Transcript Forensic Accounting Update Exam II Copyrighted 2002 D

© D.L. Crumbley
Forensic Accounting, Forensic
Techniques, and Fraud Detection
Copyrighted 2001
D. Larry Crumbley, CPA, Cr.FA
KPMG Endowed Professor
Department of Accounting
Louisiana State University
Baton Rouge, LA 70803
225-578-6231
225-578-6201 Fax
[email protected]
Dr. Crumbley is the editor of the Journal of
Forensic Accounting: Auditing, Fraud, and
Taxation, former chair of the Executive Board of
Accounting Advisors of the American Board of
Forensic Accountants, member of the Fraud
Deterrence Board, and on the AICPA’s Fraud
Task Force. A frequent contributor to the Forensic
Examiner, Professor Crumbley is a co-author of
CCH Master Auditing Guide, 2nd Edition along
with more than 45 other books. His latest book
entitled Forensic and Investigative Accounting is
published by Commerce Clearing House (800224-7477). Some of his 12 educational novels have
as the main character a forensic accountant. His
goal is to create a television series based upon the
exciting life of a forensic accountant and litigation
consultant.
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Forensic Accounting Factors
• Time: Forensic accounting focuses
on the past, although it may do so in
order to look forward (e.g., damages,
valuations).
• Purpose: Forensic accounting is
performed for a specific legal forum
or in anticipation of appearing before
a legal forum.
----------------------------------------------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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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 [D.W. Yockey, “So You Want to Be a Forensic
Accountant,” Management Accounting, November 1988, pp. 19-23.]
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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
--------------------------------------------------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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Top Niche Services
1. Business Valuations
2. Estate Planning
3. Litigation Support
4. Mergers & Acquisitions
5. Business Mgt. Wealthy clients
6. Forensics/fraud
7. Employee benefits
8. Computer systems/consulting
78%
77%
73%
61%
56%
55%
55%
53%
Source: J.M. Covaleski, “Many Top 100 Growth Areas Revolve
Around Synergy of CPA/Attorney Relationship,” Accounting Today,
March 18-April 7, 2003, p.1.
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Forensic Accounting vs.
Fraud Auditing
Fraud Auditor: An accountant especially
skilled in auditing who is generally engaged
in auditing with a view toward fraud
discovery, documentation, and prevention.
-----------------------------------------------------“Economic crimes and fraud often do not
involve obvious evidence like the smoking
gun. Forensic accountants look behind the
deals and handshakes and probe beyond the
numbers to uncover the reality of financial
situations.”
Source: D.W. Squires, “Problems Solved with Forensic Accounting: A
Legal Perspective,” Journal of Forensic Accounting., Vol. IV (2003),.
P. 131.
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Forensic Accountants
“Rather than combing torn clothing,”
forensic accountants “comb through
corporate books, looking for oddities
that could signal swindles,” says
Bruce Dubinsky. Investigations can be
extremely complex, with crates and
crates of documents and thousands of
computer files. Investigators look for
flags or patterns that would not
normally occur.
Source: Mark Maremont, “Tyco Is Likely to Report
New Woes,” Wall Street Journal, April 30, 2003, p.
C-1.
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Potpourri
• Deutsche Bank is being sued for $1.3 billion by Bruce
Winston (one of the heirs of Harry Winston diamond
dynasty) for priceless gems disappearing from a
trust under their control.
• A Burlington, Kentucky city finance director is
accused of embezzling more than $1.2 million to
support his estranged wife and his girlfriend.
• Martin Frankel vanished with between $200 million in
cash and diamonds one day. He accomplished this
insurance fraud by buying poorly capitalized insurance
companies, cooking the books to show increased
premium value, and by including non-existing real
estate and leases on the balance sheet.
• After the terrorists’ attack in New York city, about
4,500 people manipulated the broken ATM machines
of a municipal employees credit union, stealing as
much as $15 million.
• A U.S. Lime officer embezzled nearly $2.2 million by
forging signatures of other company officers on
checks, and falsifying the company’s check register to
create the impression that the amounts he received
went to U.S. Lime creditors.
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Auditors Blamed (cont.)
•As part of the securitization agreement,
UC agreed to pay the principal and interest
on defaulted loans.
•Creditors contend that UC failed to
account for the interest it was paying, and
D&T should have caught the mistake
earlier.
•After UC wrote off $605 million in debt,
the company filed for bankruptcy.
• Confidential mid-court settlement.
Source: Adrian Angelette, “United Companies Settlement Reached,”
Baton Rouge Advocate, October 31, 2003, pp. A-1 and A-12
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Forensic Accounting Knowledge Base
LAW
Criminology
Investigative
auditing
Accounting
Forensic Accountant
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Be like
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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.”
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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.
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White-Collar Crime: Rich
People Steal
• Edwin Sutherland coined the term
“white-collar crime.” [Indiana
University sociology professor.]
• Sutherland believed that white-collar
crime is a learned behavior, a
consequence of corporate culture
where regulations are regarded as
harassment, and profit is the
measure of the man.
• “White-collar crime violates trust and
thus create distrust, and this lowers
social morale and produces social
disorganization on a large scale.
Cynthia Crossen, “A Thirties Revelation: Rich People Who
Steal are Criminals, Too,” Wall Street Journal, October 15,
2003, p. B-1
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Tyco Prosecutor’s Closing
Argument
“Remember, these are two very,
very smart men; they are not
charged with being stupid men,” she
said of Mr. Kozlowski and Mr. Swartz.
“These crimes have an element of
sophistication so you can be sure
that when they were committing them
they built in an element of
deniability.” She added: “Every good
scheme has it. That is how whitecollar criminals work.”
• Mistrial on April 2, 2004.
Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,” N.Y.
Times, March 17, 2004, p. C-1.
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Sarbanes-Oxley Act (7-30-2002)
• Most significant change since 1934
Securities Exchange Act
• New five-member Public Company
Accounting Oversight Board (PCAOB)
• Authority to set and enforce auditing,
attestation, quality control and ethics
(including independencies) standards for
auditors of public companies.
• Empowered to inspect the auditing
operations of public accounting firms that
audit public companies as well as impose
disciplinary and remedial sanctions for
violations of the board’s rules, securities
laws and professional auditing and
accounting standards.
• Rotation of lead audit partner every five
years.
• For now no requirement to rotate auditing
firm
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Sarbanes-Oxley Act (7-30-2002)
• Eight types of services outlawed:
– Bookkeeping.
– Information systems design and
implementation
– Appraisals or valuation services, fairness
opinions, or contribution-in-kind-reports.
– Actuarial services
– Internal audit outsourcing
– Management and human resources services
– Broker/dealer, investment adviser, and
investment banking services
– Legal or expert services related to audit
services
• Applies to foreign accounting firms filing
with SEC.
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Incumbent Auditors
• An incumbent auditor may not perform
legal services and expert services
unrelated to an audit for audit clients
(i.e., can not be an expert witness).
• An auditor is not prohibited from legal
and expert services for nonaudit clients
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Legal Services
Under the rules, CPAs cannot provide
a service for an audit client that only
someone licensed to practice law can
perform.
The concern this rule addresses is that
the auditor would be acting as an
advocate, which the SEC (partly in
reliance on United States v. Arthur Young)
concludes would preclude the CPA from
maintaining the “objectivity and
impartiality that are necessary for an
audit.”
Source: T.J. Purcell, III and D. Lifson, “Tax Service After Saebanes-Oxley,”
Journal of Accountancy, November, 2003, p. 37.
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Expert Service Unrelated to Audit
This covers engagements where the CPA
firm’s specialized knowledge, experience and
expertise support audit client positions in
adversarial proceedings. The prohibition
includes providing an opinion to the client or a
client representative to advocate a client’s
interests in litigation or in a regulatory or
administrative investigation or proceeding. The
rules do not define this term.
The examples involve the SEC Division of
Enforcement, forensic accounting engagements
for the client itself and helping the audit
committee investigate potential accounting
impropriety. The rules appear to reject the
proposal that the advocacy prohibition be
confined to public settings and allow internal
investigations and fact-finding engagements for
the audit committee, as well as providing factual
accounts, testimony or explanations of positions
taken, conclusions reached or work performed.
Source: T.J. Purcell, III and D. Lifson, “Tax Service After Saebanes-Oxley,” Journal
of Accountancy, November, 2003, p. 37.
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Tax Services Not Defined
PCAOB will not define tax services,
but will be inspecting them.
Representing an audit client in court
could impair independence.
PCAOB “will focus on the
profession’s role in both structuring and
signing off on abusive tax shelter designed
to make their clients’ financial statements
look better.”
PCAOB’s annual inspections will
examine how accounting companies audit
and structure “questionable, tax-orientated
transactions.”
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
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Acceptable Non-audit Services
• Payroll sales, property, state income, federal
income and other tax-compliance services,
even though the audit firm reviews the client’s
work that becomes part of the financial records
through the recording of a liability.
• Traditional tax planning services, such as
where the CPA prepares an analysts of a
transaction (lease vs. buy) and the client uses
the CPA’s work product to develop the
appropriate financial accounting entries.
• Analysis of clients records (with
recommendations for redesign) to determine
strategies for minimizing state and local
income sales, property and payroll taxes.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
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Acceptable Non-audit Services (cont.)
• Appraisal services undertaken for taxcompliance reasons (such as assigning values
to intangible assets under IRC section 197,
calculating gains on distributions of assets to
shareholders under section 338 election,
implementing mark-to-market values under
section 475 and allocating purchase prices
under section 1060), even though the company
uses the derived values in part for financial
statement purposes.
• Tax-consulting engagements that examine, for
example, the efficiency of internal tax
departments, procedures used to protest state
and local property tax valuations or state
income tax studies.
• “Loaning” tax staff or supervisors to an audit
client for special projects or short-term
personnel emergencies.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
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© D.L. Crumbley
Acceptable Non-audit Services (cont.)
• Designing or commenting on the tax aspects
of a compensation package for specific
individuals or the general management staff of
the audit client-for example, reviewing the
applicability of antidiscrimination provisions of
IRC section 132 and the reasonable
compensation and incentive compensation
provisions of section 162(m).
• Meeting with prospective candidates for the
tax director or CFO position to discuss the tax
issues the company faces.
• Recommending that controlling shareholders
sell their stock to an ESOP to take advantage of
IRC section 1042; advising a client to consider
an ESOP as part of a benefits package (or,if an
ESOP already exists, that a client sell
additional shares to it); or recommending that
an estate sell its stock in an audit client to use
the provisions of IRC section 303 or to
otherwise efficiently administer the estate.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services, But Will
Inspect Them,” Tax Notes, October 20, 2003, p. 330; C. Bryan – Low,
“Accounting Board to Look at Abuses in Tax Shelters,” Wall Street Journal.,
October 22, 2003, p. A-2.
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© D.L. Crumbley
Acceptable Non-audit Services (cont.)
• Representing the audit client in IRS exams,
sales tax proceedings, state income tax audits,
payroll tax audits, local government property
tax proceedings and the like.
• Helping an audit client prepare requests for a
ruling or changes in accounting periods or
method or for determination letters on various
issues from the IRS or other administrative
agencies.
Source: Sheryl Stratton, “Accounting Board Won’t Define Tax Services,
But Will Inspect Them,” Tax Notes, October 20, 2003, p. 330; C.
Bryan – Low, “Accounting Board to Look at Abuses in Tax Shelters,”
Wall Street Journal., October 22, 2003, p. A-2.
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© 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.
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Sarbanes-Oxley (contd.)
• Many of the Sarbanes-Oxley’s provisions became
effective July 30, 2002.
• www.tnwinc.com
The Network
• Thus, SEC will control the accounting standards, not
the AICPA.
• Auditors to report to audit committee, and audit
committee must approve all services.
• Crime to corruptly alter, destroy, mutilate, or conceal
any document with the intent to impair the object’s
integrity or availability (up to 20 years).
• Statute of limitations for the discovery of fraud is now
two years from the date of discovery and 5 years after
the act.
• Maximum penalty for mail and wire fraud is increased
from 5 to 10 years.
• Financial statement filed with SEC: certified by CEO
and CFO. Maximum penalties for willful and
knowingly violation: fined not more than $5 million
and/or imprisonment of up to 20 years.
• Sense of Congress: CEO should sign the Federal
income tax return.
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SEC’s Proposed Rules (12-5-2002)
Auditor may not
1. Audit own work.
2. Perform management function.
3. Act as an advocate of a client.
 Traditional tax preparation service okay:
•
•
•
•
•
preparation of tax returns.
tax compliance.
tax planning.
tax recovery.
other tax-related services.
 Reviewing tax accruals is audit service.
 Tax Court representation would impair an auditor’s
independence.
 Formation of tax strategies (e.g., tax shelters) is not
okay.
 Unknown: Tax opinions for tax shelters.
 The audit committee must weigh the risk associated
with using the company auditor for tax services versus
the cost savings of using the company auditor.
Source: Sheryl Stratton, “SEC Seeks Input on Defining Scope
of Tax Service,” Tax Notes, December 9, 2002, pp. 1265 –
1266.
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Sarbanes-Oxley Act Creates Need For
Forensic Accounting
1.To assist corporations in their quest to ensure
compliance with the mandates of S-O,
especially the audit committee.
2.Public accounting firms must introduce
forensic techniques into audits, and they may
request help from forensic experts.
3.Internal auditors should introduce forensic
accounting techniques into their audit programs.
----------------------------------------------------------------SEC Chairman William Donaldson
responds to a question why there is “such
appalling fraud” in business in the following
manner. There are 15,000 companies out there,”
and “the majority of those companies are run by
honest, dedicated people.” But he admitted that
“there has been in my view, a gradual erosion of
corporate ethics over the bull market of the last
decade, and particularly the last five years.”
Bobby Eberle, “Justice Department Celebrates One Year of Corporate Fraud Task
Force,” Talon News, July 23, 2003,
www.gopusa.com/news/2003/july/0723corporatefraud.shtml.
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Assistance of Forensic Accountants
1. S-O requires principal executives and
financial officer to personally certify annual
and quarterly reports.[Section 302]. Effective
August 202.
2. Certification must cover internal controls,
disclosure controls, and fraud. Need for a
Chief Forensic Officer? The SEC suggests
the entity assign the duties of monitoring
internal controls to a specific individual. SEC
suggests a disclosure committee, also.
3. Officers and directors are prohibited from
influencing, coercing, manipulating, or
misleading the accountant performing the
independent audit.
4. Civil and criminal penalties against officers
for violations of S-O.
5. Auditors workpaper retentions for five years.
6. PCAOB shall adopt auditing standards.
7. SEC may censure auditors.
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Section 404-Sarbanes-Oxley
• Beginning June 2004, large
companies must have in place
tight internal controls, assess the
effectiveness of these controls
annually, 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.
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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.coso.org
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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
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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.
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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
•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
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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
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Using Work of Specialists (SAS No.73)
Specialist defined: a professional service firm
or individual who possesses special skills or
knowledge in a particular field other than
accounting and auditing
To reply on specialist’s findings, auditor
 Must understand the objectives and scope of
work performed.
 Assumptions used must be clear to auditor.
 Auditor must consider the appropriateness
of utilizing the specialists findings.
 Auditor must test the data that client
provides to the specialist.
 Auditor must evaluate whether findings
support the assertions in the financial
statements.
 If specialist’s findings inconsistent, SAS
No.73 provides additional procedures which
auditor must follow.
 Auditor will need copies of workpapers of
specialists.
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Michael Comer’s Types of Fraud
1. Corruptions (e.g., kickbacks).
2. Conflicts of interest (e.g., drug/alcohol
abuse, part-time work).
3. Theft of assets.
4. False reporting or falsifying
performance (e.g., false accounts,
manipulating financial results).
5. Technological abuse (e.g., computer
related fraud, unauthorized Internet
browsing).
Comer’s Rule: Fraud can happen to
anyone at anytime.
Source: M.J. Comer, Investigating Corporate Fraud,
Burlington, Vt.: Gower Publishing Co., 2003, pp. 4-5.
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Starwoods Hotels Poll of Executives
Starwoods Hotels interviewed 401 top
executives who golf. The results are
surprising.
Consider themselves to be honest in
business
Played with someone who cheats at golf
Cheated themselves at golf
Hated others who cheated at golf
Believe that business and golf behaviors
are parallel
99%
87%
82%
82%
72%
Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA
Today, June 26, 2002, p. A-1.
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The Cost of Fraud
 Organizations lose 6 percent of
annual revenue to fraud and
abuse.
 Fraud and abuse costs U.S.
organizations more than $600
billion annually ($4,500 per
employee).
 The average organization loses
more than $12 a day per
employee due to fraud and abuse.
Source: 2002 Wells Report
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The Cost of Fraud (cont.)
 Over 80% of occupational frauds
involve asset misappropriations.
 Average length of a fraud scheme is
18 months.
 Most common way of detecting
occupational fraud is by tips from
employees, customers, vendors, or
anonymous sources.
 Second most common detection:
accident.
 The most targeted asset is cash.
Source: 2002 Wells Report
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Fraud Multiplier
Employee Fraud = $ for $ reduction in net
income
Suppose $100,000 bottom line reduction.
Suppose 20% profit margin
How much new revenue needed to offset the
lost income?
$100,000 = $500,000
20%
So ACFE says $600 billion lost per year.
$600 billion = $3 trillion needed revenue
20%
45
© D.L. Crumbley
Advantage of Compliance
Spending
General Counsel Roundtable says
that each $1 of compliance spending
saves organizations, on 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.
46
© D.L. Crumbley
Ernst & Young Study (2000)
 Leading companies and public bodies
in 15 (82) countries
 More than 82% (50%) have been
victims of fraud in the past year.
 82% (84%) of total losses can be
attributed to staff.
 33% (50%) of the most serious frauds
were committed by the organization’s
own management.
 Most with company more than 5 years
(25% more than 10 years).
 Theft of cash and purchasing schemes
(i.e., employee kickbacks) constituted
the majority of frauds.
 Reasons: Poor internal controls and
finance directors had a limited
knowledge of internal controls.
47
© 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.
48
© 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.
49
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.
50
© D.L. Crumbley
SEC’s Definition of Fraud
It shall be unlawful for any person, directly
or indirectly, by the use of any means or
instrumentality of interstate commerce, or
the mails, or of any facility of any national
securities exchange,
a) To employ any device, scheme, or artifice to
defraud,
b) To make any untrue statement of a material
fact or to omit to state a material fact
necessary in order to make the statements
made, in the light of the circumstances
under which they were made, not
misleading, or
c) To engage in any act, practice, or course of
business which operates or would operate as
a fraud or deceit upon any person, in
connection with the purchase or sale of any
security.
SEC Rule 106-5
51
© D.L. Crumbley
Foreign Corrupt Practices Act of 1977
A)
B)
1)
2)
Public companies shall maintain adequate
internal controls:
Make and keep books, records, and
accounts, which, in reasonable detail,
accurately and fairly reflect the transactions
and dispositions of the assets of issuer; and
Devise and maintain a system of internal
accounting controls sufficient to provide
reasonable assurances thattransactions are executed in
accordance
with management’s general or specific
authorization;
transactions are recorded as necessary (1) to
permit preparation of financial statements in
conformity with generally accepted
accounting principles or any other criteria
applicable to such statements….
FCPA Section 102
52
© D.L. Crumbley
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).
53
© D.L. Crumbley
Superseded SAS No. 53
Accounting Fraud Referred To As
“Irregularities”
The term “irregularities” refers to
intentional misstatements or omissions of
amounts or disclosures in financial statements.
Irregularities include fraudulent financial
reporting undertaken to render financial
statements misleading, sometimes called
management fraud, and misappropriation of
assets, sometimes called defalcations.
Irregularities may involve acts such as the
following:
•Manipulation falsification, or alteration of
accounting records or supporting documents
from which financial statements are prepared.
•Misrepresentation or intentional omission of
events, transactions, or other significant
information.
•Intentional misapplication of accounting
principles relating to amounts, classifications,
manner of presentation, or disclosure.
54
© 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 (out of 25):
1) Known history of securities law violations
(14.6%)
2) Significant compensation tied to aggressive
accounting practices (12.9%)
3) Management’s failure to display
appropriate attitude about internal controls
(12.6%)
Source: B.A Apostolou et.al, “The Relative Importance of
Management Risk Factors,” Behavioral Research in
Accounting, January 1, 2001, pp. 1-24.
55
© D.L. Crumbley
SEC Staff Accounting Bulletin No.99
Fraudulent accounting entries
known by senior management can not be
left unadjusted merely because they are
“immaterial” by some mechanical,
quantitative standard (e.g., percentage of
net income).
Thus materiality loophole
eliminated in 1999.
Something is material if there is a
substantial likelihood that a reasonable
person would consider it important.
56
© D.L. Crumbley
SEC SAB No. 99 Examples
Among the considerations that may
well render material a quantitatively
small misstatement of a financial
statement item are—
•Whether the misstatement arises from an
item capable of precise measurement or
whether it arises from an estimate and, if
so, the degree of imprecision inherent in
the estimate.
•Whether the misstatement masks a
change in earnings or other trends.
•Whether the misstatement hides a failure
to meet analysts’ consensus expectations
for the enterprise.
•Whether the misstatement concerns a
segment or other portion of the registrant’s
business that has been identified as playing
a significant role in the registrant’s
operations or profitability.
57
© D.L. Crumbley
SEC SAB No. 99 Examples
•Whether the misstatement affects the
registrant’s compliance with regulatory
requirements.
•Whether the misstatement affects the
registrant’s compliance with loan
covenants or other contractual
requirements.
•Whether the misstatement has the effect
of increasing management’s compensation
- for example, by satisfying requirements
for the award of bonuses or other forms of
incentive compensation.
•Whether the misstatement involves
concealment of an unlawful transaction.
SAB No. 99, Appendix B.
58
© 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.
Committee on Sponsoring Organizations.
59
© 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
delisiting.
4. Avoiding a pretax loss and bolstering
other financial results.
www.coso.org.
60
© 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.
61
Joseph W. Koletar’s Opinions
© D.L. Crumbley
“In my private-sector forensic career, I have seen
few organizations that have a firm grasp on the
size and components of their fraud problems.
Usually they rely on incidental reports and, in turn
generate incremental responses.” p. 99.
Business failures and financial statement fraud
“occur because existing controls were not
operating, not because they were improperly
designed and installed. Often internal auditors are
not permitted to do their jobs. Serious audit results
impact executives, and many executives are
resistant to change or feel threatened. Consequently,
those who make a difference are stifled.” Barry
Lipton’s letter, p. 104.
“Far too many organizations are penny wise and
pound foolish in their approach to internal controls
staffing and monitoring….” p. 117.
-------------------------------------------------------------Michael J. Comer: “The Cow grows fat under the
eyes of the owner.” p. 8.
Source: J.W. Koletar, Fraud Exposed, John Wiley & Sons, 2003.
62
© D.L. Crumbley
The Methods
 Asset misappropriation
accounted for more than four out
of five offenses (80%).
 Bribery and corruption
constituted about 13 % of
offenses.
 Fraudulent statements were the
smallest category of offense
(most costly). $4.25 million per
scheme.
Source: 2002 Wells Report
63
© D.L. Crumbley
Restatements of Financial Statements
2002
-
330
2001
-
270
2000
-
233
1999
-
216
1998
-
158
Reasons for 2002 restatements:
1. Accounting rules.
2. Human and system errors.
3. Fraudulent behavior.
• Although the number of public registrants have
decreased by 14% since 1999, restatements
have risen by 53%. Revenue recognition was
the cause of 85 of the restatements (22%) in
2002.
• Arthur Andersen had averaged 11 restatements
before 2002. In 2002, they had 40, with 26
after new auditors were retained.
Source: “An Analysis of Restatement Matters,” Huron Consulting
Group, www.huronconsultinggroup.com.
64
© D.L. Crumbley
Cynthia Cooper’s Suggestions
•
•
•
•
•
•
•
Improve the tone at the top (e.g.,
a fish rots from the top).
Robust Codes of Conduct.
Training on Ethics/Internal
Controls.
Holistic approach to Risk
Assessment/Internal Controls.
Fraud Hotlines.
Control self-assessment.
Control repositories.
Source: Cynthia Cooper, L.S.U., November 24, 2003.
65
© D.L. Crumbley
Triple Fraud Sting
 A Michigan woman received an email from a Nigerian asking her to set
up a bank account in the U.S. in order
to help him steal $18 million.
 She set up the bank account (to help
pay the so-called bribes and fees) by
allegedly embezzling $2 million from
her employer during seven months in
2002.
 Guess what? She never received a
penny. She was indicted on 13 counts
of wire fraud.
 Fraud schemes are much like
derivatives. They spring up, die out,
and new ones are started each week.
Source: Kim Komando, “Delete These Scams – Now,”
MSN Business,
www.bcentral.com/articles/komando/109.asp.
Reviewed June 15, 2003.
66
Rite Aid Fraud Case
© D.L. Crumbley
 Former CEO Martin Glass bragged that the
computer used to generate backdated letters had
disappeared at sea. “They have no computer.
The letters that were done on the
computer…they do not have and never will have,
unless they use a Trident submarine.”
 Wrong. President Timothy Noonan was wearing
a wire. He recorded 6 meetings over 10 weeks.
Federal investigators heard everything.
 CFO Franklyn Bergonzi:
 Obtained $30 million in extra profits by dunning
Rite Aid’s suppliers for merchandise that was
supposedly outdated or damaged (but not so).
 Another $75.6 million came from rebates from
pharmaceutical firms that had yet to be earned.
 Failed to report certain expenses properly.
 Increased the useful life of some assets.
 The financial restatements wiped out $1.6 billion
in profits.
 KPMG agreed to pay $125 million fine.
Source: Mark Maremont, “Call To Account: Rite Aid Case
Gives Early View of Fraud on Trial,” Wall Street J., June
11, 2003, p. A-6.
67
© 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
68
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).
69
© 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
70
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
71
© D.L. Crumbley
“Finding fraud is like trying to load
frogs on to a wheelbarrow.”
Larry Crumbley
-------------------------------------------H.R. Davia suggests that for every
three fraud events which are detected, two
remain undetected, and that conclusions
drawn from studying those that are detected
do not necessarily apply to those whose
existence has not been revealed.
Source: Davia, H.R., “Fraud Specific Auditing,” Journal of Forensic
Accounting, June 2002.
72
© 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.
73
© D.L. Crumbley
How Fraud Is Detected
1. Tips from employees (26.3%).
2. By accident (18.8%).
3. Internal audit (18.6%).
4. Internal controls (15.4%).
5. External audits (11.5%).
6. Tips from customers (8.6%).
7. Anonymous tips (6.2%).
8. Tips from vendors (5.1%).
Therefore, 46.2% from tips.
Source: 2002 Wells Report.
74
© D.L. Crumbley
Tips Are Important
Some of the biggest recent accounting
scandals (e.g., WorldCom, HealthSouth,
Xerox, Waste Management) involve
situations where the auditors were tipped
off or otherwise alerted to possible frauds
but they failed to investigate them deeply
enough.
---------------------------------------------------In her book Power Failure, Sherron
Watkins says she talked to Jim Hecker, at
Arthur Andersen, on the phone about the
dangers of the Raptors and Fastow’s
inherent conflict. Hecker wrote a memo to
the files and forwarded copies to David
Duncan and Enron’s audit partner, Debra
Cash. His note: “Here is my draft memo,
for your review, for ‘smoking guns’ that
you can not extinguish.” p. 285.
75
© 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
back-up.
Source: Charles Mollenkamp, “Accountant Tried in Vain to Expose
HealthSouth Fraud,” Wall Street Journal, May 20, 2003, pp. A-1
and A-13.
76
© D.L. Crumbley
HealthSouth
Billy Massey, 37-year-old CPA, had a wife
and two children and looked like an
accountant from central casting.
Massey was the personal accountant for
HealthSouth’s Richard Scrushy. He was
Scrushy’s personal CFO for his private
interests, doing the financing, paying the
bills, moving around money – and stealing
some $500,000.
Massey spent the money on lavish dinners
and gifts for his mistress. One week after
he was found to be an embezzler and
adulterer, he committed suicide.
Source: John Helyar, “The Insatiable King Richard,” Fortune,
July 7, 2003, p. 78.
77
© D.L. Crumbley
Quotes
You should attack fraud
problems the way the
fictional Sherlock Holmes
approached murder cases
D. Larry Crumbley
To be a good fraud auditor,
you have to be a good
detective.
Source: Robert J. Lindquist
78
© 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.
30-34.
www.investigation.com/artilces/library/2002Articles/15.htm.
79
© 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
Columbo-esque investigative style. “We
don’t wear special windbreakers that say
‘forensic accountant.’”
Source: Eric Krell, “Will Forensic Accounting Go
Mainstream?” Business Finance Journal, October 2002, pp.
30-34.
www.investigation.com/articles/library/2002Articles/15.htm
80
© D.L. Crumbley
D.R. Cressey’s Fraud Pyramid
“It was definitely the perfect fraud…
unfortunately they hired the perfect
investigator.”
Cartoon in M.J. Comer’s book
81
© 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, ParkRider, N.Y.:
London House Press, 1989, pp. 1-5.
82
© D.L. Crumbley
SAS No. 99 Characteristics of Fraud
Incentives / pressures
Attitude /
Rationalization
Opportunity
83
© 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.”)
84
© 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.
85
© 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
86
© D.L. Crumbley
How Fraud is Discovered-Singapore 2002
•
•
•
•
•
Management investigation (41%).
Anonymous letter/informant (35%).
Internal controls (33%).
By chance (26%).
Internal auditor review (12%).
Source: KPMG Fraud Survey Report, 2002.
87
© D.L. Crumbley
Singapore Fraud Survey, 2002
•
•
•
•
•
•
Management investigation, informant
notification, and good internal controls
rank highly as methods of fraud
detection.
76% of the frauds were perpetrated
internally [management (41%) and nonmanagement employees (35%)]
Poor internal controls, override of
internal controls, and collusion between
employees and third parties were the top
three reasons cited as to why frauds were
allowed to take place
“Red flags,” which should have alerted
respondents to the fraud, were present
and ignored in 29% of cases.
The main reason for not reporting fraud
was lack of evidence
The typical fraudster is predominantly
male within the age group of 26-40 years
and has an annual income between
$15,000 to $30,000. 44% of fraudsters
have tertiary educational qualifications.
88
© 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.
89
© 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.
90
© 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.
91
© 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
92
© 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.
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Three Types of Brainstorming
•
•
•
Open brainstorming: unstructured;
few rules; free-for-all; someone should
record ideas.
Round-robin brainstorming: start with
no talking, silent period; assigned
homework ahead; each individual
presents own ideas; each member has a
turn.
Electronic brainstorming: shortens
meetings, increases ideas, and reduces
personalizing ideas because an idea’s
author remains anonymous.
Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming
Fraud Risks,” Journal of Accountancy, December 2003, pp.
33-34.
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How Management Overrides Controls
(SAS No. 99)
 Recording fictitious journal
entries (especially near end of
quarter or year).
 Intentionally biasing
assumptions and judgments used
to estimate accounts (e.g.,
pension plan assumptions or bad
debt allowances).
 Altering records and terms
related to important and unusual
transactions.
95
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Overriding Internal Controls?
Saddam’s son presented a note
with his father’s signature to the
Iraqi Central Bank which resulted
in a world record bank theft of $1
billion. A team of workers took two
hours to load $900 million in U.S.
$100 bills and $100 million in
Euros into three tractor trailer
trucks. This dirty deed was done
before the employees came to work.
Was this a straight bank robbery
or an example of overriding
internal controls by a high
official?
96
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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.
Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil
Reserves Prove Unrefined,” Wall Street Journal, January 14,
2004, p. C-4
97
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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
98
and C-4.
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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.
99
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Expensing Stock Options: Black
Scholes Model
If risk-free rate higher
Option value higher
If dividend yield higher
Option value lower
If expected life longer
Option value higher
If volatility higher
Option value higher
100
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Most Firms Underreport
• They fool around with the assumptions to
keep fair value down.
• Only about 10% are truth tellers.
• Most companies are underreporting
volatility.
• Only 8 firms did not use Black-Scholes.
Source: L.D. Holder, W. Mayew, M.C. McAnally, and C.D. Weaver,
“Employee Stock Option Valuation: How Reliable are Black-Scholes
Disclosures,” working papers, March 5, 2004
101
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Journal Entries at Year End
Apparently, Arthur Andersen was given
limited access to the general ledger at
WorldCom, which had a $11 billion fraud
(largest accounting fraud in history). Most
of the original entries for online costs were
properly placed into expense accounts.
However, near the end of the period these
entries were reversed. One such entry was
as follows:
Other Long-term Assets
$629,000,000
Construction in Progress
$142,000,000
Operating Line Costs
$771,000,000
The support for this entry was a yellow
post-it note.
WorldCom’s outside auditors refused to
respond to some of Cynthia Cooper’s
questions and told her that the firm had
approved of some of the accounting
methods she questioned.
102
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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 Postit Note and attached to a printout of the
entry."
• Third Quarter of 2001: "Myers gave Sethi
a Post-it Note that said 'Assume $742
million.' Later, Myers and Sethi had a
conversation confirming that $742 million
identified on the Post-it Note was the line
cost capitalization entry for the quarter.”
http://thestreet.com/pf/markets/dumbestgm/10093441.html
103
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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, rounddollar 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
104
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WorldCom Fraud Massive
 At least 40 people knew about the fraud.
 They were afraid to talk.
 Scott Sullivan handed out $10,000
checks to 7 involved individuals.
 Altered key documents and denied
Andersen access to the database where
most of the sensitive numbers were
stored.
 Andersen did not complain about denied
access.
 Cynthia Cooper ignored her boss and
started doing financial audits, looking at
the financial information the company
was reporting.
Source: Rebecca Blumenstein and Susan Pullian, “WorldCom
Fraud Was Widespread,” Wall Street J., June 10, 2003, p.
3.
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WorldCom Fraud Massive (contd.)
 David Schneedan, CFO at a division,
refused to release reserves twice.
 E-mail from David Myers, WorldCom
comptroller, to Schneedan:
“I guess the only way I am going to get
this booked is to fly to DC and book it
myself. Book it right now; I can not wait
another minute.”
 Buddy Gates [director of general
accounting] said to an employee
complaining about a large accounting
discrepancy:
“Show those numbers to the damn
auditors, and I’ll throw you out the
f_____ window.”
Source: Rebecca Blumenstein and Susan Pullian,
“WorldCom Fraud Was Widespread,” Wall Street J., June
10, 2003, p. 3.
106
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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.
107
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Fraudulent financial reporting may
occur by the following:
 Manipulation, falsification, or
alteration of accounting records,
or supporting documents from
which financial statements are
prepared.
 Misrepresentation in or
intentional omission from the
financial statements of events,
transactions, or other significant
information.
 Intentional misapplication of
accounting principles relating to
amounts, classification, manner
of presentation, or disclosure.
Source: SAS No. 99, “Consideration of Fraud in a
Financial Statement Audit,” New York: AICPA
108
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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
repurchased had not really been bought.
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Falsification
Enron’s crude oil trading operation
based in Valhalla, New York was fictitious,
according to one auditor.
“It was pretend. It was a playhouse.
There were a lot of expensive people
working there, and it was impressive
looking, but it wasn’t legitimate work.
The traders were keeping two sets of books,
one for legitimate purposes – to show Enron
and auditors from Arthur Andersen – one
other set in which to record their ill-gotten
gains.
Source: Mimi Swartz and Sherron Watkins, Power Failure, New
York: Doubleday, 2003, p.31.
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SAS No. 99 Ways to Overcome the
Risk of Management Override of
Controls
 Examining journal entries
and other adjustments,
especially near the end of the
quarter.
 Reviewing accounting
estimates for bias, including
a retrospective review of
significant management
estimates.
 Evaluating the business
rationale for significant
unusual transactions.
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Examine Journal Entries
 Enron issued $1.2 billion of stock to
special purpose entities and recorded a
$1.2 billion notes receivable (rather than a
contra account to stockholders equity).
Both assets and owners equity were
overstated by $1.2 billion.
 HealthSouth allegedly overstated profits
by at least $14 billion by billing Medicare
for physical – therapy services the
company never performed. The company
submitted falsified documents to
Medicare to verify the claims over 10
years.
 E&Y collected $2.6 million from
HealthSouth (as audit-related fees) to
check the cleanliness and physical
appearances of 1,800 facilities. A 50- point
checklist was used by dozens of juniorlevel accountants in unannounced visits.
For 2000, E&Y audit fee, $1.03 million;
other fees, $2.65 million.
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TRUTH
Given the right pressures, opportunities, and
rationalizations, many employees are capable of
committing fraud.
Bev Harris says that fraudsters and embezzlers are the
nicest people in the world:
Wide-eyed mothers of preschoolers. Your best
friend. CPAs with impeccable resumes. People
who profess deep religious commitments. Your
partner. Loyal business managers who arrive
early, stay late, and never take a vacation. And
sometimes, even FAMILY MEMBERS. So if
you’re looking for a sinister waxed mustache
and shifty eyes, you’re in for a surprise –
scoundrels come in every description.
Source: “How to Unbezzle A Fortune,” www.talion.com/embezzle.htm,
p. 1.
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SAS No. 99 Types of Fraud
Unlike errors, fraud is intentional and
most often involves deliberate
concealment of facts by mgt.,
employees, or third parties
 Fraudulent Financial Reporting: does
not follow GAAP (e.g., recording
fictitious sales)
 Misappropriation of Assets:
embezzling receipts, stealing assets, or
causing an entity to pay for goods or
services that have not been received.
Often accomplished by false or
misleading records or documents,
possibly created by circumventing
internal controls.
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Comparison of Auditing and Forensic Examination
Issue
Audit
Forensic Examination
Timing
Recurring: audits are
conducted on a regular
basis
Nonrecurring: fraud
examinations are
nonrecurring. They are
conducted only with
sufficient predication.
Scope
General: collection of
sufficient, competent
data to support the
opinion rendered.
Specific: the fraud
examination is conducted to
resolve specific allegations.
Objective
Opinion: express
opinion on financial
statements
Affix blame: determine if
fraud occurred and who is
responsible. Adversarial in
nature.
Methodology Audit techniques
applied primarily to
financial data.
Presumption
Fraud examination
techniques include document
examination, public record
searches, and interviews.
Professional skepticism Proof to support or refute an
allegation of fraud.
Source: Apostolou, B, “Course 992003: Fundamentals of Fraud
Detection and Prevention,” www.education.smartpros.com, 1998.
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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.
116
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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.
117
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The Good, The Biased, and Ugly Results
 Auditors are vulnerable to “unconscious bias,”
because accounting is subjective and the
relationship between accounting firms and clients
are often tight (or internal auditors v. audited
units).
 Auditor may unintentionally distort the
numbers in ways to mask a company’s true
financial picture [or a unit].
 Psychological studies show that our desires have
a powerful influence on the ways we interpret
information.
 We tend to discount information that contradicts
the conclusions we wish to reach.
 Five structural aspects of accounting create
opportunity for bias to influence judgment.





Ambiguity.
Attachment (They hire and fire us).
Approval.
Familiarity (Not willing to harm friends).
Discounting (focus on immediate events).
Source: M.H. Bazerman et.al, “Why Good Accountants Do
Bad Audits,” Harvard Business Review, November 2002.
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Assessment of Internal Controls
The PCAOB believes that an
attestation is an expert’s communication
of a conclusion about the reliability of
someone else’s assertion (e.g., a financial
statement audit is a form of attestation).
S-O Act Section 404(b) states that an
auditor’s attestation of management’s
assessment of internal controls is not a
separate engagement. Instead, PCAOB
states that an “integrated audit results in
two audit opinions: one on internal control
over financial reporting and one on the
financial statements.”
-----------------------------------------------------PCAOB 2004 budget: $103 million.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7,
2003.
119
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Internal Controls
PCAOB states that internal controls over
financial reporting includes company policies
and those procedures “designed and operated
to provide reasonable assurance - -a high,
but not absolute, level of assurance - - about
the reliability of a company’s financial
reporting and its process for preparing
financial statements in accordance with
generally accepted accounting principles.”
Also included are those policies and
procedures for “the maintenance of
accounting records, the authorization of
receipts and disbursements, and the
safeguarding of assets.”
Even the PCAOB believes that internal
controls “cannot provide absolute
assurance of achieving financial reporting
objectives because of inherent limitations
(e.g., a process that involves human diligence
and compliance can be intentionally
circumvented).”
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
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The Costs and Benefits of Internal Controls
Reliable financial reporting adds value
and also can offset risks in a manner that is
cost-beneficial to a company.Evaluating a
company’s internal control over financial
reporting is sometimes costly, but also has
many far-reaching benefits.
Some of the benefits of a company
developing, maintaining, and improving its
system of internal controls include
identification cost-effective procedures,
reducing costs of processing accounting
information, increasing productivity of the
company’s financial function, and simplifying
financial control systems.
The primary benefit, however, is to
provide the company, its management, its
board and audit committee, and its owners,
and other stakeholders with a reasonable basis
to rely on the company’s financial reporting.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
121
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Auditing Internal Controls
1.
2.
3.
4.
5.
The audit of internal controls includes
these steps:
Planning the audit.
Evaluating the process management
used to perform its assessment of
internal control effectiveness.
Obtaining an understanding of the
internal controls.
Evaluating the effectiveness of both the
design and operation of the internal
controls.
Forming an opinion about whether
internal controls over financial reporting
is effective.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7,
2003.
122
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Anti-Fraud Program
An auditor must perform
“company-wide anti-fraud programs and
controls and work related to other controls
that have a pervasive effect on the company,
such as general controls over the
company’s electronic data processing.”
Further, the auditor must
“obtain directly the ‘principle evidence’
about the effectiveness of internal controls.”
Source: PCAOB Briefing Paper, Proposed Auditing Standards,
October 7, 2003.
------------------------------------------------------------------------------------
The world is not the way they tell you it is.
Adam Smith, in the “Money Game.”
123
Walkthroughs
© D.L. Crumbley
An auditor must perform
“walkthroughs” of a business’ significant
processes. PCAOB suggest that an auditor
should confirm his or her understanding by
performing procedures that include making
inquires of and observing the personnel that
actually perform the controls; reviewing
documents that are used in, and that result
from, the application of the controls; and
comparing supporting documents (for example,
sales invoices, contracts, and bills of lading) to
the accounting records.”
According to PCAOB, in a
walkthrough an auditor traces “company
transactions and events – both those that are
routine and recurring and those that are unusual
– from origination, through the company’s
accounting and information systems and
financial report preparation processes, to their
being reported in the company’s financial
statements.” Auditors should perform their own
walkthroughs which provides auditors with
appropriate evidence to make an intelligent
assessment of internal controls.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
124
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Material Weaknesses
•
•
•
PCAOB provides several strong
indicators that material weaknesses
exist in internal controls:
Ineffective oversight of the company’s
external financial reporting and internal
control over financial reporting by the
company’s audit committee.
Material misstatement in the financial
statements not initially identified by the
company’s internal controls.
Significant deficiencies that have been
communicated to management and the
audit committee but that remain
uncorrected after a reasonable period of
time.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7,
2003.
125
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Pre SAS 99
Consulting
Standards
Auditing
Standards
Traditional
Investigation
Traditional
Audit
Post SAS 99
Auditing
Standards
Consulting
Standards
Traditional
Investigation
Forensic
Procedures in
the Audit
Environment
SAS 99
Source: Ronald L. Durkin et.al, Litigation and Dispute Resolution
Services Subcommittee, Incorporating Forensic Procedures in an
Audit Environment, AICPA, 2003, Fraud Task Force.
126
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Steps Toward Forensic Audit
Traditional audit [forensic
techniques & fraud prevention
program].
If suspect fraud, bring in-house
forensic talent into the audit.
If no in-house talent or fraud
complex, engage an outside
forensic accountant (e.g., Cr.FA,
CFFA, or CFE).
As audit moves toward forensic
investigation, auditor must
comply with litigation services
standards (consulting).
127
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AICPA Audit Committee Toolkit
“In some situations, it may be
necessary for an organization to look
beyond the independent audit team for
expertise in the fraud area. In such
cases, CPA forensic accounting
consultants can provide additional
assurance or advanced expertise,
since they have special training and
experience in fraud prevention,
deterrence, investigation, and
detection.
Forensic accounting consultants
may also provide fresh insights into
the organization’s operation, control
systems, and risks. The work of
forensic accounting consultants may
also provide comfort for the
organization’s CEO and CFO, who are
required to file certifications under
Sarbanes-Oxley.”
128
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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.
129
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Two Major Types of Fraud
Investigations
• Reactive: Some reason to suspect
fraud, or occurs after a significant
loss.
• Proactive: First, preventive
approach as a result of normal
operations (e.g., review of internal
controls or identify areas of fraud
exposure). There is no reason to
suspect fraud. Second, to detect
indicia of fraud.
Source: H.R. Davia, “ Fraud Specific Audting,” Journal of
Forensic Accounting, Vol. 111, 2002, pp. 111-120
130
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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.]
131
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Guilt Pyramid
Source: Michael Kurland, How to Solve A Murder: Macmillan,
1995, pp. 7-8
132
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Koletar’s Murder vs. Fraud Comparison
 Fraud is committed for only one reason - greed.
 Fraud is committed in the workplace, where
there should be tighter controls.
 Those committing fraud return to the scene
of their crime time and time again, often for
many years.
 Fraud tends to be accumulative, getting
bigger with time.
 Fraudsters wear the same employee badges
we do and eat in the same cafeterias.
 Normally, there is a victim available with a
fraud, with detailed knowledge about the
perp, technique, and motive.
 Since the penalties are less severe for fraud,
the possibilities for cooperation is
increased.
Source: J.W. Koletar, Fraud Exposed, John Wiley &
Sons, 2003, p. 153.
133
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How Fraud Occurs
Source: KPMG Fraud Study
134
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Types of Fraud
Source: KPMG Fraud Study
135
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Certain Fraud is Increasing
Source: KPMG Fraud Study
136
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Measures Helpful in Preventing Fraud
1. Strong Internal Controls (1.62)
2. Background checks of new
employees (3.70)
3. Regular fraud audit (3.97)
4. Established fraud policies (4.08)
5. Willingness of companies to
prosecute (4.47)
6. Ethical training for employees (4.86)
7. Anonymous fraud reporting
mechanisms (5.02)
8. Workplace surveillance (6.07)
1 = Most effective
8 = Least effective
Source: 2002 Wells Report
137
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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.”
138
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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.
139
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Public Company Accounting
Oversight Board (PCAOB)
• The Sarbanes-Oxley Act of 2002
created a new, five-member
oversight group called the PCAOB.
• The PCAOB is empowered to set
accounting standards that establish
auditing, quality control, and ethical
standards for accountants.
• The PCAOB is also empowered to
adopt or amend standards issued
or recommended by private
accounting industry groups or to
adopt its own standards independent
of such private industry standards or
recommendations.
• http://www.pcaob.us, to get free
subscription to PCAOB Update.
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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.
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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.
142
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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.
143
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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.
144
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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”
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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.”
146
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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.”
147
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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.
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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.
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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.
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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?
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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
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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.
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Investigative Techniques
“Facts weren’t the most important part of
an investigation, the glue was. He said
the glue was made of instinct,
imagination, sometimes guesswork and
most times just plain luck.” (p. 163).
-------------------------------------------------“In his job, he [Bosch] learned a lot about
people from their rooms, the way they
lived. Often the people could no longer
tell him themselves. So he learned from
his observations and believed that he was
good at it.” (p. 31).
-------------------------------------------------Michael Connelly, The Black Ice, St. Martin’s
Paperbacks, 1993.
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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.
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Be Proactive
 Fraud hotline (reduce fraud losses
by 50%).
 Suggestion boxes.
 Make everyone take vacations.
 People at top must set ethical tone.
 Widely known code of conduct.
 Check those employee references.
 Reconcile all bank statements.
 Count the cash twice in the same
day.
 Unannounced inventory counts.
 Fraud risk assessment (CFD).
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Changing the Culture
“The idea is to change the
culture. We work very closely with
audit committees and management
to build up their fraud awareness.
We also talk about the leading
practices that an organization
should have. That could be a code
of conduct, and we help the audit
committee understand its oversight
responsibilities.”
Richard Girgenti, KPMG
Source: H.W. Wolosky, “Forensic Accounting to the Forefront,”
Practical Accounting, February 2004, pp. 23-28.
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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 (Section 301, S-O).
 Annual report must contain a statement
regarding the effectiveness of internal
controls.
 Employees have the right to sue
companies for whistle-blowing
retaliation.
 Managers found guilty of retaliation face
penalties, including up to 10 years in
prison.
See The Network, www.tnwinc.com/hotlines
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Inside v. Outside Hotlines
“Organizations with fraud hotlines
cut their losses by 50% per scheme
- The Wells Report
EthicsLine and The Network, Inc. (800357-5137) www.tnwinc.com
ComplianceLine of Compliance
Concepts, Inc. (800-617-0415)
www.complianceline.com
Cor-Tech of Management
Communication Systems, Inc. (612-9267988) www.getintouch.com
Edcor (888-222-9950) www.edcor.com
Ethicspoint, Inc. (866-297-0224)
www.ethicspoint.com
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Ethics Programs/Background Checking
Stephen J. Burns: “If only on paper, corporate
business ethics programs exist in most large
international companies. Unfortunately, many of
these efforts would have to be regarded as
meaningless.”
The good news is there is no more effective and,
in the long run, efficient process to select
employees than through the use of a
professional, fair, well-designed, and well-run
background and selection program. Basic
background inquiries for about $50 per person.”
J.W. Koletar, p. 141.
“There are also companies and vendors who will
sell or design software programs that permit an
organization’s own human resources (HR)
department to do these checks themselves.”
Koletar, p. 141.
Sources: Burns, “Combating Corruption,”
Internal Auditor, June 1997, p. 56; J.W. Koletar,
Fraud Exposed, John Wiley & Sons, 2003
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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
161
Whistle-Blowing
© D.L. Crumbley
It almost always turns out badly for the
whistle-blower. Often they regret it. They
lose their job, have family problems, or they
are shunted off to the side. The kiss of death
for a career to get a reputation as someone
who is not a team player.
Fate of Recent Whistle-Blowers
Name
Company
Allegations
Personal
Outcome
Company
Outcome
David Chacon
Salmon Smith
Barney
Improper
IPO
allotments
Left firm,
filed
lawsuit
Subject of
congressional
and NASD
probes
Cynthia Cooper
WorldCom
Massive
accounting
fraud
Talking to
U.S. Justice
Department
Forced into
bankruptcy
Roy Olofson
Global Crossing
Round-trip
trades and
improper
accounting
Fired, filed
lawsuit
Forced into
bankruptcy
Barron Stone
Duke Energy
Improper
accounting
Forced to
change jobs
at Duke
Awaiting
results of an
audit
Sherron Watkins
Enron
Massive
acctg. Fraud
Testified to
Congress
Forced into
bankruptcy
Source: Joseph McCafferty, “Whistle-Blowing, Talk or Walk,” CFO, October 2002, pp. 90-91.
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Danger of Whistle-Blowing
Sherron Watkins had a very real
reason to be concerned about the corporate
behemoth she had decided to challenge. At
the time she wrote the memo, she was
concerned about her personal safety. She
was concerned enough to store in a lockbox
a copy of the memo she sent Kenneth Lay.
She wanted to ensure that the memo was
somewhere safe, where it could not be
destroyed
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91
-------------------------------------------------------------------------------------------
Today the SEC is getting 1,300
complaints per day from whistleblowers,
compared to 1,300 per year in 1996.
Source: Krane, H., “Securities Law Update,” California Lawyer, February 2004.
163
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Daryl Zero
Daryl Zero, the world’s
greatest detective in the movie
Zero Effect, has the
appropriate mottos for FAs:
 Precise Observation and
Careful Intervention.
 Passion is the enemy of
Precision.
164
Some Take-Aways
© D.L. Crumbley
 Need to really understand the business
unit. What they really do.
 Have a mandatory vacation policy.
 Rotation of assignments.
 Have a written/signed ethics policy.
 Do things differently each time you
audit a unit.
 Do not tell client what you are doing.
 Hard to find fraud in the books.
Look/listen. Look for life style changes.
 Do not rely on internal controls to deter
fraud.
 Auditors should have control of the
confirmation process.
 When checking endorsements, be
careful with the ones with only the
account number (may have a fake name
on the account).
165
More Take-Aways
© D.L. Crumbley
 Check employee references/resume.
 Stop giving the employee/client the
answer when you ask a question.
 Zero tolerance for allowing
employee/executive to get away
with anything.
 Always reconcile the bank
statements.
 Try to think like a criminal.
 Get inside the criminal’s mind. Be a
detective.
 Do not assume you have honest
employees.
 Bond employees.
Source: Gary Zeune
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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.
167
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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.
168
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Integrity Testing
 Pre-employment drug testing.
 Post-employment drug testing
more sensitive.
 Pre-employment polygraph
tests prohibited by 1988 Act
(Federal, State, Local
Governments and Federal
Contractors exempted from the
Act).
 Written integrity tests.
169
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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
governance-research firm. Hefty pay
checks and perks to current or
former chief executives.
 Poor BODs have in common: an
inability to say no to current or
former chief executives.
Source: Monica Langley, “Big Companies Get Low
Marks for Lavish Executive Pay,” Wall Street J.,
June 9, 2003, p. C-1.
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Tyco’s Payments to Executives
The accountant, Sheila Rex, testified that Tyco
had three accounts where Mr. Dennis Kozlowski’s
spending was recorded – his Key Employee Loan
account, intended to help pay taxes on restricted stock
after it was vested; a relocation account, where
mortgages and other house-related spending were
logged; and a third account, for short-term loans, to be
paid back within 30 days.
Ms. Rex told jurors the accounting department
had procedures for recording spending by Mr.
Kozlowski. Mr. Swartz and other senior executives. Mr.
Kozlowski’s relocation loans were listed under “Note
Receivable Employee A,” Ms. Rex said, Mr. Swartz was
“Note Receivable Employee C.”
The third account, where Sardinia expenses
were logged, was “Notes Receivables LDK,” Ms. Rex
said.
She also described the way forgiven loans were
accounted for on Tyco’s books, including $38.5 million
that was forgiven in 1999. Of that amount; Mr.
Kozlowski received $25 million; Mr. Swartz, $12.5
million; and an events planner, Barbara Jacques, $1
million.
Source: Bloomberg News, “Accountant at Tyco Tells of Payments to Executives,”
New York Times, November 11, 2003, C-3.
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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 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.”
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Acted With Criminal Intent
•Government used coverup conspiracy to
obtain conviction of 5 former Rite Aid
executives accused of accounting fraud.
•Martha Stewart was charged with and
convicted for obstructing investigations into
her conduct and securities fraud (not insider
trading).
•The two Tyco executives (CEO and CFO)
used as their defense that they were open
about their conduct. “What kind of fraud
can you have when you don’t try to conceal
it?”
•Prosecutors of the Tyco executives argued
that they hid the disputed bonuses and loans
from two important groups: company
directors and shareholders. Also, employees
who helped process the disputed items
shared in the largesse; thus they had
incentives to not ask too many questions.
Mark Maremont, “Kozowski’s Defense Strategy: Big Spending Was No Secret,” WSJ,
February 9, 2004, pp. A-1 and A-23.
173
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No Crime Being Committed?
Prosecutor Ann Donnelly said
this about the argument that the Tyco
executives committed no crime
because they were committed in
plain view:
“Simply a red herring. Theft
that occurs at a corporation on this
level has to be on the books and
records; there is no other way to steal
the money.”
Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,” N.Y.Times,
March 17, 2004, p. C-9
174
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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
175
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Internal and External Fraud
Internal Fraud
Employee
Stock theft
Misappropriation of
cash/assets
Lapping
Check forgery
Expense account
Petty cash
Kickbacks
Loans/investments
Management
Lapping
Expense accounts
False financial
statements
Misappropriation of
cash/assets
Unnecessary purchase
Check forgery
Kickbacks
Ghost vendors
Diversion of sales
External
Check Forgery
Check Forgery
False insurance claims
Credit card fraud
False invoices
Product substitution
Bribes/secret
commission
Bid rigging/price fixing
False representation of
funds
Shoplifting
Source: KPMG, Fraud Awareness Survey, Dublin: KPMG, 1995, pp. 10-12.
176
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External Fraud-Shoplifting
It’s not just stars (e.g., Bess
Myerson, Hedy Lamarr, and may
be Winona Ryder). Why, each year,
ordinary people shoplift $13 billion
of lipstick, batteries, and bikinis
from stores.
800,000 times a day the thrills and
temptations win over fear – a
product of the late 19th century with
the larger stores.
Source: Jerry Adler, “The Thrill of Theft,”
Newsweek, February, 2002.
177
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Three M’s of Financial
Reporting Fraud
• Manipulation, falsification, or
alteration of accounting records or
supporting documents from which
financial statements are prepared
• Misrepresentation in or intentional
omission from the financial
statements of events, transactions, or
other significant information
• Intentional misapplication of
accounting principles relating to
amounts, classification, manner of
presentation, or disclosure
Source: Zab Rezaee, Financial Statement Fraud, 2002,
John Wiley.
178
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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.
179
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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
180
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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.
181
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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.
182
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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
183
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Professor Ketz’s Shoddy Accounting
Practices
•Pro forma means “as if,” so pro forma
earnings means earnings that would have been
reported had the corporation been using
alternative methods (e.g., everything but the
bad stuff).
•“Today, however, pro forma numbers are
seldom published for the purpose of informing
investors and creditors in a better manner.
Instead, these disclosures have become a way
of underminding orthodox accounting by not
recognizing a variety of items as expenses.”
•Examples: Goodwill never declines. Moving
expenses and losses from operating items to socalled nonrecurring items. Kodak has taken
one-time charges every year for the past 12
years (to improve PE ratio).
•Contrast the income with the firm’s operating
cash flow.
Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003
184
Spotting Financial Fakery
© D.L. Crumbley
Do the Sniff Test – This one’s
subjective, but it’s powerful. Essentially, if
something looks wrong, and management
can’t provide a convincing explanation, it
probably is wrong. Trust your gut.
Remember that Cash is Always King
– Does accounting gobbledygook make
your head spin? Fear not – there is one
very simple thing you can do: Keep an
eye on cash flow. Over time, increases in
a company’s cash flow from operations
should roughly track increases in net
income.
If you see cash from operations
decline even as net income keeps
marching upward – or if cash from
operations increases much more slowly
than net income – watch out.
Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance,
February 11, 2004.
185
Spotting Financial Fakery
© D.L. Crumbley
Beware Overstuffed Warehouse –
When inventories begin rising faster than
sales, trouble is likely on the horizon.
Sometimes the buildup is just temporary
as a company prepares for a new product
launch, but that’s usually more the
exception than the rule.
Keep an Eye on Accounts Receivable
– Roughly speaking, watch A/R as a
percentage of sales, and watch the growth
rate in A/R relative to the growth rate of
sales. If A/R is moving up much faster
than sales, something may be amiss.
Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance, February 11,
2004.
186
Spotting Financial Fakery
© D.L. Crumbley
Watch the Honeypot – Companies
in the midst of big changes will often
take a huge charge – which Wall
Street is supposed to look right
through, because, hey, it’s a one –
time thing – to set up a “restructuring
reserve,” and then slowly reverse
some of the charge later on. This
technique is known as a “honeypot,”
because the company can dip into it
whenever its operational results
aren’t looking so great.
Source: Pat Dorsey, “Five Tips for Spotting Financial Fakery,” Yahoo! Finance,
February 11, 2004.
187
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Hiding Debt
Companies hide debt by these techniques:
1.
Using the equity method (rather than
Trading Security and Available for Sale
methods). Nets the assets and liabilities of
the investee.
2. Lease accounting (arguing that leases are
operating leases). Understates 10 to 15% .
3. Pension accounting – netting of the
projected benefit obligation and the pension
assets. Must unnet them.
4. Hiding debt inside Special – Purpose
Entities – trillions of dollars of SPE debt is
off the books (e.g., securitization, SPE
borrowings, synthetic leases).
Readers can make analytical adjustments by
searching footnotes for 1,2, and 3. But no
disclosures for asset securitization, SPE
borrowings, and synthetic leases.
Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003
188
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Water Into Wine
•
•
•
•
•
•
A Parmalat subsidiary issues a security of
500 million euros, and buyer makes an
irrevocable commitment to convert debt
into equity in 2008.
Balance sheet treats 500 million euros
transaction as $523.8 million in funds for
capital increase.
Amount rolled into a single entry of $764
million which encompasses minority
interest funds for capital increase and
shareholder equity.
On consolidation under equity method
shown as $523.8 million equity.
Therefore, debt into equity.
Of Parmalat $18 billion debt, nearly $16
billion was not disclosed. Until mid-2003,
Parmalat received a clean bill of health
from auditors.
Source: Henry Sender, “Parmalat Unit May Offer Accounting Clues,”
Wall Street Journal, January 29, 2004, p. C-5
189
Corporate Fraud Task Force
© D.L. Crumbley
 Interagency Corporate Fraud Task Force was formed in
July 2002.
 To coordinate investigations into alleged misconduct at
major corporations (e.g., Adelphia Communication and
Quest Communications).
 To equip local staffs with the expertise and resources to
obtain indictments.
 In the past accounting fraud has been difficult to
prosecute, but lawyers now believe many common
accounting restatements can put corporate executives
at risk for jail time.
 According to John K. Markey, “With the new SarbanesOxley requirement to have strong internal controls and
officer certification of financial statements, the bar has
been lowered on the ‘knew or should have known’
standard,” says Markey. “The presumption will be that
the CFO must have known if something has gone
wrong.”
 The Department of Justice is now encouraging
prosecutors to “flip” lower level participants to get the
“big guys.” The FBI has an agency-staffed hotline that
should “generate four or five new corporate fraud
cases each month.”
Source: Alix Nyberg, “Fraud Squad,” CFO, April 2003, pp. 36-44
190
Corporate Fraud Task Force…
© D.L. Crumbley
The following 17 offices (with the then holders) make up the Task
Force, with the Deputy Attorney General as the chairperson:
Larry Thompson, Deputy Attorney General (leader)
Robert Mueller, Director of the Federal Bureau of Investigation
Michael Chertoff, Assistant Attorney General for the DOJ’s Criminal
Division
Eileen O’Connor, Assistant Attorney General for the DOJ’s Tax
Division
James Comey, U.S Attorney for the Southern District of New York
Roslynn Mauskopf, U.S. Attorney for the Eastern District of New
York
Patrick Fitzgerald, U.S. Attorney for the Northern District of Illinois
Michael Shelby, U.S. Attorney for the Southern District of Texas
Kevin Ryan, U.S. Attorney for the Northern District of California
Debra Yang, U.S. Attorney for the Central District of California
John Snow, Secretary of the Treasury
Elaine Chao, Secretary of Labor
William Donaldson, Chairman of the Securities and Exchange
Commission
James Newsome, Chairman of the Commodity Futures Trading
Commission
Patrick Wood III, Chairman of the Federal Energy Regulatory
Commission
Michael Powell, Chairman of the Federal Communications
Commission
Lee Heath, Chief Postal Inspector of the U.S. Postal Inspection
Service
191
Indictments
© D.L. Crumbley
Adaptec
•US v. Michael Allen Ofstedahl Indictment
Adelphia
•US v John J. Rigas, Timothy J. Rigas, Michael J. Rigas, James R. Brown,
Michael C. Mulcahey Sealed Complaint
•Indictment
Allfirst
•US v. John M. Rusnak Indictment, June 5, 2002
Alliance
•US v. Susan Denice Browne, Charles Edward Browne, Laurence Crowell
Leafer, David Lee Halsey, Braccus Lucien Giavanno, Jonathan Walter Lang
Indictment
Anicom
•US v. Carl Putnam, Donald Welchko, John Figurelli, Daryl Spinell, Ronald
Bandyk, and Renee Levault Indictment
AremisSoft
•US v. Lycourgos K. Kyprianou, Roys S. Poyiadjis, and M.C. Mathews
Indictment
•US v. Roys S. Poyiadjis Indictment
Biocontrol
•US v. Fred E. Cooper Information
Capital City Bank
•US v. Clinton Odell Weidner II, and David C. Wittig First Superseding
Indictment
Capital Consultants
•US v. Dean Kirkland, Gary Kirkland, Robert Legino Indictment, August 22,
2002
Cendant
•US v. Walter A. Forbes and E. Kirk Shelton Superseding Indictment
Commercial Financial
•US v. Jay Lowell Jones Information, September 13, 2002
•US v. William R. Bartmann Indictment, December 12, 2002
Countrymark
•US v. David Heath Swanson Superseding Indictment
Critical Path
•US v. Jonathan A. Beck Information
•US v. Kevin P. Clark Information
•US v. Timothy J. Ganley Indictment
•US v. David A. Thatcher Information
192
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Indictments
eConnect
•US v. Thomas S. Hughes First Superseding Indictment
•Complaint Affidavit
Enron
•US v. Jeffrey S. Richter Information
FLP Capital Group
•US v. Frank L. Peitz, Daniel B. Benson, Peter A. Loutos,
Sr., Robert D. Paladino, Randall W. Law, and Monica M.
Iles Indictment
FPA Medical Management
•US v. Steven Mark Lash Indictment
Health Maintenance
•US v. Clifford G. Baird Information, July 29, 2002
•US v. Donavon C. Claflin Information, July 29, 2002
•US v. Kevin L. Lawrence Indictment, July 31, 2002
•US v. Kevin McCarthy Information, July 19, 2002
•US v. James N. Wuensche Information, November 26,
2002
HealthSouth
•US v. Angela C. Ayers, Cathy C. Edwards, Rebecca Kay
Morgan, Virginia B. Valentine Information
•US v. Aaron Beam Information
•US v. Emery Harris Information
•US v. Kenneth K. Livesay Information
•US v. Michael Martin Information
•US v. Malcolm McVay Information
193
Just Say No
•
•
•
•
© D.L. Crumbley
James Comey (U.S. Attorney): “Just following
orders is not an excuse for breaking the law.”
Betty Vinson, accountant for WorldCom, was
asked by her bosses to make false accounting
entries; initially she refused but eventually
caved.
“Over the course of six quarters she continued
to make the illegal entries transferring
expenses to capital accounts to bolster
WorldCom’s profits at the request of her
superiors. At the end of 18 months, she had
helped falsify at least $3.7 billion in profits.”
She eventually confessed, hoping to be a
witness. A more aggressive prosecutor made
her a target. She and another accountant, Troy
Normand, pleaded guilty to two criminal
counts, carrying a maximum charge of 15
years in prison.
“When an employee’s livelihood is on the line,
it’s tough to say no to a powerful boss.”
Source: Susan Pulliam, “A Staffer Ordered to Commit Fraud Balked,
Then Caved,” Wall Street Journal, June 23, 2003, p. A-1.
194
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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.
195
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Audit Procedures
Audit evidence is gathered in two
fieldwork stages:
1. internal control testing phase
2. account balance testing phase
196
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Definitions
• Materiality is the measure of whether
something is significant enough to
change an investor’s investment
decision.
• Control risk is risk that a material error
in the balance or transaction class will
not be prevented or detected.
• Inherent risk is risk that an account or
transactions contain material
misstatements before the effects of the
controls.
• Detection risk is risk that audit
procedures will not turn up material
error when it exists.
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External Auditors and
Fraud Detection
•Although auditors have previously had
the responsibility to detect material
misstatement caused by fraud, SAS No. 82
details more precisely what is required
to fulfill those responsibilities.
•Now, auditors must specifically assess
and respond to the risk of material
misstatement due to fraud and must assess
that risk from the perspective of the broad
categories in the SAS.
•External auditors have to satisfy new
documentation and communication
requirements. Superseded by SAS No. 99.
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Statement of Financial Accounting
Concepts No. 2
Provides nine qualities and characteristics
that make financial information useful for
investors, creditors, analysts, and other
users of financial information
• Relevance.
• Timeliness.
• Reliability.
• Verifiability.
• Representational faithfulness.
• Neutrality.
• Comparability and Consistency.
• Materiality.
• Feasibility or Costs or Benefits.
•Transparency.
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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
200
1998, pp. 503-532.
© D.L. Crumbley
Types of Financial Statement Fraud
Schemes (contd …)
4. Fictitious Assets and/or Reductions of
Expenses/Liabilities (e.g., recording
consigned inventory as inventory).
Cendant Corporation created fictitious
revenues, and Knowledge Ware inflated
revenues with phony software sales.
5. Overvalued Assets or Undervalued
Expenses/Liabilities (e.g., insufficient
allowance for bad debts).
6. Omitted or Undervalued Liabilities
(e.g., understated pension expenses).
7. Omitted or Improper Disclosures (e.g.,
stock option expense estimates).
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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).
202
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Wrong Way Earnings Management
 Freddie Mac understated past
earnings as much as $5 billion.
 Certain transactions and
accounting policies were
“implemented with a view to their
effect on earnings” (e.g., to
smooth earnings).
 Restatements will result in higher
earnings in prior periods but lower
earnings in future periods.
 Employees appeared to knowingly
violate accounting rules in an
effort to manipulate earnings.
Source: Patrick Barta and J.D. McKinnon,
“Freddie Mac Profits May Have Been Low
By Up to $4.5 Billion,” Wall Street J., June
26, 2003, pp. C-1 and C-11.
203
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Tax Issues: Freddie Mac
• The company used a so-called
linked swaps to shift at least $420
million into the future.
• Internal report said the linked swaps
had minimal business justifications
other than the shifting of operating
earnings.
• Company’s recent disclosure:
potential additional tax liability as
much as $750 million, plus interest.
Source: Dawn Kopecki and J.D. Mckinnon, “IRS Probes Tax
Issues at Freddie Mac,” Wall Street Journal, October 22,
2003, p.A-6.
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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.
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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
206
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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
without a private investigator’s license.
207
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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.
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.
208
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The Magic of the Double Entry System
The double entry method of accounting possesses
a peculiar elegance; results of operations are presented
from two differing points of view – an income statement,
presenting results over time, from period A through
period B; the second point-of-view presented is always a
balance sheet, which is nothing more than a “Kodak
moment,” simple snapshot of things remaining on hand
at the end of period B.
Part of the perverse and peculiar elegance of the
double-entry system is that distortion of one point-ofview requires distortion in the other. Sooner or later, the
distortion of a balance sheet, that Kodak snapshot,
becomes visible to the naked eye. The distortion becomes
discernable through various tests and measures – and
audit procedures.
In other words, you can put off the inevitable, but
only for so long. Six months. A year maybe. In really
egregious situations, perhaps longer. If there are many
parties in collusion, or if the fraud is very complex,
perhaps it can be put off far longer. In time, though, the
balance sheet puffery bursts of its own accord.
Even a tick can swell only so far.
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91
209
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So Get Two, Three, Four Ticks
• Enron’s management figured an
ingenious method of overriding the
double-entry of accounting. They
simply ignored it.
• It remains the simplest, most elegant
financial fraud. Enron created specialpurpose entities (SPEs) and pledged
Enron stock – just pieces of paper.
• If the SPE was successful, they
recognized income.
• When the SPE had huge losses they
issued more paper. Debts were filed
off-balance sheet in the partnerships.
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 92-93.
210
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So Get Two, Three, Four Ticks
• Enron’s management figured an
ingenious method of overriding the
double-entry system of accountancy.
They simply ignored it.
• It remains the simplest, most elegant
financial fraud. Enron created specialpurpose entities (SPEs) and pledged
Enron stock—just pieces of paper.
• If the SPE was successful, they
recognized income.
• Debts in the partnerships were kept off
the Enron balance sheet.
• When the SPE had huge losses, they
issued more paper. Debts were held offbalance sheet in the partnerships.
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91
211
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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.
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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.
213
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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%
214
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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 (Cendant
Corp.).
• If either accounts receivable or inventory is rising
faster than revenue, the company may not be
selling its goods as fast as needed or may be having
trouble collecting money from customers. For
example, in 1997 Sunbeam’s revenue grew less
than 1% but accounts receivable jumped 23 percent
and inventory grew by 40 percent. Six months later
in 1998 the company shocked investors by
reporting a $43 million loss.
• If cash from operations is increasing or decreasing
at a different rate than net income, the company
may be being manipulated.
• Falling reserves for bad debts in relation to account
receivables falsely boosts income (cookie jar
accounting).
215
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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).
• Underfunded defined pension plans.
• Unreasonable management compensation.
Source: Scott Green, “Fighting Financial Reporting Fraud,”
Internal Auditor, December 2003, pp. 58-63.
216
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Five Statistically Significant Ratios
• Use the ratios for two successive fiscal
years.
• Convert into indexes for benchmarking.
• All indexes should be close to one.
Day’s Sales in Receivable Index:
(Accounts Receivable t / Sales t )
(Accounts Receivable t-1 / Sales t-1)
Index for manipulators: 1.5 to 1
-------------------------------------------------------Gross Margin Index:
[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]
[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]
Index for manipulators = 1.2 to 1
-------------------------------------------------------Source: M.D. Beneish, “The Detection of Earnings
Manipulation,” Financial Analysts Journal,
September/October, 1999. t-1 = prior year.
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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.
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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.
219
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A Charles Lundelius Example
Comparison to peer group benchmarks:
Characteristic
DSRI
GMI
AQI
SGI
TATA
MPS
1.56
2.00
1.23
1.50
0.10
Peer group
1.03
1.10
1.04
1.20
0.05
% over peers
51%
82%
18%
25%
100%
Source: C.R. Lundelius, Financial Reporting Fraud, AICPA, 2003, p.
129.
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Ratio Analysis
1. Current ratio =
Current assets (cash and equivalents, receivables and inventories)
Current liabilities (payables, accruals, taxes, and debt due in 1 year)
2. Quick ratio =
Cash and equivalents plus receivables
Current liabilities
3. Working capital = Current assets – Current liabilities
Cost of goods sold
4. Inventory turnover = Average inventory
The number of days inventory is on hand can be calculated as
365
Inventory turnover
Net credit sales
5. Receivables turnover = Average receivables
6. Gross Margin = 1 –
Cost of goods sold
Sales
www.smartmoney.com
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7. Expense ratio =
Selling general and administrative expenses
Sales
8. Operating margin =
9. Profit margin =
Operating income
Sales
Net income before extraordinary items
Sales
10. Interest coverage ratio =
11. Margin of safety =
Income before interest and taxes
Fixed charges
Income after fixed charges before income taxes
Sales
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12.Debt-to-equity ratio =
Total current and long-term + capitalized leases
Total stockholder’s equity
Or
Total debt at book value
Total debt and preferred stock + common stock at market
Net income
13.Return on assets (ROA) = Average total assets
Or
Earnings before interest and taxes
Average total assets
Net income
14.Return on equity (ROE) = Average common equity
15. Return on invested capital =
Earnings before interest and taxes
Average invested capital
16.Number of years to pay off debt by application of internally generated cash flows
Total fixed obligations
= Operating cash flows
17. Ratio of senior debt to capital =
Total senior debt
Subordinated debt + net worth
223
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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.
224
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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.
225
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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.
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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.
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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.
228
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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.
229
© D.L. Crumbley
Nonverbal Language
• 60% of communication is nonverbal.
• Previous contact with person helpful.
• During President Bill Clinton’s testimony
he touched his nose several times when he
was lying, but did not touch his nose
during truthful testimony.
• Two-thirds of truthful interviewees cross
their legs.
Source: “Lying 101: There May Be Nonverbal Indicators of Lying,”
http://members.tripod.com/nwacc_communication/id25.htm.
230
© D.L. Crumbley
Posture Language
Truthful
• Frontally aligned.
• Upright or forward.
• Open (perhaps crossed legs).
• Dynamic, comfortable changes.
Deceptive
• Non-frontally aligned.
• Slouched, retracted or leaning.
• Barriers (crossed arms, purse in lap).
• Frozen and rigid.
Source: John E. Reid Associates, Inc.
231
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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.
232
© D.L. Crumbley
Interviewing Techniques
“Bosch didn’t say anything. He
knew that sometimes when he was
quiet, the person he needed
information from would eventually
fill the silence.” (pp. 5-6).
-------------------------------------------“Just listen. You are a detective.
Detectives are supposed to listen.
You once told me that solving
murders are getting people to talk
and just listening to them.” (pp. 9293).
-------------------------------------------------Source: Michael Connelly, The Black Ice, St. Martin’s Paperback,
1993.
233
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Progression of Interpersonal Communication
Investigative
Communication
Type
Investigative
Conversation
Structured
Investigative
Interviewing
Basic
Forensic
Interrogation
Advanced
Forensic
Interrogation
Time
Requirements
Flexible
Thirty
minutes to
one hour
Three to six
hours
Three to six
hours
Required
Environment
Flexible
Private
setting
Intimate
setting
Intimate
setting
234
© D.L. Crumbley
Progression of Interpersonal Communication
Skill/Training
Requirements
Minimal
training
required.
Preferable to
have training
in active
listening
skills,
question
formulation
and basic
behavior
analysis as
well as
psychology of
investigative
discourse.
Minimum
fifteen hours
training in
structured
interview
formats and
behavior
analysis.
Minimum
fifteen hours
interviewing
training plus
thirty hours
of training
in Reid
Nine
Steps.*
Minimum
standards for
structured
formats and
basic
interrogation
as well as
minimum ten
hours of
advanced
training.
*Inbau, F.E., Reid, J. E. & Budkley, J.P. (1986) Criminal Interrogation and
Confessions, third edition (Baltimore, Williams and Wilkins).
Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I.
02911.
235
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Progression of Interpersonal Communication
Appropriate
Use and
Restrictions
When you are
looking for
direction in an
investigation.
Result is a
gamble rather
than a
predictable
outcome
When you
have
established
the need for a
formal
investigation
and are
interacting
with
witnesses,
victims,
complainants
or suspects.
Must accept
information as
it is presented
without
confrontation.
When you are
interacting
with an
uncooperative
suspect and
require a
truthful
account of that
person’s guilt.
Make use of
perception
manipulation
and as such
requires
comprehensive
quality control.
Most desirous
form for
uncooperative
suspects of
severe
offences or
suspects who
may be
emotionally
unstable.
Does not use
perception
manipulation
and therefore
beneficial
when you
need to
identify true
motivation for
the offence.
Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I. 02911.
236
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.”
237
© D.L. Crumbley
HealthSouth’s Richard Scrushy
• The beauty of acquisition accounting – perfectly
legal - - was the room it allowed for all sorts of
gimmicks and restatements, masking true
operating performance.
• Enter Richard Scrushy (HealthSouth). Allegedly
King Richard and 11 other co-conspirators were
called the “family.” From 1997 through mid-2002,
the SEC says HealthSouth overstated its earnings
by $2.5 billion - - 2,500% higher than true
earnings. [By 1/21/04, $2.5 to $4.6 billion.]
• Scrushy allegedly met monthly with company
financial executives, and he would say, “If we are
not making the numbers, go figure it out.”
• Lower-level bean counters then inflated assets and
used other creative accounting to plug the
difference. They overstated profits by at least $1.4
billion by billing Medicare for physical-therapy
services the company never performed. They
submitted falsified documents to Medicare to
verify the claims.
Source: John Helyar, “The Insatiable King Richard,” Fortune,
July 7, 2003, p. 84.
238
© D.L. Crumbley
Non-Audit Fees
• E&Y classified $1.3 million as an auditrelated fee for HealthSouth in 2001, which
was called pristine audit janitorial
inspections.
• These “audits” included checking toilets,
parking lots, and other parts of HealthSouth
facilities for cleanliness (50-point
questionnaire).
• Fortune said E&Y missed billions in
financial fraud, but they were great at
finding dust bunnies in their white-glove
tests.
Source: John Helyar, “The Insatiable King Richard,” Fortune,
July 7, 2003, p. 82.
239
© D.L. Crumbley
Look For Fraud Symptoms
•Source Documents.
•Journal Entries.
•Accounting Ledgers.
240
© D.L. Crumbley
Source Documents
•
•
•
•
•
•
•
•
Checks.
Employee time cards.
Sales invoices.
Shipping documents.
Expense invoices.
Purchase documents.
Credit card receipts.
Register tapes.
241
© 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.
242
© 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.
243
© D.L. Crumbley
Ledger Fraud Symptoms
•Underlying assets disagree.
•Subsidiary ledger different than
general ledger.
244
© D.L. Crumbley
AICPA Top 10
Technologies Task Force
The task force found the following top ten
technologies for 2004 in descending
order of importance:
1. Information Security. The hardware,
software, processes and procedures in
place to protect an organization’s
systems. It includes firewalls, anti-virus,
password management, patches and
locked facilities, among others.
2. Spam Technology (new). The use of
technology to reduce or eliminate
unwanted e-mail. Technologies range
from confirmation of the sender via ISP
lookup to methods where the recipient
accepts e-mail only from specific
senders.
245
© D.L. Crumbley
AICPA Top 10
Technologies Task Force
3. Digital Optimization (new). Also known
as “The Paperless Office.” The process of
capturing and managing documents
electronically (i.e., PDF and other
formats).
4. Database and Application Integration
(new). The ability to update one field
and have it automatically synchronize
between databases. An example would be
the transfer of data between disparate
systems.
5. Wireless Technologies. The transfer of
voice of data from one machine to
another via the airwaves without physical
connectivity.
246
© D.L. Crumbley
AICPA Top 10
Technologies Task Force
6. Disaster Recovery. The development,
monitoring and updating of the process
by which organizations plan for
continuity of their business in the event
of a loss of business information
resources due to theft, weather damage,
accidents or malicious destruction.
7. Data Mining (new). The methods by which
a user can sift through volumes of data to
find specific answers.
8. Virtual Office (new). The technologies,
processes and procedures that allow
personnel to work effectively, either
individually or with others, regardless of
physical location.
247
© D.L. Crumbley
AICPA Top 10
Technologies Task Force
9. Business Exchange Technology (new).
The natural evolution from EDI to
greater business transaction and data
exchange via the Internet using datasets
that are transported easily between
programs and databases (e.g., XBRL).
10. Messaging Applications (new).
Application that permit users to
communicate electronically, including email, voicemail and instant messaging.
248
© D.L. Crumbley
Using Technology to
Gather Evidence
•
•
•
•
Drill-down functionality
Electronic imaging
Benford’s law
Digital Analysis Tests and Statistics
(DATAS)
• Data warehousing/mining
• Inductive vs. deductive method
249
© 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.”
Bret Lacativo, Southlake, Texas
------------------------------------------------------“We use off-the-shelf software (IDEA) to
import large databases, read different data
files, set up queries, and compare database
files such as addresses, telephone numbers,
and Social Security numbers. This process
will tell us, for example, if a purchase order
was done on Saturday or Sunday when the
company isn’t open.”
Cal Klausner, Bethesda, Md.
H.W. Wolosky, “Forensic Accounting to the Forefront, “ Practical
Accountant, February 2004, pp. 23-28
250
© 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.
251
© D.L. Crumbley
Wiz Rule Data Auditing Tool
• Based upon date mining.
• Performs complex analysis of data,
finding errors, inconsistencies, and
situations that require further
investigation.
• WizRule reveals all the if-then rules,
mathematical formula rules, and
spelling irregularities.
• Divides situations deviating from the
rules into data entry errors and
suspicious errors.
• Can be used in auditing, fraud detection,
data scrubbing, and due diligence
reviews.
• Learning curve is short.
• Cost license is $1,395 and yearly
maintenance fee is $279.
Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html.
252
© 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
253
© D.L. Crumbley
Computer-Assisted Audit
Techniques
Parallel simulation – actual company data are
processed using auditor – controlled
software program. Does not contaminate
data.
Test data – dummy transactions are prepared
by the auditor and processed under auditor
control by the client’s computer program.
Simple, quick, and inexpensive.
Integrated test facility – creates a small
subsystem within the regular IT system.
Can create errors in clients files.
Continuous monitoring of online real time
systems – use test data to test controls.
Contamination can occur.
Tagging Transactions – place indicators or
tags on selected transactions and trace
through the system.
Source: Boynton et.al, Modern Auditing, 7th Edition., 396-398.
254
© 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
255
© 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.
256
© 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.”
257
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.
258
© 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].
259
© 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.
260
© 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.
261
© 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.
262
© 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.
263
© 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.
264
© D.L. Crumbley
Accounts Receivables Schemes
• Lapping.
• Fictitious receivables [for a
fictitious sale], which is later
written off.
• Borrowing against receivables
(use receivable as collateral).
• Improper posting of credits
against receivables.
265
© D.L. Crumbley
Lapping
Lapping
• Recording of payment on a customer’s
account some time after receipt of
payment. Later covered with receipt from
another customer (robbing Peter to pay
Paul).
• Lapping is more successful where one
employee has both custody of cash and
record keeping responsibility.
Audit Steps
• Independently verifying customers who
do not pay.
• Reviewing write-offs.
• Reviewing customers’ complaints.
266
© 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.
267
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
268
© D.L. Crumbley
Inventory
Inventory Fraud
• Stealing inventory/supplies for personal use or
for sale at flea markets/garage sales.
• Kickback schemes (vendor/supplier and an
employee). Sale of unreported inventory or at
inflated prices.
• Use renumbered inventory tags matched to
count sheets; use count procedures for work-inprogress items; separate duties between
purchasing and logging receipts of shipments
Audit Steps for Inventory Fraud
• Check for same vendors.
• Prices higher than other vendors.
• Purchasing agent does not take vacation.
• Only photocopies of invoices are available.
• Age of inventory.
• Inventory turnover
• There is data-mining software.
269
© 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.
270
© 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.
271
© 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.
272
© 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.
273
© D.L. Crumbley
Some Employee Schemes (contd …)
Other Fraud Schemes (contd …)
• A ponzi scheme is a pyramid-type
technique where early investors are
paid with new money collected from
future investors, who lose their
investments.
• Bid rigging occurs when a vendor is
given an unfair advantage in an open
competition for a certain contract.
274
© D.L. Crumbley
Ponzi Scheme Example
• Women Helping Women group hosted
invitation – only “birthday parties” that
promised $40,000 in the future to each
woman who invested $5,000.
• Some of the women received the pay-off,
but most lost out.
• $12 million pyramid schemes.
• Cheryl Bean, the leader, given 3 years
probation, ordered to pay $15,000 in
restitution, and $10,000 to a charity fund.
Source: AP, “Pyramid Scheme Leader Pleads No Contest,” Las Vegas
Sun, November 8, 2003.
275
© D.L. Crumbley
Hammersmith Trust Ponzi Scheme
• Hundreds of sophisticated investors put
$100 million in this prime banking
scheme that promised as much as 1,600%
annual return.
• The scheme revolved around the so-called
international prime banking instruments
(e.g., high-yield commercial paper or
secret bank debenture programs). There is
no market for prime bank instruments.
• “Not a single dime is invested in anything
– save the fraudulent pyramid itself, with
some money going from one investor to
the other in the form of purported
“interest” and “return of principal
“payments – while most of it sticks to the
pyramid or rather, to the people running
the
pyramid.”
Source: John Anderson, “Take The Money & Run,” Smart Money,
December 2003, pp. 122-130.
276
© D.L. Crumbley
Bid Rigging or Bid Pooling
• Sherman Antitrust Act – illegal
restraint of trade. Felony. Substantial
fines and up to three years.
• Group of dealers choose one dealer
to bid on items. Later the dealers
themselves bid on the items bought
and they, therefore, share the profits.
277
© D.L. Crumbley
Bid Rigging Red Flags
• Low turnout of auction attendees.
• Winking, hand signals or other similar signs
among dealers after the bidding is opened.
• A uniformity to the bidding. For example,
Dealer One bids on a particular lot and buys it
with little or no activity, and then Dealer Two
buys another lot, again with little or no
competition.
• Difficulty getting things going.
• A lot of handshaking and other signs of
recognition among several dealers before or
after the auction takes place.
• An air of silence throughout the auction since
auctions are generally noisy – or conversely, a
lot of conversation among bidders during the
sale of lots they normally should be bidding on.
• Low competition among known dealers who
normally bid strongly against one another.
Source: www.harryrinker.com/bidrigging: The Official Government
Auction Guide.
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
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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
281
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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.
282
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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.
283
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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.
284
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Barter Deals
AOL created ad revenues out of thin
air. With an obsession to get
advertising revenue in the door,
“nobody there appears to have paid
much attention to whether the business
deals at issue were really producing ad
‘revenues’ by any acceptable
definition….”
At least $90 million of revenues were
expunged by mid-2003, with another
$400 million contested.
Source: C.J. Loomis, “Why AOL’s Accounting
Problems Keep Popping Up,” Fortune, April 28,
2003, p. 86.
285
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IRS’s Forensic Analysis
•IRS Commissioner Mark W. Everson said that the role of
the IRS in the HealthSouth matter was to trace the flow of
money. “IRS agents in this case used the same
comprehensive financial analysis that we use in criminal
tax investigations to document million of dollars in
transactions through dozens of financial institutions,
including banks and brokerage firms,” Everson said.
•“The IRS will use its financial expertise to help the
government hold accountable those executives who engage
in fraud,” Everson said. “Our investigation supports the
money-laundering charges as well as the forfeiture counts
against Mr. Scrushy involving a staggering sum of money
– over a quarter of a billion dollars – which he
accumulated during a seven-year period,”
•“This money went to support a lavish lifestyle, one few
Americans could possibly imagine,” the Commissioner
continued. “With his ill-gotten gains, Mr. Scrushy
purchased multiple estates, racing and leisure boats, fine
art by such artists as Picasso, Miro, and Renoir, cars
including a Lamborghini and a Rolls-Royce, and
extravagant jewelry, such as a 22-carat diamond ring.”
Source: Amy Hamilton, “Everson Publicizes Criminal
Charges Against HealthSouth CEO,” Tax Notes, November
10, 2003, p. 671.
286
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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
287
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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.
288
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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.
289
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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
290
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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,
,id=108149,00.html
291
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Minimum Income
Probes
• For nonbusiness returns, an agent
question the taxpayer or representative
about possible sources of income other
than reported on the return. If there is
no other information in the file
indicating potential unreported
income, the minimum income probe is
met.
• For taxpayers who are self-employed
and file a Schedule C or F, an analysis
is made of tax return information to
determine if reported income is
sufficient to support the taxpayer’s
financial activities.
292
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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.
293
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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
294
Preliminary Cash-T (contd …)
© D.L. Crumbley
The cash hoard defense is
illustrated in the Edwin Edwards’
gambling corruption trial in 2000. An IRS
agent testified that Edwards spent
hundreds of thousands of dollars more in
cash than he reported in earnings.
On Monday, jurors got another
avalanche of numbers as prosecutors tried
to prove their charge that Edwards hid
money he extorted from riverboat casino
owners.
A financial analyst testified for the
prosecution about how the former
governor spent his cash, testimony the
defense challenged every step of the way.
Don Semesky, a special agent for
the Internal Revenue Service, used a chart
to show that Edwards spent $872,000
more in cash than he reported receiving
from 1986 to 1997.
Source: C. Baughman, “Prosecution Concludes Case In
Edwards’ Trial,” The Advocate Online, April 4, 2000.
295
Preliminary Cash-T (contd …)
© D.L. Crumbley
Semesky said Edwards started
1986 with $82,000 in cash. He based that
figure on Edwards’ own testimony in an
unrelated trial in 1985.
In the current trial, Edwards
testified he always had between $250,000
and $500,000 in cash during the mid1980s. Using $250,000 as a starting
point, Semesky said, Edwards still spent
$704,000 more in that period than he
reported receiving.
“I believe the evidence in this case
is that Mr. Edwards received cash from
other, unreported sources,” Semesky told
prosecutor Mike Magner.
In either calculation, Edwards
started spending more cash in 1996,
Semesky said. He agreed with Magner’s
allegation that the increase in spending
coincided with Edwards getting extortion
payments from Robert Guidry.
296
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Preliminary Cash-T (contd …)
Guidry, the former owner of the
Treasure Chest casino in Kenner, testified
he paid Edwards and his son along with
Edwards’ former, aide Andrew Martin,
$100,000 a month from early 1996 until
August 1997.
Like he did with Laura East, Small
wasted little time attacking Semesky’s
numbers, which were displayed for the
jury on a chart.
Semesky’s total for cash spent by
Edwards included $383,500 the FBI
seized from his safe-deposit box on April
29, 1997.
Edwards testified that cash was left
over from $400,000 Eddie DeBartolo Jr.
had given him in a legitimate business
deal on March 12, 1997. He said it was
primarily to prepare for a gambling
election in Bossier City, where DeBartolo
was applying to put in a casino boat.
297
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Preliminary Cash-T (contd …)
DeBartolo, who has pleaded guilty in
the case, testified for the prosecution that
Edwards extorted the $400,000 from him.
But while Semesky showed the
$383,500 as cash spent, he did not show the
$400,000 from DeBartolo as cash received,
Small said.
“Isn’t it a fact that you screwed up
and you missed the $400,000?” Small asked
Semesky.
“Mr. Small, you’re not understanding
the concept of this chart,” Semesky said.
“The government’s contention in this case is
that it (the $400,000) came from extorted
payments.”
The purpose of the chart was to show
legal sources of cash, Semesky said. That
included $1,586,800 in net gambling
winnings Edwards had from 1986 until
1997, he said.
298
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Preliminary Cash-T (contd …)
But Small said the cash
shortfall that Semesky found - about $872,000 - - could be made up
by starting with $500,000 in cash in
1986, as Edwards testified he might
have had.
Add the $400,000 from
DeBartolo and the shortfall
disappears, Small said.
Later in 1997, DeBartolo
reported to the IRS he had given
Edwards the money, Small said.
But Semesky maintained that
the $400,000 could not be counted
as a legitimate source of cash.
“It doesn’t belong on that
schedule,” he said.
299
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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.
300
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Source/Application of Funds
Application of funds:
Bank balance increase
Down payment on home
Closing costs on home
Purchase of SUV
Rent payment (4 months)
Mortgage payment
Down payment on boat
Credit card payments
Miscellaneous (living)
Balance
2002
2003
$7,300
15,000
3,700
17,600
2,000
4,200
14,000
11,500
75,300
$29,500
8,400
10,000
38,800
37,000
$123,700
$3,600
49,500
7,000
3,000
0
$63,100
$12,200
$1,700
53,000
13,000
3,000
7,000
$77,700
$46,000
Known sources of funds:
Cash on hand
Salary
Consulting
Dividends and interest
Loan proceeds
Balance
Net unreported funds
301
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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).
302
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
303
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Net Worth Application
2003
Calculated Net Worth1
Computed Net Worth2
Net Asset increase
Unexplained net worth
increase
Income
Expenses
Net asset increase
2004
2005
$225,000 $421,000
225,000 310,000
0 $111,000
11,000
21,000
$610,000
420,000
$190,000
23,000
$90,000
$167,000
$81,000
60,000
$21,000
$87,000
64,000
$23,000
$62,000
51,000
$11,000
1 Actual Net Worth recalculated based upon actual assets less
liabilities.
2 Net Worth based upon reported income less expenses.
304
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Non-Tax Net Worth Use
In a narcotics conspiracy trial,
defendant argued that the expert
auditor should have to followed the net
worth method to prove that defendant’s
wealth is disproportionate to his
reported income.
Holland need not be followed in
non-tax cases. Unlike tax prosecutions,
narcotics conspiracy charges do not
involve financial gain as necessary
elements of offense, so less stringent
standards are allowable.
U.S. v. Cuervo, No. 02-2898 (CA-8, 2004).
305
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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).
306
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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
307
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Formula for Expenditure Method
Expenditures
less: Known sources of income
=
Unknown sources of income
$210,000
115,000
$95,000
308
Percentage of Markup Method © D.L. Crumbley
Gross Profit on Sales Formula
Sales per books
$100,000
25%
Gross profit percentage
$25,000
Gross profit as recomputed
Sales on Cost of Sales Formula Cost of SalesPercentage of Sales Price
Cost of Product A
$10,000
$20,000
Cost of Product B
Cost of Sales – Percent of Selling Price
Product A
25%
Product B
50%
Recompiled Sales of products A and B
Product A
$40,000
(10,000/.25)
Product B
$40,000
(20,000/.5)
Sales as recomputed
$80,000
Ratio Analysis Formula
Restaurant Sales
Number of waiters
Average sales per waiter
Customer’s tip percentage
Waitress tip income as recomputed
$90,000
3
30,000
10%
$3,000
309
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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
310
Some Exercises
© D.L. Crumbley
30) Given the following facts about Sammie Bright,
calculate his preliminary understatement using the
Cash-T method.
Schedule C expenses
$102,000
Personal living expenses
59,000
Schedule C receipts
112,000
31) Based upon the following facts about Phil Tizzard, in
Sour Lakes, Texas, calculate any unexplained net worth
increase (if any):
Computed Net worth (reported income
less expenses)
$520,000
Calculated Net worth (actual net worth
recalculated upon actual assets less liabilities) $618,000
Income
$93,000
Expenses
$67,000
32) Ben Lautenberg is a waiter in Las Vegas, and reports
tip income of $4,200 for the year. The restaurant sales
where he works were $360,000 and there were 5
waiters. Assume that the waiters have about the same
amount of sales. Compute Ben’s tip income
recomputed if customers’ tip percentage is
approximately 11%
311
Some Exercises
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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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Tax Fraud
•
•
•
•
•
•
•
Tax fraud is somewhat different than
legal fraud. The Supreme Court in
Spies v. U.S. provides some badges of
tax fraud:
Abnormal cash dealings.
False entries in records or creation of
false documents such as invoices.
Duplicate set of books.
Concealing assets or sources of
income.
Fictitious transactions.
Expenses not deducted to divert
attention from unreported income.
Destruction of books or records.
Source: 317 U.S. 492 (1943).
314
Tax Fraud
•
•
•
•
•
•
•
•
•
•
•
© D.L. Crumbley
Bradford v. Commissioner provides
other badges of fraud:
Understatement of income.
Inadequate records.
Failure to file tax returns.
Implausible or inconsistent
explanations of behavior.
Concealing assets.
Failure to cooperate with tax
authorities.
Engaging in illegal activities.
Attempting to conceal illegal activities.
Dealing in cash.
Failing to make estimated tax
payments.
Many of these badges and others may
be found in the Internal Revenue
Manual.
Source: 796 F. 2d 303 (CA-9, 1986).
315
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Tax Fraud Schemes
• Slavery Reparation Credit – 80,000
claims in 2001, totaling $2.7 billion. IRS
paid out $30 million.
• Social Security Refund – promoters tell
taxpayers they can recover all of their
FICA and Medicare taxes paid. Typical
charge: $100 plus 10% of the refund.
• Home – based businesses – claim
deductions for home – based businesses
(i.e., hobby losses).
• Domestic and foreign trust schemes
charges range from $5,000 to $70,000
• Many frivolous protestor theories.
See: S.F. Holub, “Tax Fraud and Tax Protesters,” The Tax Adviser,
December 2002, pp. 790-792.
316
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Venue for Tax Fraud
Criminal Tax Fraud: Federal District
Court
Civil Tax Fraud:
• Federal District Court.
• U.S. Tax Court.
• Federal Claims.
317
Fraud vs. Avoidance
Chevron
50%
© D.L. Crumbley
Texaco
50%
Caltex (Indonesian companies)
• U.S. companies paid Caltex excessive
amounts for Indonesian Crude Oil ($4.55
per barrel).
• Therefore, excessive dividend income, with
foreign tax credits and cost of sales
deductions on U.S. income tax returns.
• To compensate Caltex for the extra taxes it
paid, Indonesian Government provided
Caltex with oil in excess of the amount
called for under the formal productionsharing contract.
• Total Federal and State taxes avoidance of
$8.6 billion and $433 million.
Source: J.D. Gramlich and J.E. Wheeler, “How Chevron, Texaco,
and Indonesian Government Structured Transactions to
Avoid Billions in U.S. Income Taxes,” Accounting Horizons,
June 2003, pp. 107-122.
318
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Financial Statement Fraud May
Serve Many Purposes:
1. Obtaining credit, long-term
financing, or additional capital
investment based on misleading
financial statements;
2. Maintaining or creating favorable
stock value;
3. Concealing deficiencies in
performance;
4. Hiding improper business
transactions (e.g., fictitious sales or
misrepresented assets); and
5. Resolving temporary financial
difficulties (e.g., insufficient cash
flow, unfavorable business
decisions, defense control in
maintaining prestige).
Source: Zab Rezaee, Financial Statement Fraud, New
York: John Wiley & Sons, 2002.
319
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Management may also engage in
financial statement fraud to obtain
personal benefits of:
1. Increasing compensation
through higher reported
earnings;
2. Enhancing value of personal
holding of company stock
such as stock-based
compensation;
3. Converting the company’s
assets for personal use; and
4. Obtaining a promotion or
maintaining the current
position within the company.
Source: Zab Rezaee, Financial Statement Fraud, New
York: John Wiley & Sons, 2002.
320
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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?
321
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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.
322
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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.
323
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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.
324
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State and Local
Government Susceptibility
Government bankruptcy is an
important issue for fraud prevention
and detection because likes business
corporations and organizations,
governments facing severe financial
difficulties can be fertile ground for
fraud. Government bankruptcy also
may trigger an investigation in order to
determine if fraud has contributed to
such financial distress.
325
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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
326
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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
--------------------------------------------------------------
2002 Wells Report: 25% of fraud
incidents occurred in government agencies,
with a $48,000 median loss (.25 times $600
billion = $150 billion).
327
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New Zealand Government Fraud
•The Ministry of Social Development
was defrauded of $1.1 million by a
trusted employee.
•The employee created 67 fictitious
invoices for payment over 28 months,
at a time when there had been changes
in management or at the time of the
month when there was pressure to
approve payment of accounts payable.
•Another employee noticed his own
signature apparently forged on a
document.
Source: Helen Bishop and Ashley Burrows, “Fraud in New Zealand
Government Despite Auditor General’s Warning,” Journal of
Government Financial Management, Winter 2003, Vol. 52, No. 4, pp.
42-46.
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Government Quiz 101
The ________ in 2002, improperly recorded
some expenses, kept “inappropriate
balances” in some accounts, and failed to
verify how much money it was collecting in
transaction fees.
While this government agency’s overall
internal controls were “effective,” their
financial reports are not presented in
accordance with applicable federal
accounting requirements.
This agency did not properly record capital
leases for computer hardware and did not
properly account for its software licensing
fees and other in-house expenses. They need
to do a better job of tracking transaction
fees.
Source: Deborah Soloman, “SEC’s Own Accounting
Requires Tightening, Internal Audit Says,” Wall Street J.,
July 3, 2003, A-2.
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Top-Side Entries: Smoking Gun
An Oct. 14, 2002, New York Times article by
Joel Brinkley stated that “auditors studying the
financial records of federal government departments
find may of them so disorganized, even chaotic, that
the agencies cannot account for tens of billion of
dollars.” So how did the agencies make their books
balance? Through the magic of top-side balancing
entries.
The Forest Services, a division of the U.S.
Department of Agriculture, tried to balance its books
at the end of the 2001 fiscal year. It booked more than
15,337 adjusting entries, debits, and credits totaling
more than $11 billion gross. Auditors determined that
73 percent of these adjustments, totaling $7.9 billion,
were unsupported.
The U.S. Department of Defense alone entered
an unsubstantiated balance adjustment totaling $1.1
trillion in 2000, down from $2.3 trillion the prior year.
Source: Scott Green, “Fighting Financial Reporting Fraud,” Internal Auditor,
330
December 2003, pp. 58-65.
© D.L. Crumbley
GASB Statement No. 34
•Governmental Accounting Standards Board:
nonprofit agency charged with setting GAAP for
state and local governments.
•Although GASB has no authority to set law, many
public agencies follow its standards.
•Statement No. 34 retains the fund accounting focus
(good for budgeting and short-term focus), but adds
government-wide financial statements (e.g., account
for all assets and liabilities).
•Requires capitalization and depreciation of
infrastructure assests.
•Goes from the Governmental Funds Statements to
the Statement of Net Assets and Statement of
Activities.
•Goes from the modified accrual statements to the
full accrual statements.
•New Management Discussion and Analysis (MD
& A) Statement – a narrative discussion of any
significant changes in the overall financial picture
of a given agency.
Source: K. Middaugh, “The Great GASB,” Government Technology,
October 2003, pp. 50-52.
331
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Qui Tam Suits
• The Qui Tam suit allows any
concerned citizen to seek relief in
the name of the government.
• Many whistle-blowers initially file
qui tam suits to get a dispute on the
books and started.
• Once a qui tam suit is initiated, the
U.S. Department of Justice evaluates
the case to see whether the DOJ
believes there are sound reasons to
pursue the conflict.
• Whatever parts of the qui tam suit the
U.S. DOJ does not take, a whistleblower and his or attorney can
continue to litigate.
332
© D.L. Crumbley
Taxpayers Against Fraud
The Taxpayers Against Fraud has an
Internet site called “The False Claims Act
Legal Center.” Their Qui Tam Attorney
Network assists attorneys in their efforts to
provide effective representation to qui tam
plaintiffs. This group disseminates
information about the False Claims Act and
qui tam provision.
An attorney may request an amicus
brief submission. They state that
enforcement of the False Claims Act and
its qui tam provisions have returned more
than $12 billion to the U.S. Treasury over
the past 17 years ($2.1 billion in 2003
fiscal year).
Whistle-blowers paid $319 million in
2003 fiscal year (up to 25% of judgment).
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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
ability to generate a stream
of inflows sufficient to make
interest payments.
Decreasing
Source: B.A. Chaney, D.M. Mead, and K.R. Schermann, “The New
Governmental Reporting Model,” Journal of Governmental Management,
Spring 2002, p. 29.
334
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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 –
three-year trend
14.Expanding annual unfunded pension obligations
Source: H.C. Grossman and T.E. Wilson, “Assessing Financial
Health,” Handbook of Governmental Accounting & Finance,
Somerset, N.J.: John Wiley & Sons, 1992, pp. 38-1 to 38-13.
335
Assess Financial Health of
Governmental Units
© D.L. Crumbley
Ratios
Negative
Indicator
Credit
Industry
Benchmark
Cash and investments/current
liabilities
Decreasing
Less than 1%
Operating surplus (deficit)/total Decreasing
revenue
5% or
consecutive
Elastic revenue (sales, utilities,
other elastic taxes)/total
revenue
Decreasing
Varies
State and federal aid / total
revenue
Increasing
Varies
Current liabilities/total revenue
Increasing
5%
Uncollected property taxes/
current tax levy
Increasing
Greater than
8%
Fixed costs/ total expenditures
Increasing
Varies
Debt service/total revenue
Increasing
Greater than
20%
Tax levy/tax limit
Increasing
Greater than
90%
Debt outstanding/debt limit
Increasing
Greater than
90%
Source: S.M. Winckler and Dewey Ward, “Can City Hall Go Broke? The Going Concern
Issue,” Journal of Accountancy, May 1984.
336
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.
337
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.
338
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.
339
© 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.
340
© 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.
341
Some Exercises
© D.L. Crumbley
1. You have the following data for a city in the southwest. Calculate the
quick ratio. Is this ratio favorable or unfavorable?
Current Liabilities
$28 million
Cash
$27 million
Investments (current)
$36 million
Accounts Receivables
$12 million
Due from other funds
$2.5 million
2. You have the following information about a mid-west city. Calculate
the ratios of fund balance to revenues and determine if they are
favorable or unfavorable.
General Fund
$62 million
Unreserved Fund
$54 million
General Fund Revenues
$401 million
3. You determine the following data about a local government in the
southeast. Determine the ratios of unreserved fund balance and
reserved fund balance to total revenues. Are these ratios favorable?
Revenues from Property Taxes
$36 million
Unreserved Fund Balance
$5 million
Reserved Fund Balance
$3.5 million
4. Assume the following facts about a local government. Determine the
Tax Limit Exhausted and the Debt Limit Exhausted ratios.
Tax Limit
$11 million
Debt Limit
$13 million
Tax Levy
$8.5 million
Total Debt subject to Limit
$9 million
5. Assume that Debt Service Expenditures is $16.2 million and Total
Revenues is $70.1 million. Calculate the Debt Service/total revenue
ratio. Is the ratio favorable?
342
© D.L. Crumbley
6. Determine if the following situations are negative indicators of
the financial health of a government unit.
a. Cash and investments divided by current liabilities ratio is
decreasing over several years.
b. Current liabilities divided by total revenues ratio is
decreasing.
c. Fixed costs divided by total expenditures ratio is increasing.
d. Real Property Taxes Receivables divided by Real Property Tax
Revenue ratio is increasing over time.
e. Debt Service expenditures as a percentage of revenues is
greater than 25%.
f. Debt Service Expenditures divided by Gross Expenditures
ratio is decreasing over time.
g. Gross Revenues – Gross Expenditures : Decreasing over time.
Gross Expenditures
h. The debt service expenditures as a percentage of revenues is
25% or larger.
i. A fund balance is greater than 10% of revenues.
j. Unreserved fund balance divided by gross expenditures ratio
is decreasing over time.
k. The quick ratio of a large state government is 2.2 to 1.
l. Long-Term Debt divided by population ratio is decreasing
over time.
m.Current Liabilities divided by Gross Revenues ratio is
increasing over time.
n. Tax Levy divided by Tax Limit ratio is decreasing over time.
343
© D.L. Crumbley
Favorable
344
© D.L. Crumbley
6. Determine if the following situations are negative indicators of the
financial health of a government unit.
a. Cash and investments divided by current liabilities ratio is
decreasing over several years. Negative
b. Current liabilities divided by total revenues ratio is decreasing.
Positive
c. Fixed costs divided by total expenditures ratio is increasing.
Negative
d. Real Property Taxes Receivables divided by Real Property Tax
Revenue ratio is increasing over time. Negative
e. Debt Service expenditures as a percentage of revenues is greater
than 25%. Negative
f. Debt Service Expenditures divided by Gross Expenditures ratio is
decreasing over time. Positive
g. Gross Revenues – Gross Expenditures : Decreasing over time.
Gross Expenditures
Negative
h. The debt service expenditures as a percentage of revenues is 25%
or larger. Negative
i. A fund balance is greater than 10% of revenues. Favorable
j. Unreserved fund balance divided by gross expenditures ratio is
decreasing over time. Negative
k. The quick ratio of a large state government is 2.2 to 1. Favorable
l. Long-Term Debt divided by population ratio is decreasing over
time. Favorable
m.Current Liabilities divided by Gross Revenues ratio is increasing
over time. Negative
n. Tax Levy divided by Tax Limit ratio is decreasing over time.
Favorable
345
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.
346
© D.L. Crumbley
Fraud in Not-for-Profit
Organizations
The website of Clark, Schaefer,
Hackett & Company states the
following reasons not-for-profit
organizations become targets of fraud:
Many smaller not-for-profits just don’t
have the personnel size required for a real
segregation of duties. They often don’t
require much approval for disbursements.
And, when fraud is discovered, they
frequently don’t prosecute it very
aggressively because of the perceived
negative publicity.
347
© D.L. Crumbley
Blue Cross Overcharged
•Two men supplied hundreds of
phony invoices to Blue Cross
from 1996-2001 in a scheme to
defraud more than $14 million.
•Prosecutors said V.J. Croce and
Joseph Quattrone overcharged
Blue Cross for buildingmaintenance supplies and repairs.
•Two men convicted, receiving
eight years in jail and $9.2 in
restitution.
Source: AP, “Men in Blue Cross Fraud Case Sentenced,” Las Vegas
Sun, January 17, 2004.
348
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Red Flags of Fraud for NPOs
•Budget cutbacks.
•High turnover.
•Refusal to take legitimate perks (e.g.,
vacations).
•Overemphasis on short-term fund-raising
goals.
•Poorly monitored remote event or promotional
locations.
•Bounced checks.
•Things don’t add up.
•Anonymous tips.
•Lifestyle or behavior changes.
•Inattention to details.
•Not conducting background checks on anyone
handling money.
•Keeping problems a secret.
•Failing to investigate and then prosecute to the
fullest extent of the law.
K. Anne Midkiff, “Catching the Warning Signs of Fraud in NPOs,”
Journal of Accountancy, January 2004, p. 28.
349
© D.L. Crumbley
Don’t Volunteer For Trouble
Dos and Don’ts
If you volunteer CPA services to an NPO, do
• Avoid the appearance of impropriety.
• Check the volunteer liability statutes in your state.
• Examine the NPO’s internal controls, bylaws and
procedures.
• Educate yourself about how the organization operates.
• Attend board orientation and understand job
descriptions.
• Attend as many board meetings as you possibly can and
document votes and discussions.
• Make sure the organization has proper insurance
coverage.
• Be prepared to contribute time, talent and resources.
Your follow-through is important, so don’t
• Skip board meetings.
• Rubber-stamp decisions.
• Sign checks without documentation.
• Ignore employee complaints of discrimination or sexual
misconduct.
• Serve if you are unable to regularly attend meetings.
Source: Joan Sompayrac, “Don’t Volunteer for Trouble,”
Journal of Accountancy, January 2003, p. 82.
350
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The End Is Here
352