Source: Marc Santora, “After Help in Corruption Cases, Central
Figure Gets 51 Months,” N.Y. Times, November 21, 2003, p. C-12.
267
© D.L. Crumbley
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.
268
© D.L. Crumbley
Refund Schemes
• A television station’s former
accounting director pleaded guilty
to stealing more $1.8 million from
her employees and spending it on
jewelry, paintings, and fur coats.
• She would overpay the station’s
travel bills and divert the refunds
to her own credit card bills and
personal accounts.
• She was sentenced to 7 ½ years in
prison on a single count of theft
from CBS affiliate WBBM – TV
Source: AP, “Ex-Accountant at CBS Affiliate Sentenced,” Las Vegas
Sun, November 5, 2003.
269
© D.L. Crumbley
Accounts Receivable’s Schemes
• Lapping.
• Fictitious receivables [for a
fictitious sale], which is later
written off.
• Borrowing against receivables
(use receivable as collateral).
• Improper posting of credits
against receivables.
270
© D.L. Crumbley
Lapping
Lapping
• Recording of payment on a customer’s
account some time after receipt of
payment. Later covered with receipt from
another customer (robbing Peter to pay
Paul).
• Lapping is more successful where one
employee has both custody of cash and
record keeping responsibility.
Audit Steps
• Independently verifying customers who
do not pay.
• Review write-offs.
• Review customers’ complaints.
271
© D.L. Crumbley
Lapping (cont.)
• Compare the checks on a sample
of deposit slips to the details of the
customers’ credits that are listed
on the day’s posting to the
customer’s account receivables.
272
© D.L. Crumbley
Inventory
Inventory Fraud
• Stealing inventory/supplies for personal use or
for sale at flea markets/garage sales.
• Kickback schemes (vendor/supplier and an
employee). Sale of unreported inventory at
inflated prices.
Audit Steps for Inventory Fraud
• Use renumbered inventory tags matched to
count sheets; use count procedures for work-inprogress items; separate duties between
purchasing and logging receipts of shipments
• Check for same vendors.
• Prices higher than other vendors.
• Purchasing agent does not take vacation.
• Only photocopies of invoices are available.
• Aging of inventory.
• Inventory turnover
• There is data-mining software.
273
© D.L. Crumbley
Stealing Diamond Inventory
• Farrah Daly was charged with
stealing at least 39 diamonds (1 to 3
carats), one at a time over several
years from a diamond sorting area.
• She and her husband allegedly had
friends and others sell the
approximately $500,000 worth of
diamonds at pawn shops and
jewelry stores.
Source: AP, “Ohio Woman Accused of Stealing Diamonds,”
Las Vegas Sun, November 10, 2003.
274
Reducing Bad Debts
© D.L. Crumbley
 Before MCI was acquired by WorldCom,
Walter Paulo a billing manager, had to reduce a
$180 million bad debt expense down to $15
million.
 Eventually MCI had to write-off $650 million
in bad debt.
 His schemes:
• Allow a customer to sign a promissory note
to turn the receivable into a short-term asset.
• Redacting invoices.
• Developing interpretations to explain why
some items are aged so long.
• Using questionable codes.
• Used unapplied cash to cover.
 Arthur Andersen did not audit the smaller bad
debt accounts where the questionable accounts
occurred (e.g., the third tier).
 Paulo said that the AA auditors were young,
inexperienced, and fresh out of college.
Source: J.M. Jacka, “An Environment for Fraud,” Internal Auditor, April 2004, pp. 49-52
275
© D.L. Crumbley
Payroll
Payroll Schemes
• Ghost Employee: A person on the
payroll who does not work for that
company.
• False Workers’ Compensation
claims: Fake injury to collect
disability payments.
• Commission schemes: Falsify
amount of sales or the commission
rate.
• Falsify hours and salary: Exaggerate
the time one works or adjusts own
salary.
276
© D.L. Crumbley
Some Employee Schemes (contd …)
Fictitious Disbursements
• Multiple payments to same payee.
• Multiple payees for the same product or
service.
• Ghosts on the payroll.
• Inflated invoices.
• Shell companies and/or fictitious persons.
• Bogus claims (e.g., health care fraud and
insurance claims).
• Overstate refunds or bogus refunds at cash
register.
• Many fictitious expense schemes (e.g.,
meals, mileage, sharing taxi, claiming
business expenses never taken).
• Duplicate reimbursements.
• Overpayment of wages.
277
© D.L. Crumbley
Some Employee Schemes (contd …)
Other Fraud Schemes
• Stealing inventory/scrap.
• Stealing property.
• Theft of proprietary assets.
• Personal use of assets.
• Shoplifting.
• False down grading of products.
• A land flip involves a situation where a
company decides to purchase land for a project.
A person or group will find the land and buy it
under a front name or company. The fraudster
then increases the price of the land before
selling it to the company.
• Money laundering is the use of techniques to
take money that comes from one source, hide
that source, and make the funds available in
another setting so that the funds can be used
without incurring legal restrictions or penalties.
278
© D.L. Crumbley
Forensic Auditing Steps
•
•
•
•
Count the Petty Cash Twice in a Day
Investigate Suppliers (Vendors)
Investigate Customers’ Complaints
Examine Endorsements on Canceled
Checks
• Add Up the Accounts Receivable
Subsidiary
• Audit General Journal Entries
• Match Payroll to Life and Medical
Insurance Deductions
Source: Jack C. Robertson, Fraud Examination for Managers and
Auditors, Austin, TX: Viesca Books, 2000, pp. 213-216.
279
© D.L. Crumbley
Forensic Auditing Steps (contd …)
• Match Payroll to Social Security
Numbers
• Match Payroll with Addresses
• Retrieve Customer’s Checks
• Use Marked Coins and Currency
• Measure Deposit Lag Time
• Document Examination
• Inquiry, Ask Questions
• Covert Surveillance
Source: Jack C. Robertson, Fraud Examination for Managers and
Auditors, Austin, TX: Viesca Books, 2000, pp. 213-216.
280
© D.L. Crumbley
Acquisition/Payment Cycle
From 62 standard audit procedures, external
and internal auditors judged these 20 procedures to be
more efficient is detecting fraud in the acquisition and
payment cycle (in descending order).
• Examine bank reconciliation and observe whether
they are prepared monthly by an employee who is
independent of recording cash disbursement or
custody of cash.
• Examine the supporting documentation such as
vendor’s invoices, purchase orders, and receiving
reports before signing of checks by an authorized
persons.
• Examine the purchase requisitions, purchase orders,
receiving reports, and vendors’ invoices which are
attached to the vouchers for existence, propriety,
reasonableness and authenticity.
•Examine internal controls to verify the cash
disbursement are recorded for goods actually rendered
to the company.
•Discuss with personnel and observe the segregation
of duties between accounts payable and custody of
signed checks for adequacy.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
281
© D.L. Crumbley
Acquisition/Payment Cycle (Contd.)
• Confirm inventories in public warehouse and on
consignment.
•Examine internal controls to insure the vendor’s
invoices, purchase orders, and receiving reports are
matched and approved for payment.
• Examine internal controls for the following
documents: vendor’s invoices, receiving reports,
purchase orders, and receiving reports.
• Trace a sample of acquisitions transactions by
comparing the recorded transactions in the purchase
journal with the vendor’s invoices, purchase
requisitions, purchase orders, and receiving reports.
• Establish whether any unrecorded vendors’ invoices
or unrecorded checks exist.
• Examine the internal control to verify the proper
approvals of purchase requisitions and purchase
orders.
• Reconciled recorded cash disbursement with
disbursements on bank statements.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 204-205
282
© D.L. Crumbley
Acquisition/Payment Cycle (Contd.)
• Discover related party transactions.
• Examine the internal control to verify the approvals
of payments on supporting documents at the time that
checks are signed.
• Discuss with personnel and observe the procedures
of examining the supporting documentation before the
signing of checks by an authorized person.
• Examine canceled checks for authorized signatures,
proper endorsements, and cancellation by the bank.
• Account for the numerical sequence of prenumbered
documents (purchase orders, checks, receiving reports,
and vouchers).
• Trace a sample of cash payment transactions.
• Trace resolution of major discrepancy reports.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
283
© D.L. Crumbley
Sales/Collection Cycle
These 10 audit procedures were judged as
being more effective for detecting fraud in the sales
and collection cycle (in descending order)
• Observe the proper and appropriate segregation of
duties.
• Review monthly bank reconciliation and observe
independent reconciliation of bank accounts.
• Investigate the difference between accounts
receivable confirmation and customer account
receivable balances in the subsidiary ledger and
describe all these exceptions, errors, irregularities, and
disputes.
• Review sales journal, general ledger, cash receipts
journal, accounts receivable subsidiary ledger, and
accounts receivable trial balance for large or unusual
amounts.
• Verify accounts receivable balance by mailing
positive confirmations.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
284
© D.L. Crumbley
Sales/Collection Cycle (Contd.)
• Examine internal controls to verify that each cash
receipts and credit sales transactions are properly
recorded in the accounts receivable subsidiary ledger.
• Examine subsequent cash receipts and the credit file
on all accounts over 120 days and evaluate whether the
receivable are collectible.
• Compare dates of deposits with dates in the cash
receipts journal and the prelisting cash receipts.
• Examine copies of invoices for supporting the bills of
lading and customers’ orders.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
285
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Inventory/Warehouse Cycle
These 14 standard audit procedures were
judged by external and internal auditors as being more
effective for detecting fraud in the inventory and
warehousing cycle 9in descending order):
• Discover related party transactions.
• Follow up exceptions to make sure they are resolved.
• Review major adjustments for propriety.
• Review inventory count procedures: a. Accounting
for items in transit (in and out); b. Comparison of
counts with inventory records; and c. Reconciliation of
difference between counts and inventory records.
• Review adequacy of physical security for the entire
inventory.
• Confirm inventories in public warehouse.
• Review procedures for receiving, inspecting, and
storing incoming items and for shipments out of the
warehouses.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
286
© D.L. Crumbley
Inventory/Warehouse Cycle (Contd.)
• Trace shipments to sales records, inventory records,
and bill of lading (shipping documents).
• Determine if access to inventory area is limited to
approval personnel.
• Observe the physical count of all location.
• Recount a sample of client’s counts to make sure the
recorded counts are accurate on the tags (also check
descriptions and unit of count, such as dozen or gross)
• Trace inventory listed in the schedule to inventory
tags and the auditor’s recorded counts for existence,
descriptions, and quantity.
• Trace shipments to sales journal.
• Perform compilation tests to insure that inventory
listing schedules agrees with the physical inventory
counts.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 206-207.
287
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Payroll/Personnel Cycle
These 12 audit procedures were judged the
more effective for detecting fraud in the payroll and
personnel cycle (in descending order):
• Sample terminated employees and confirm that they
are not included on subsequent payrolls and confirm
propriety of termination payments.
• Observe the actual distribution of payroll checks to
the employees.
• Observe the duties of employees being performed to
insure that separation of duties between personnel,
timekeeping, journalizing payroll transactions, posting
payroll transactions, and payroll disbursement exists.
• Examine internal controls to verify that hiring, pay
rates, payroll deductions, and terminations are
authorized by the personnel department.
• Sample personnel files and physically observe the
presence of personnel in the work place.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
288
© D.L. Crumbley
Payroll/Personnel Cycle (Contd.)
• Examine internal control over payroll records to
verify that payroll transactions are properly
authorized.
• Discover related party transactions.
• Review the files of new hires for appropriate
approvals, pay rates, and dates of accession.
• Review the payroll journal, general ledger, and
employee individual pay records for large or unusual
amounts.
• Examine internal controls to verify that unclaimed
payroll checks are secured in a vault or safe with
restricted access.
• Examine internal controls to verify that employee
time cards and job order work tickets are reconciled.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 208.
289
Anti-fraud Checklist
© D.L. Crumbley
Business policy
• Is there a published ethics policy with
definitions of fraud?
• Is fraud included in the company’s
overall business risk assessment?
• Is there a plan in place to respond to risk
and to limit damage to the business?
Staff
• Does the company check job applicants’
references and get certificates for
qualifications for appointments at all
levels?
• Are staff trained to notice signs of all
types of fraud?
• Are whistle blowers encouraged to
come forward?
Source: Adapted from Moody, M., “Fraud – enemies within”
In Director (April 2000), p. 16.
290
Anti-fraud Checklist (contd …)
© D.L. Crumbley
Commercial activities
• Does the company follow strict creditmanagement practice and enforce credit
limits?
• Does the company follow good
practices on credit cards and counterfeit
money?
• Are goods received and their prices
checked against delivery notes and
invoices?
• Is ownership checked on 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.
291
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Class Discussion
How can you defraud your
own organization, working either
from the inside or outside?
------------------------------------------“Fraudsters … identify and exploit
weaknesses specific to the
organization.”
Herling, D.J., and J. Turner, “Fraud: Effective Use of Legal Remedies for Corruption,”
9th International Anti-Corruption Conference, October 13, 1999. PowerPoint
presentation slide 56. http://
www.transparency.org/iacc/9th_iacc/papers/day3/ws1/dnld/d3ws1_djherling.ppt
292
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Red Flags or Fraud Identifiers
• Earnings problem: downward trend in
earnings
• Reduced cash flow: If net income is moving
up while cash flow from operations is drifting
downward, something may be wrong.
• Excessive debt: the amount of stockholders'
or owners' equity should significantly exceed
the amount of debt.
• Overstated inventories (California Micro)
and receivables (BDO Seidman): If accounts
receivables exceeds 15 percent of annual sales
and inventory exceeds 25 percent of cost of
goods sold, be careful.
• Inventory plugging: Record sales to other
chains as if they were retail sales rather than
wholesale chains (e.g., Crazy Eddie).
• Balancing Act: Inventory, sales, and
receivables usually move in tandem because
customers do not pay up front if they can
avoid it.
• CPA Switching: Firms in the midst of
financial distress switch auditors more
frequently than healthy companies.
293
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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.
294
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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.
295
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Lifestyle Probes
The lifestyle of a taxpayer or employee
may give clues as to the possibilities of
unreported income. Obvious lifestyle
changes may indicate fraud and
unreported income:
– Lavish residence
– Expensive cars and boats
– Vacation home
– Private schools for children
– Exotic vacations
296
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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.
297
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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.
298
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Indirect Methods
An indirect method should be used when:
• The taxpayer has inadequate books and
records
• The books do not clearly reflect taxable
income
• There is a reason to believe that the
taxpayer has omitted taxable income
• There is a significant increase in year-toyear net worth
• Gross profit percentages change
significantly for that particular business
• The taxpayer’s expenses (both business
and personal) exceed reported income and
there is no obvious cause for the
difference
299
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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,i
d=108149,00.html
300
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Minimum Income Probes
• For non-business returns, an agent
question the taxpayer or
representative about possible sources
of income other than reported on the
return. If there is no other information
in the file indicating potential
unreported income, the minimum
income probe is met.
• For taxpayers who are self-employed
and file a Schedule C or F, an analysis
is made of tax return information to
determine if reported income is
sufficient to support the taxpayer’s
financial activities.
301
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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.
302
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Preliminary Cash-T
Gross Receipts:
Schedule C
Business Expenses:
$120,000 Schedule C
Personal Living
Expenses
Preliminary
Understatement
$95,000
$60,000
$155,000
$35,000
303
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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.
304
© D.L. Crumbley
Source/Application of Funds
Application of funds:
Bank balance increase
Down payment on home
Closing costs on home
Purchase of SUV
Rent payment (4 months)
Mortgage payment
Down payment on boat
Credit card payments
Miscellaneous (living)
Balance
2005
2006
$7,300
15,000
3,700
17,600
2,000
4,200
14,000
11,500
75,300
$29,500
8,400
10,000
38,800
37,000
$123,700
$3,600
49,500
7,000
3,000
0
$63,100
$12,200
$1,700
53,000
13,000
3,000
7,000
$77,700
$46,000
Known sources of funds:
Cash on hand
Salary
Consulting
Dividends and interest
Loan proceeds
Balance
Net unreported funds
305
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Net Worth Method
The net worth method is a common indirect
balance sheet approach to estimating income.
To use the net worth method, an IRS agent or
forensic accountant must:
1. Calculate the person’s net worth (the
known assets less known liabilities) at
the beginning and ending of a period
2. Add nondeductible living expenses to
the increase in net worth
3. Account for any difference between
reported income and the increase in net
worth during the year as (a) nontaxable
income and (b) unidentified differences
Hollard v. U.S., 348 U.S. 121 (1954).
306
Net Worth Example
© D.L. Crumbley
Total assets (at cost)
$1,200,000
Less: Total liabilities
(550,000)
Net worth, end of the year
650,000
Net worth at beginning of year
530,000
Increase or decrease in net worth
120,000
Add: living expenditures
145,000
Estimated Income
265,000
Less: Known sources of income
(130,000)
Unexplained income
$135,000
307
© D.L. Crumbley
Bank Deposit Method
The bank deposit method looks at the
funds deposited during the year. This
method attempts to reconstruct gross
taxable receipts rather than adjusted.
Gleckman v. U.S., 80 F.2d 394(CA-8,
1935).
308
© D.L. Crumbley
Formula for Bank Deposit Method
Total deposits to all accounts
Less: Transfers and re-deposits
=
Net deposits
plus: Cash Expenditures
=
All total receipts
less: Funds from known sources
=
Funds from unknown sources
$195,000
21,000
174,000
68,000
242,000
119,000
123,000
309
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Formula for Expenditure Method
Expenditures
less: Known sources of income
=
Unknown sources of income
$210,000
115,000
$95,000
310
Percentage of Markup Method © D.L. Crumbley
Gross Profit on Sales Formula
Sales per books
$100,000
25%
Gross profit percentage
$25,000
Gross profit as recomputed
Sales on Cost of Sales Formula Cost of SalesPercentage of Sales Price
Cost of Product A
$10,000
$20,000
Cost of Product B
Cost of Sales – Percent of Selling Price
Product A
25%
Product B
50%
Recompiled Sales of products A and B
Product A
$40,000
(10,000/.25)
Product B
$40,000
(20,000/.5)
Sales as recomputed
$80,000
Ratio Analysis Formula
Restaurant Sales
$90,000
Number of waiters
3
Average sales per waiter
30,000
Customer’s tip percentage
10%
Waitress tip income as recomputed
$3,000
311
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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
312
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Other Techniques
A check spread deals with
disbursements and may be used when a
target uses checking accounts. George A.
Manning says the following information is
needed to perform a check spread: date,
payee, check number, amount, bank from,
bank to, first endorsement, second
endorsement, and second signatory. Check
spreads show patterns of activities and can
gather data for the net worth method.
A deposit spread deals with the
receipts into a checking account, and shows
patterns of activities and gathers data for the
net worth and expenditures methods.
Credit card spreads may be used for
legal and stolen credit cards to show where
a target has been geographically over time.
Source: G.A. Manning, Financial Investigation and
Forensic Accounting, Boca Raton, FL: CRC Press,
1999, pp. 196-198.
313
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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?
314
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KPMG’s 10 steps to follow contd..
6. Consider prosecution. Before you make
the call, weigh the plusses and minuses
and determine if your insurance
company requires prosecution.
7. Terminate business relations. If the fraud
is external, business relations with the
suspect individual or organization should
be terminated.
8. Seek advice and assistance. An
important consideration is whether you
have the knowledge and resources
necessary to effectively manage the
process.
9. Prepare a witness list. It is important that
statements be taken before a “party line”
can develop.
10. Consider the message. Whatever you do
will affect future situations. Now may be
the time to change the way your business
operates.
315
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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.
316
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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.
317
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Use IRS Form 1099 Threat
• For fraudsters and embezzlers,
use the threat of filling a Form
1099 for amounts stolen.
• Ask for an installment payback.
• If they stop payment, report them
to the IRS on a Form 1099.
318
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Interviewing Executives
One way to detect fraud is to interview company personnel. The AICPA
Fraud Task Force provides an interviewing template of 13 questions for
CEOs, CFOs, and Controllers.
1. Explain the purpose of interview- need to assess risk and comply with audit
responsibilities
2. Inquire whether they are aware of any instances of fraud within their
organization- Do they have reason to believe that fraud may have occurred
or is occurring?
3. Has the CEO or CFO ever approved an accounting treatment for
transactions that were not appropriate?
4. Have there been any instances where someone has attempted to inflate
assets or revenue or deliberately understate liabilities and expenses?
5. Is there any member of management that has a direct interest or indirect
interest in any customer, vendor, competitor, supplier or lender?
6. Is any member of management related to any other member of
management?
7. Does anyone in the company have any personal, financial or other problems
that might affect their job performance?
8. If there was an area within the company that might be vulnerable to fraud,
what would that be?
9. Has anyone within the accounting department been let go or resigned
within the past year?
10.Is there anyone in management that appears to be living a lifestyle beyond
their means? – expensive cars, trips, jewelry, vices
11.Has anyone been involved in civil or criminal proceedings or filed
bankruptcy
12.Does the company have a strong ethics policy?
13.Has anyone ever been fired for committing fraud against the company?
Source: Ronald L. Durkin et. al, “Incorporating Forensic Procedures in an
Audit Environment,” Litigation and Dispute Resolution Services
Subcommittee, New York: AICPA, 2003.
319
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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
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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
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Advantage and Disadvantages
Advantages of an interview (nonaccusatory)
• Facilitates the development of cooperation.
• Easier to develop rapport.
• More effective way of developing usable
information.
Disadvantages of Interrogation
• Interviewee may be alienated and refuse to
speak to anyone later.
• If interviewee will not speak to anyone,
ability to obtain information or admission is
diminished.
Source: John E.Reed Associates, Inc.
322
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Verbal and Nonverbal Behavior
Verbal behavior includes not only
words, but timing, pitch, rate, and
clarity of the responses.
Nonverbal behavior includes body
movement, position changes gestures,
eye contact, and facial expressions.
See “Interviewing & Interrogation,” The Reid Technique, John
E.Reid Associates, Inc., L.E.R.C Law Enforcements.
323
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Nonverbal Language
• 60% of communication is nonverbal.
• Previous contact with person helpful.
• During President Bill Clinton’s testimony
he touched his nose several times when he
was lying, but did not touch his nose during
truthful testimony.
• Two-thirds of truth interviewees cross their
legs.
Source: “Lying 101: There May Be Nonverbal Indicators of Lying,”
http://members.tripod.com/nwacc_communication/id25.htm.
324
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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
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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
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Lying: James R. Brown Style
• “I lied in person to investors when I
met them. I lied in company’s filings.
I lied in the company’s press
releases.” Adelphia Communications
vice-president of finance.
• He had no formal training in
accounting and finance.
• Adelphia began manipulating its
financial reports soon after the
company went public in 1986.
• We regularly fabricated statistics on
the number of subscribers, cash flow,
cable-system upgrades, and other
closely followed metrics.
327
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Lying: James R. Brown Style
(cont.)
• Top executives would meet on Saturdays
to determine if we were meeting loan
agreements. If not, we would make other
types of manipulations of either arbitrarily
moving expenses between companies or
adding invented affiliate income or interest
income from one internal company to
another.
• For more than 10 years we kept two sets of
books.
Source: Chad Bray, “Adelphia Witness Lays Out Lies,” WSJ, May 19, 2004,
pp. C-1 and C-2.
328
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Voice – Analysis Software
• Developed in Israel; can be used over
the phone. Nemesysco system.
• Measures stress levels and displays
them on a screen.
• U.K. insurers are using it, connected
between the telephone and computer.
• Screen flashes “High Stress.”
• 70% O.K. Of 30% high risk, 12%
prove O.K., but 18% rejected as
fraudulent.
Source: Charles Fleming, “Insurers Employ Voice-Analysis Software
to Detect Fraud,” WSJ, May 17, 2004, pp. B-1 and B-4.
329
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Fewer People Lie in E-mail
• People tell fewer lies in e-mails than
in phone calls and face-to-face
conversations.
• Possible reason: Most people know
that e-mails leave a record.
J. T. Hancock, Corporate Human Interaction
-------------------------------------------------
I got one thing to tell you,
I…oooo, I ain’t tryin’ to sell ya’,
No lies.
Grand Funk Railroad
330
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Interviewing Techniques
“Bosch didn’t say anything. He knew
that sometimes when he was quiet,
the person he needed information
from would eventually fill the
silence.” (pp. 5-6).
-------------------------------------------“Just listen. You are a detective.
Detectives are supposed to listen.
You once told me that solving
murders are getting people to talk
and just listening to them.” (pp. 9293).
-------------------------------------------------Source: Michael Connelly, The Black Ice, St. Martin’s Paperback,
1993.
331
Chance of Confession
© D.L. Crumbley
John Baldwin found in 600
investigative interviews that 35.7 percent
of suspects confessed from the outset and
an additional 16.2 percent confessed
initially to part of the allegation.
“Police Interviewing Techniques,” British Journal of
Criminology, Vol. 33, 1993.
William Morrisette believes that “an
investigator who properly identifies and
implements the appropriate investigative
communication type should be able to
achieve an 85 percent confession rate
through basic interrogation and a 95
percent rate by way of advanced
interrogation.”
332
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Fraud Detection
Questions
Question # 1 –
Reason Why? Do you know why
you are here today?
Principle: Innocent subjects will
acknowledge the reason for the
interview, while the guilty
subject will generally avoid
indicating knowledge of the
issue.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
333
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Fraud Detection
Questions
Question #2 –
Know/Suspect: Who do you think
may have taken that $5,000
from the safe?
Principle: Innocent subjects are
more likely to volunteer a name
or offer a suspicion.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
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Fraud Detection
Questions
Question #3 –
Vouch: Is there anyone that you work
with that you feel would not have
taken that $5,000 from the safe?
Principle: Innocent subjects will
vouch for others, while the guilty
will vouch for themselves or no one.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s
Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.
335
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Fraud Detection
Questions
Question #4 –
Think: Do you think that the
$5,000 was actually stolen?
Principle: Innocent subjects will
generally agree that the money
was actually stolen.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
336
© D.L. Crumbley
Fraud Detection
Questions
Question #5 –
Opportunity: Who do you think would
have the best opportunity to take
that $5,000 from the safe?
Principle: Innocent subjects will
usually offer a name of an individual
or named position who would have
had the best opportunity.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s
Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.
337
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Fraud Detection
Questions
Question #6 –
Happen: What do you think
should happen to the person
who stole that missing $5,000?
Principle: Innocent subjects will
generally offer harsher
punishment than the guilty.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
338
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Fraud Detection
Questions
Question #7 –
2nd Chance: Would you be inclined to
give someone a second chance?
Principle: Innocent subjects generally
continue to offer harsh punishment,
while the guilty are more likely to
offer a second chance.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s
Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.
339
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Governmental Frauds
The Office of Management and
Budget reported that in fiscal year
2001 the federal government paid out
$20 billion in erroneous payments.
On June 19, 2003: We analyzed a
portion of the programs and already
know that erroneous payments
exceeded $35 billion a year.” Office of
Mgt. And Budget
340
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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
--------------------------------------------------------------
2004 Wells Report: 25% of fraud
incidents occurred in government agencies,
with a $48,000 median loss (.25 times $660
billion = $165 billion).
341
© D.L. Crumbley
GASB Statement No. 34
•Governmental Accounting Standards Board:
nonprofit agency charged with setting GAAP for
state and local governments.
•Although GASB has no authority to set law, many
public agencies follow its standards.
•Statement No. 34 retains the fund accounting focus
(good for budgeting and short-term focus), but adds
government-wide financial statements (e.g., account
for all assets and liabilities).
•Requires capitalization and depreciation of
infrastructure 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.
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Assess Financial Health
Ratio
Purpose
Negative
Indicator
Financial
Position:
Unrestricted Net Assets
Expenses
Measures a government’s
ability to provide basic
government services
Decreasing
Financial
Performa
nce:
Change in Net Assets
Total Net Assets
Measures a government’s
financial performance during
the current fiscal year by
comparing the change in the
Net Assets derived from the
Statement of Activities to the
total net assets.
Decreasing
(General Revenues +
Transfers) / Expenses
Measures the extent to
which the cost of services
are paid for out of general
revenues.
Decreasing
Liquidity:
(Cash + Current
Investments +
Receivables) / Current
Liabilities
Measures the extent to
which current liabilities are
covered by the more liquid
current assets.
Decreasing
Solvency:
Long-term Debt / Assets
Measures a government’s
long-term financial viability
by comparing the extent to
which assets are financed by
incurring long-term debt.
Increasing
(Change in Net Assets +
Interest Expense) / Interest
Expense
Measures the government’s
Decreasing
ability to generate a stream
inflows
sufficient to“The
makeNew
Source: B.A. Chaney, D.M. Mead, andofK.R.
Schermann,
interest payments.
Governmental Reporting Model,” Journal of Governmental Management,
Spring 2002, p. 29.
343
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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 – threeyear 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.
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Assess Financial Health of Governmental Units
Ratios
Negative
Indicator
Credit
Industry
Benchmark
Cash and investments/current
liabilities
Decreasing
Less than 1%
Operating surplus (deficit)/total
revenue
Decreasing
5% or
consecutive
Elastic revenue (sales, utilities,
Decreasing
other elastic taxes)/total revenue
Varies
State and federal aid / total
revenue
Increasing
Varies
Current liabilities/total revenue
Increasing
5%
Uncollected property taxes/
current tax levy
Increasing
Greater than
8%
Fixed costs/ total expenditures
Increasing
Varies
Debt service/total revenue
Increasing
Greater than
20%
Tax levy/tax limit
Increasing
Greater than
90%
Debt outstanding/debt limit
Increasing
Greater than
90%
Source: S.M. Winckler and Dewey Ward, “Can City Hall Go Broke? The Going Concern
Issue,” Journal of Accountancy, May 1984.
345
Office of New York State Comptroller © D.L. Crumbley
Indicator 1: Revenue and Expenditures Per Capita
Recurring Revenues Per Capita
a. Gross Revenues
Population
b. Gross Expenditures
Population
c. Recurring Revenues (Gross Revenues – One-Time Revenues)
Population
Negative Trend: Indicator 1b increasing faster than indicator 1a or 1c.
Indicator 2: Real Property Taxes Receivable
Real Property Taxes Receivable
Real Property Tax Revenue
Negative Trend: The percentage increases over time.
Indicator 3: Fixed Costs – Personal Services and Debt Service
a. Salaries and Fringe Benefits
Gross Expenditures
b. Debt Service Expenditures
Gross Expenditures
c. Salaries and Fringe Benefits + Debt Service
Gross Expenditures
Negative Trend: Percentages increasing over time.
Some analysts use a variation of the 3b ratio based upon debt service
expenditures as a percentage of revenues. A ratio of 25% for debt
service expenditures to “own source” revenues is considered a danger
signal.*
* J.R. Razek et. al, Introduction to Governmental and Not-For-Profit
Accounting, Prentice-Hall, 2000, p. 412.
346
Office of New York State Comptroller © D.L. Crumbley
Indicator 4: Operating Surplus/Deficit
a. Gross Revenues – Gross Expenditures
Gross Expenditures
b. Gross Revenues – Gross Expenditures – One-Time Revenues
Gross Expenditures
Negative Trend: Percentages decreasing over time.
Indicator 5: Unreserved Fund Balance and Appropriated
Fund Balance
a. Unreserved Fund Balance
Gross Expenditures
b. Appropriated Fund Balance
Gross Expenditures
Negative Trend: Percentages decreasing over time.
Deficits in major funds in excess of 1.5% of fund expenditures or
$50,000 (whichever is greater) are generally causes for concern.
Some analysts use a variation of this ratio: the budgetary
cushion. Here the fund balance is compared to revenues. The
greater the fund balance as a percentage of revenues, the more
likely a local government may weather hard times. A good rule
of thumb is that a fund balance should be at least 5% of
revenues.[1]
[1] J.R. Razek et. al, op. cit., p. 411.
347
Office of New York State Comptroller © D.L. Crumbley
Indicator 6: Liquidity
Cash and Investment as a Percentage of Current Liabilities
Cash and Investments as a Percentage of Gross Monthly Expenditures
a. Cash and Investments
Current Liabilities
b. Cash and Investments
Gross Expenditures/12
Negative Trend: Percentages decreasing over time.
A government should generally have year-end cash equal to about
50% of current liabilities and 75% of average monthly expenditures.
A governmental accounting textbook states that this quick ratio (or
acid test) omits receivables and amounts due from other funds
because of difficulties converting them into cash. They suggest that a
large state government should consider a quick ratio of less than 50
percent as an indicator of financial stress.*
Indicator 7: Long-Term Debt
Long-Term Debt
Population
Negative Trend: Percentage increase over time
Note: An increase in #7 would likely trigger a future increase in #3
formula as well as a decrease in #8.
Indicator 8: Capital Outlay
Capital Outlay
Gross Expenditures
Negative Trend: Percentage decreasing over time
Note: This eighth indicator is an early warning sign of financial
stress.
* Razek and Hosch, ibid., p.411.
348
© D.L. Crumbley
Office of New York State Comptroller
Indicator 9: Current Liabilities
Current Liabilities
Gross Revenues
Negative Trend: Percentage increasing over time
Indicator 10: Intergovernmental Revenues
Intergovernmental Revenues
Gross Revenues
Negative Trend: Percentage increasing over time.
Indicator 11: Economic Assistance Costs
Economic Assistance Cost
Gross Expenditures
Negative Trend: Percentage increasing over time.
349
© D.L. Crumbley
Office of New York State Comptroller
Indicator 12: Public Safety
Public Safety Cost
Gross Expenditures
Negative Trend: Percentage increasing over time
Indicator 13: Tax Limit Exhausted
Tax Levy
Tax Limit
Negative Trend: Percentage increasing over time
The tax limit is the maximum amount of taxes that can be levied
based upon some statutory authority.
Indicator 14: Debt Limit Exhausted
Total Debt Subject to Limit
Debt Limit
Negative Trend: Percentage increasing over time
Debt limit is the maximum amount of debt that can be issued
under applicable statutory authority. Compare this ratio with
indicators 3 and 7.
350
Not-For-Profits
© D.L. Crumbley
• There are more than 1 million not-forprofits in the U.S.
• Often there is little segregation of duties.
• They often deal in an atmosphere of trust,
with employees having little accounting and
business experience.
• Difficult to estimate and control the cash
contributions and revenues (e.g., Salvation
Army’s Christmas kettles take in $1,000 $1,500 per day).
• Fountains at charitable organizations may
take in several thousand dollars in coins.
• The Non Profit Times (www.nptimes.com).
• Some people believe the Sarbanes-Oxley
Act will be imposed on large not-forprofits.
• Moral: Do not go to a hospital that you are
giving away money to in your will.
351
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Don’t Volunteer For Trouble
Dos and Don’ts
If you volunteer CPA services to an NPO, do
• Avoid the appearance of impropriety.
• Check the volunteer liability statutes in your state.
• Examine the NPO’s internal controls, bylaws and
procedures.
• Educate yourself about how the organization operates.
• Attend board orientation and understand job descriptions.
• Attend as many board meetings as you possibly can and
document votes and discussions.
• Make sure the organization has proper insurance coverage.
• Be prepared to contribute time, talent and resources.
Your follow-through is important, so don’t
• Skip board meetings.
• Rubber-stamp decisions.
• Sign checks without documentation.
• Ignore employee complaints of discrimination or sexual
misconduct.
• Serve if you are unable to regularly attend meetings.
Source: Joan Sompayrac, “Don’t Volunteer for Trouble,”
Journal of Accountancy, January 2003, p. 82.
352
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
1. Often exchange small
denomination bills for one hundred
dollar bills. This techniques
reduces the bulk of the currency
several fold and makes it easier to
conceal and transport.
2. Purchase monetary instruments
such as money order, travelers
checks, bank drafts, cashiers
checks, treasurers checks, and
official bank checks with currency
in amounts below the $3,000
record-keeping requirement,
thereby reducing the bulk of
currency.
353
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
3. Purchase the monetary instruments
mentioned above in increments just
below the $10,000 Currency
Transaction Report threshold. This
will result in the financial institution
identifying the purchaser and
maintaining a log of these
transactions; however, money
launderers recognize that the log is
not filed with the government.
4. Bulk ship currency to a jurisdiction
with bank secrecy laws. Although a
Currency and Monetary Instrument
Report must be filed with the U. S.
Customs Service anytime currency
and/or monetary instruments are
exported from the U. S. or imported
into the U. S. money launderers do
not file the report. Section 371 of the
USA PATRIOT Act makes bulk
shipping cash into or out of the
United States a crime.
354
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
5. Recognize that financial institutions
report repeated deposits of just
under $10,000. Therefore many
money launderers will open several
accounts in the names of family
members and possibly friends at
several financial institutions and
deposit small amounts of currency in
each account. The deposited amount
in these situations may be less than
$1,000 on a daily basis or $2,000 to
$3,000 twice or possibly three times
a week. These deposited amounts
remain below the thresholds of any
known internally developed
monitoring system and would
probably only be detected using
comprehensive technology along with
a compliance team.
355
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
6. May purchase a currency generating
business to launder funds. Money
launderers have used businesses such
as restaurants and service/gasoline
stations. These businesses serve as both
a method to place and layer dirty money
simultaneously.
7. Use electronic transfers to move dirty
money. A money launderer may fund an
electronic transfer with up to $3,000 in
currency without providing identification.
These funds can be rapidly transferred
anyplace in the world. In many cases
the money launderer may request that a
representative of a money service
business (MSB) execute several wire
transfers during the course of a day all
below the $3,000 record-keeping
threshold. The money launderer will
normally offer the MSB employee a bribe
for the accommodation.
356
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
8. May elect to execute electronic transfers
below the $3,000 record-keeping
threshold at several financial
institutions. Doing this will keep these
transfers under the radar screen since
they are small increments and they are
being distributed to multiple places.
9. Purchase a big-ticket item such as a car
and use currency to pay down loans at
an accelerated rate. The dealership is
required to file a currency report if the
money launderer uses currency and/or
monetary instruments with a face value
of $10,000 or less and the total value of
the currency and the monetary
instruments aggregates to over
$10,000. Financing the automobile and
making accelerated payments on the
loan will evade the filing of a currency
report.
357
© D.L. Crumbley
Did You Know That Money
Launderers (Don Temple)
10. Attempt to disassociate
themselves from the proceeds of a
fraud quickly. Money launders may
deposit the fraudulent proceeds
into an account and almost
immediately withdraw those funds
in the form of currency at various
branches of an institution or via
ATMs.
Source: Don Temple, “Money Laundering 101: Ten
Ways to Place Dirty Money,” July 26, 2002,
http://www.smartpros.com/x34833.xml
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The End Is Here
360