Transcript Forensic Accounting Update Exam II Copyrighted 2002 D

© D.L.
Crumbley
Forensic Accounting: Some Strategies
for Detecting & Preventing Fraud
D. Larry Crumbley, CPA, Cr.FA, CFD, FCPA
KPMG Endowed Professor
Department of Accounting
Louisiana State University
Baton Rouge, LA 70803
225-578-6231
225-578-6201 Fax
[email protected]
Dr. Crumbley is the
Editor of the Journal of Forensic Accounting: Auditing,
Fraud, and Risk,
Former chair of the Executive Board of Accounting
Advisors of the American Board of Forensic Accountants,
Member of the NACVA’s Fraud Deterrence Board, and
On the AICPA’s Fraud Task Force (2003-2004).
A frequent contributor to the Forensic Examiner, Professor
Crumbley is a co-author of CCH Master Auditing Guide,
along with more than 50 other books and 350 articles. His
latest book entitled Forensic and Investigative Accounting is
published by Commerce Clearing House (800-224-7477).
Some of his 12 educational novels have as the main character
a forensic accountant. His goal is to create a television series
based upon the exciting life of a forensic accountant and
litigation consultant.
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Forensic Report
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TALLY STICKS
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Glimpse Forward
• Overview of Forensic Accounting
• Persuasiveness/ Costs of Fraud/ Abuse
• COSO’s Model
• After FRA: Detection and Investigation
• Misappropriation of Assets/ Cooking the Books
• Detection, Investigation, and Deterrence
• Types of Misappropriations
• Procurement Frauds
• Developing Fraud Interviewing Skills
• Best Fraud Auditing Techniques
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Now John at the bar is a friend of mine.
He gets me my drinks for free.
Sing us a song, you’re the piano man.
“Piano Man”
Billy Joel
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Some Fraud Figures
• Australia’s annual fraud, 2003, $5.8 billion or
1.147% of GDP.
• Malaysia’s telecom operators lose 3% of
revenue to fraud each year.
• A KPMG Malaysian survey found that more
than a third of the polled companies lost over
RM 1 million from fraud in 2 years.
• Fraud and abuse in U.S. is $652 billion to $1
trillion annually.
• The quantity of corruption crimes has
continued to rise in China after the market
liberalizations in 1978 (because so much more
money involved).
• An employee at the Australian mint stole
$100,145 over ten months by hiding bills and
coins in his lunch box and boots. He carried
away on an average 150 coins in each boot
every day.
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Fannie Mae Forensic Probe
• BOD hired investigators who cleared the
current management of Fannie Mae of
knowingly participating in any wrongdoing.
• The report took 17 months; 616 pages plus
2,000 plus pages of supporting documents.
• Cost of $60 million to $70 million.
• The fraud was estimated to be $11 billion.
• Former N.H. Senator Warren Rudman used
The Huron Consulting Group.
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Definition of Forensic Auditor
Someone who can look behind the
facade--not accept the records at
their face value--someone who has a
suspicious mind that the documents
he or she is looking at may not be
what they purport to be and someone
who has the expertise to go out and
conduct very detailed interviews of
individuals to develop the truth,
especially if some are presumed to
be lying.
Robert G. Roche, a retired chief of the IRS Criminal Investigation
Division of the IRS
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Narrow vs. Broad Definition
• Narrow: Fraud detection is major area.
• Broad: Employed to seek, interpret, and
communicate transactional and reporting
event evidence in an objective, legally
sustainable fashion, not only in situations
where there are specific allegations of
wrongdoing, but also in situations where
interested parties judge that the risk of
loss from wrongdoing is such that proper
prudence requires legally sustainable
evidence to support the conclusion that
no wrongdoing is occurring (James
Edwards).
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Narrow Approach
Accounting
Forensic
Accounting
Internal and External
Auditing
Planning
Risk Assessment
Internal controls
Audit Evidence
Reporting
Accounting
Litigation Matters
and Investigations
Fraud
Prevention and Deterrence
Detection
Investigation
Remediation
U.S. Dept. of Justice, Education and Training in Fraud and
Forensic Accounting: A Guide for Educational Institutions,
Stakeholder Organizations, Faculty and Students, Draft Copy,
December 23, 2005.
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Broad Approach
“I liken it to ‘CSI’ or ‘Law & Order,’ but instead of figuring out the
trajectory of a bullet, you’re trying to find out how a transaction
occurred.”
Terry McCarthy
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Definition of Forensic Accounting
Forensic accounting is the application of
accounting, tax, auditing, finance,
quantitative analysis, investigative and
research skills, and an understanding of
the legal process for the purpose of
identifying, collecting, analyzing, and
interpreting financial or other data or
issues in connection with:
1) Litigation services: providing assistance
for actual, pending or potential legal or
regulatory proceedings before a trier of
fact in connection with the resolution of
disputes between parties, or
2) Non-litigation
services:
performing
analyses or investigations that may require
the same skills used in 1, above, but may
not involve the litigation process.
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Definition of Forensic Accounting
Litigation Service
Forensic accounting litigation services
are
the
professional
assistance
accountants provide related to the
litigation process. These services may
involve accounting, financial, auditing,
tax,
quantitative
analysis,
and
investigative and research skills, as well
as an understanding of the legal process
to provide assistance for actual, pending,
or potential legal or regulatory
proceedings before a trier of fact in
connection with the resolution of a
dispute between parties.
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Definition of Forensic Accounting
Non-Litigation Services
Forensic
accounting
non-litigation
services are the professional assistance
accountants provide not related to the
litigation process. These services may
involve accounting, financial, auditing, tax,
quantitative analysis, and investigative and
research skill as well as an understanding of
the legal process to provide assistance in
connection with matter or issues not
involving the litigation process.
“You’re trying to piece together a puzzle where you do not
have the picture on the box to know what it’s going to look like.
The facts are not settled, and actually it’s the facts that are in
dispute.”
Andrew Bernstein
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Puff Adder
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“What the use of finger prints was to the 19th century and DNA analysis was
to the 20th, forensic accounting will be to the 21st century.”
- Gordon Brown, Chancellor of the Exchequer, 10 October 2006.
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Short History
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1. Late 1800’s – Find fraud
2. 1930’s- Puff Adder –encyclopedia
3. 1933-1934-independent audits
4. 1950’s-Eighth edition Montgomery auditing reduced
formal stress on fraud detection.
5. January 1957- H.W. Bevis, AR, questioned the benefit of
discovering minor employee thefts.
6. 1960s-auditors claimed no responsibility.
7. Financial audits: Consistency.
8. Audit surveillance: test of details (disappeared).
9. Stock market bubble
10.Panel on Audit Effectiveness (2000)
11.Enron/ WorldCom/ Parmalat/ HealthSouth
12.Sarbanes-Oxley/ PCAOB
13.SAS No. 99
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Why Growth in Forensic Accounting
1.
2.
3.
4.
Increase in fraud.
Less loyalty to organization.
Employee mobility.
Change in societal values.
a. Break-up of family unit.
b. Less religious.
c. Less ethics.
5. Computers replacing accounting
functions. External accountants are
looking for new jobs.
6. Higher insurance premiums for
auditing.
7. Auditors became sales people.
8. Grade inflation/coursework deflation.
9. Enron/WorldCom/Xerox.
10. SOX/ SAS No. 99.
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Transparency International Corruption Perceptions
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Index
2006
Crumbley
Country Rank
Country
2006 CPI Score
Surveys used
Confidence range
1
Finland
9.6
7
9.4 - 9.7
Iceland
9.6
6
9.5 - 9.7
New Zealand
9.6
7
9.4 - 9.6
4
Denmark
9.5
7
9.4 - 9.6
5
Singapore
9.4
9
9.2 - 9.5
6
Sweden
9.2
7
9.0 - 9.3
7
Switzerland
9.1
7
8.9 - 9.2
8
Norway
8.8
7
8.4 - 9.1
9
Australia
8.7
8
8.3 - 9.0
Netherlands
8.7
7
8.3 - 9.0
Austria
8.6
7
8.2 - 8.9
Luxembourg
8.6
6
8.1 - 9.0
United Kingdom
8.6
7
8.2 - 8.9
14
Canada
8.5
7
8.0 - 8.9
15
Hong Kong
8.3
9
7.7 - 8.8
16
Germany
8
7
7.8 - 8.4
17
Japan
7.6
9
7.0 - 8.1
18
France
7.4
7
6.7 - 7.8
Ireland
7.4
7
6.7 - 7.9
Belgium
7.3
7
6.6 - 7.9
Chile
7.3
7
6.6 - 7.6
USA
7.3
8
6.6 - 7.8
Belarus
2.1
4
1.9 - 2.2
Cambodia
2.1
6
1.9 - 2.4
Côte d´Ivoire
2.1
4
2.0 - 2.2
Equatorial Guinea
2.1
3
1.7 - 2.2
Uzbekistan
2.1
5
1.8 - 2.2
Bangladesh
2
6
1.7 - 2.2
Chad
2
6
1.8 - 2.3
Congo, Democratic Republic
2
4
1.8 - 2.2
Sudan
2
4
1.8 - 2.2
Guinea
1.9
3
1.7 - 2.1
Iraq
1.9
3
1.6 - 2.1
160
Myanmar
1.9
3
1.8 - 2.3
163
Haiti
1.8
3
1.7 - 1.8
11
20
151
156
160
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The Bubble Deception
There are 14,000 publicly traded
companies in the United States. Expecting
all of them to be honest is unrealistic.
Like any town of 14,000, the market is
bound to have its share of grafters and
shoplifters.
By January 2001, all manner of companies
were abusing accounting rules to mislead
their investors, seemingly without fear of
being caught. A strange madness had
gripped the market. Even its most solid
citizens were running red lights and
breaking windows. And the police were
nowhere in sight.
Alex Berenson, The Number, Random House, 2003, p. xxiii.
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Enriching Insiders
I know that sounds crazy, but the stock market has
gone from a place where investors actually own part
of a company and have a say in their management to
a market designed to enrich insiders by allowing
them to sell shares they buy cheaply through
options.
Companies continuously issue new shares to their
managers without asking their existing shareholders.
Those managers then leak that stock to the market a
little at a time. It’s unlimited dilution of existing
shareholders’ stakes, dilution by a thousand cuts. If
that isn’t a scam, I don’t know what is.
Individual shareholders have nothing but the
chance to sell their shares to the next sucker . A
mutual fund buys one million shares of a company
with your and your coworkers’ money. You own 1
percent of the company. Six weeks later you own
less, and that money went to insiders, not to the
company.
Alex Berenson, The Number, Random House, 2003, p. xviii.
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Forensic Accounting Factors
• Time: Forensic accounting focuses on
the past, although it may do so in
order to look forward (e.g., damages,
valuations).
• Purpose: Forensic accounting is
performed for a specific legal forum
or in anticipation of appearing before
a legal forum.
• Peremptory: Forensic accountants
may be employed in a wide variety of
risk management engagements within
business enterprises as a matter of
right, without the necessity of
allegations (e.g., proactive).
----------------------------------------------With a single clue a forensic
accountant can solve a fraudulent
mystery.
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One Small Clue
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A former Scotland Yard scientist tried to create
the world’s biggest fraud by authenticating $2.5
trillion worth of fake U.S. Treasury bonds.
When two men tried to pass off $25 million
worth of the bonds in Toronto in 2001, a
Mountie noticed the bonds bore the word
“dollar” rather “dollars.”
Police later raided a London bank vault and
discovered that the bonds had been printed with
an ink jet printer that had not been invented
when the bonds were allegedly produced.
Zip codes were used even though they were not
introduced until 1963.
Sue Clough, “Bungling Scientist Is Jailed for Plotting World's Biggest
Fraud,” News.telegraph.co.uk, January 11, 2003.
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Forensic Accounting
Defined
Forensic accounting is the action of
identifying, recording, settling, extracting,
sorting, reporting, and verifying past financial
data or other accounting activities for settling
current or prospective legal disputes or using
such past financial data for projecting future
financial data to settle legal disputes.
Source: Forensic and Investigative Accounting (CCH)
--------------------------------------------------------
When the death of a company
occurs under mysterious circumstances,
forensic accountants are essential. Other
accountants look at the charts but
forensic accountants actually dig into
the body.
Douglas Carmichael
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Forensic Accounting Areas
Investigative Auditing
Litigation Support
Forensic: Latin for “forum,”
referring to a public place or court.
Black’s Law Dictionary: Forensic,
belonging to the courts of justice.
Note: Corporate spooks are used to check on
competitors.
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Forensic Auditing
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Forensic auditing is a type of auditing
that specifically looks for financial misconduct,
and abusive or wasteful activity.
It is most commonly associated with
gathering evidence that will be presented in a
court of law as part of a financial crime or a
fraud investigation.
Source: B.L. Derby, “Data Mining for Improper Payments,” Journal of Government
Financial Management, Winter, 2003, pp. 10-13
----------------------------------------------------------------
“ Forget the stuffed white shirt, forensic
accountants are more parts Philip
Marlowe than Casper Milquetoast. They
open the books and crack the code,
transforming a dull science of numbers
into a suspenseful mystery with a
logical, even riveting resolution.”
Cory Johnson
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Top Niche Services
1. Business Valuations
2. SOX Compliance
3. Litigation Support
4. Attest Services
5. Estate/Trust/Gift
9. Forensic/Fraud
89%
77%
69%
67%
66%
56%
Source: Accounting Today.
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Forensic Accounting vs.
Fraud Auditing
Fraud Auditor: An accountant especially
skilled in auditing who is generally engaged
in auditing with a view toward fraud
discovery, documentation, and prevention.
-----------------------------------------------------“Economic crimes and fraud often do not
involve obvious evidence like the smoking
gun. Forensic accountants look behind the
deals and handshakes and probe beyond the
numbers to uncover the reality of financial
situations.”
Source: D.W. Squires, “Problems Solved with Forensic Accounting: A
Legal Perspective,” Journal of Forensic Accounting., Vol. IV (2003),. P.
131.
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Forensic Accounting vs.
Fraud Auditing
Forensic Accountant: A forensic
accountant may take on fraud auditing
engagements and may be a fraud auditor,
but he or she will also use other
accounting, consulting, and legal skills
in broader engagements. In addition to
accounting skills, he or she will need a
working knowledge of the legal system
and excellent communication skills to
carry out expert testimony in the
courtroom and to aid in other litigation
support engagements.
Crumbley, Heitger, Smith, Forensic and Investigative Accounting (CCH)
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AICPA’s Position
• Does not require auditors to carryout specific
forensic procedures, but rather provide guidance
on how to include forensic techniques within
processes outlines in SAS 99. This combination will
enhance the detection and prevention of fraudulent
financial statement reporting and misappropriation
of assets; thus protect investors and financial
statement users.
• Public accounting firms could use forensic
accountants to help revise their approach to
planning and fieldwork on all audits, while
requiring forensic accountants only on high risk
audit clients to aid in the interpretation of forensic
testing results and preventive control enhancements.
• The inclusion of audit procedures focused towards
detecting misappropriation of corporate assets may
lead to the identification of weaknesses within
corporate governance or control weaknesses. Frauds
that are identified which represent a material
misappropriation of assets could significantly
impact public perception.
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AICPA’s Position (cont.)
• Professional forensic accountants can best be used
by ensuring such procedures are properly developed
and executed in-line with internal audit and audit
committee concerns. Forensic accountants could then
be engaged in high-risk situations, or when a fraud
is suspected.
• Companies should not use the forensic services of
their outside audit firm, unless it pertains to the
annual audit.
• Putting a price on a substantive test or forensic
auditing procedure may be smart for business;
however, the inherent risk is that short-cuts geared
towards reducing audit costs may eventually
cause investors to question the companies’ true
financial position.
AICPA – Discussion Memo Question Responses
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Big-Six's Position
• A forensic audit is akin to a police investigation.
• All public companies should have a forensic audit
on a regular basis. Companies would be required to
have such an audit every three or five years or
face these audits on a random basis.
• Forensic auditors scrutinize all records of
companies, including emails, and would be able, if
not required, to question all company employees,
and to require statements under oath.
• Might be necessary for an audit network or a
specialized forensic auditor to complete a forensic
audit with the aid of independent attorneys (not
these who have represented the audit client in the
other engagements).
Source: “Serving Global Markets and the Global Economy: A View from
the CEOs of the International Audit Networks, November 2006, p. 13.
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Catch Me If You Can
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Numbers Don’t Lie.
Criminals are another story.
Money talks. But more often it whispers. When
shady characters are up to no good, they often
leave a trail of questionable financial
transactions. Use your skills and smarts to
trace the money trail back to the crooks in the
all-new version of Catch Me If You Can. Now
more interactive and exciting than ever. You
could win up to $2,000 in cash or other prizes.
And have a lot fun doing it.
Register to play at
www.CatchMeGame.com/college
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Forensic vs. Fraud Audit
Google result, February 11, 2007
–
–
–
–
–
–
–
–
Forensic Audit, 208,000 hits
Fraud Audit, 64,500 hits
Fraud Examination, 74,800 hits
Fraud Accounting, 45,200 hits
Forensic Accounting, 1,050,000 hits
Fraud Investigation, 932,000
Forensic Investigation, 512,000
Fraud Auditing, 83,500
---------------------------------------------I don’t care what they say, but [forensic
accounting] is here to stay.
Danny & the Juniors
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I see skies of blue and clouds of white, and I
think to myself, what a wonderful world.
Louis Armstrong
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Specialties Within
Forensic and
Investigative Accounting
• Employee Crime Specialist.
• Asset Tracing Specialist.
• Litigation Services Specialist
and Expert Witness.
• Insurance Claims.
• Valuation Analysis.
• False Claims Act Violations.
• Due diligence investigations.
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Asset Tracing
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Three Italian lawyers said in a filing to be
presented to a bankruptcy court that they
had traced $7.7 billion in missing Parmalat
funds.
“We are preparing a filing in which we are
asking for the insolvency status to be revoked
because the money was robbed and not lost,”
lawyer Carlo Zauli told Reuters.
But he said it would be an illusion to believe
proof of electronic transfers of the funds could
be found and the lawyers representing the
Parmalat Creditors Committee did not say
where the money was being held or if it was
recoverable.
An Italian website, TGfin (www.tgfin.it), said a
company linked to Parmalat founder Tanzi
was holding the funds in the form of U.S.
bonds in an account with Bank of America.
Source: Emilio Parodi and Stefano Bernabei, “Wrap-up 2: Paramalat Fraud Probe Widens to
Auditors, Ex-Banker, “forbes.com, January 8, 2004.
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Gross Profit Comparison
•
In a divorce situation, a business owner
claimed only about $75,000 annual
income.
•
He claimed he had borrowed and not
paid back huge sums.
•
Wife said he was spending about
$400,000 per year more than his salary.
Four schedules for the courtroom:
1. What was known and alleged about
husband’s expenditures.
2. Schedule comparing income with
expenditures.
3. Amounts husband claimed he had
borrowed.
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Gross Profit Comparison (cont.)
4.
•
•
Company’s income statements side-byside:
New Gross Profit
His
Per Industry
----------------$75,000
$475,000
Husband had overstated COGS.
Checks issued to vendors, into COGS.
Some of the vendors cashed the checks
and returned the money to husband.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R. T.
Edwards, 2005, pp. 49-57.
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Unreported Beer Sales
• Business owner reports only $50,000
business income, but has expensive cars,
private schools, buying significant real
estate.
• Subpoenaed records of local beer
distributors. Then went to the club and
ordered some drinks, noting the pricing of
the beer, etc.
1,000 cases of Miller’s
24 bottles
24,000
x $2
$48,000 per year
• Found that reported sales were
underreported by $500,000.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards,
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Home Improvements
• Massive improvements to personal home, not
paid for by personal funds.
• Company showed many corporate payments to
home remodeling contractors/landscapers.
• But the industrial park not owned by company.
• Only photocopies of invoices provided.
• FC demanded original documents.
• Finally, the original documents had white-outs
of job locations and work descriptions.
• Could turn over the originals and read the real
data from the back side.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards,
2005, pp. 49-57.
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Finding Unreported
Income/Hidden Assets
1.
2.
3.
4.
Look at the lifestyles.
Look at the expenses.
Look at the cash flow.
Look at the business
operations.
5. Look at the industry ratios.
6. Consider using private
investigators.
7. Use the net worth method.
Mark Kohn, “Unreported Income and Hidden Assets,” Forensic
Accounting in Matrimonial Divorce, Philadelphia: R.T.
Edwards, 2005, pp.49-57.
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Fiction v. Reality
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The main difference between fiction and
reality is that instead of using mask and gun,
today’s villains use mouse and keyboard. Instead
of hiding behind a lamppost in a trench coat and
fedora, today’s forensic accountants are more
likely to be hiding behind their own computers,
searching for clues amid mountains of data.
Source; “Book ‘EM! Forensic Accounting in History and
Literature,” The Kessler Report, Vol.1, No. 2.
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“Every investigation I did as a prosecutor, you
have a particular target, but it always branches off
because something else gets your attention. And
that’s what is going to happen with a forensic
accountant.”
Tom Carlucci:
E-library Rueter Library September 20, 2002
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Forensic Techniques Become Popular
“In many of the large accounting blow-ups, auditors
knew what was happening,” says Charles Niemeir, “but
they were willing to look the other way.”
There is a need to provide “incentives for people finding
problems,” says Douglas Carmichael. “Right now there
are no incentives for finding problems, and one who does
is treated as a trouble maker.”
Source: Cassell Bryan Low, “Accounting Firms Attempts to
Dispel the Cloud of Fraud,” Wall Street J., May 27, 2003.
Doug Carmichael, Chief Auditor for Peek-uh-boo,
faults auditors for not adopting forensic techniques.
Carmichael wishes more “test of details,” not relying
on test of controls.
He wishes more shoe-leather work.
Shoe-leather work is what we do!
Kris Frieswick, “How Audits Must Change,” CFO July
2003, p.48
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Popular (cont.)
•
E&Y’s forensic accounting team is comprised of 350
practitioners in the U.S. alone, and focuses on
strategies to mitigate and manage conflict in
bankruptcy disputes, financial and economic damages,
fraud and investigations, government contracts and
grants, insurance claims, intellectual assets, and legal
technology.
•
Deloitte’s forensic accounting expertise includes antimoney laundering, the Foreign Corrupt Practices Act,
purchase price disputes, arbitrations, construction
fraud, health care fraud, construction oversight,
intellectual property theft, and misdirected royalty
revenues, to name just a few.
They have forensic labs in nine major cities across the
U.S. and an additional 18 cities around the world,
including Hong Kong, London, Amsterdam, Frankfurt,
Cape Town and Melbourne.” All FAS labs meet the
FBI’s chain of custody requirements. “They are secure,
state-of-the-art, and house advanced systems for
storing and accessing data, including dedicated servers
and fire-resistant safes.
Stuart Kahan, “Sherlock Holmes Enters Accounting,” WebCPA,
February 11, 2007.
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This need for the forensic accountant is
demonstrated by this passage from The
CBS Murders:
Margaret Barbera was very good with
numbers. She could take a balance sheet, a
set of account books, invoices, bills, and
more, juggle and manipulate the figures
and, presto, thousands become millions,
losses become profits, profits become
losses, sales soared or fell, whatever her
employer desired, and it would take an
expert auditor knowing precisely where to
look and what to look for to figure out
what she’d done, and even then, it still
might slip by.
Professor Cramer was in front of the auditing class quoting a
passage from The CBS Murders, by Richard Hammer. [p. 67
in Trap Doors].
43
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Crumbley
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.
44
Potpourri
© D.L.
Crumbley
• Deutsche Bank is being sued for $1.3 billion by
Bruce Winston (one of the heirs of Harry Winston
diamond dynasty) for priceless gems
disappearing from a trust under their control.
• A Burlington, Kentucky city finance director is
accused of embezzling more than $1.2 million to
support his estranged wife and his girlfriend.
• Martin Frankel vanished with between $200
million in cash and diamonds one day. He
accomplished this insurance fraud by buying
poorly capitalized insurance companies, cooking
the books to show increased premium value, and
by including non-existing real estate and leases on
the balance sheet.
• Bank of China’s Mr. Wu allegedly embezzling up
to $18 million from a bank branch, using
improper bills of exchange. BoC has a number of
cases involving the embezzlement of $737 million
from branches in the Southern Guangdong
Province.
• A U.S. Lime officer embezzled nearly $2.2
million by forging signatures of other company
officers on checks, and falsifying the company’s
check register to create the impression that the
amounts he received went to U.S. Lime creditors.
45
Potpourri (contd …)
© D.L.
Crumbley
• The Chairman of Hyundai Motor, Chung
Mong-Koo, was sentenced in February 2007,
to 3 years in prison for embezzlement ($100
million) and breach of trust at South Korea’s
largest carmaker.
• Spanish authorities shut down Afinsa’s Forum
stamp-investing programs with several
hundred thousand of small investors. Alleged
investments in overvalued stamps and
suspected pyramid scheme. Eight officials
jailed.
• In 2000, Rent Way’s CAO artificially reduced
the company’s expenses by $127 million.
• WorldCom’s external auditors missed about
$11 billion improperly booked items.
• Ahold NV, a Dutch company, said a U.S. unit
had overstated revenues by $880 million by
booking more discounts from suppliers than
actually received.
• One Philippine peso coin has the same size as
1 dirham, but worth only 7 fils. Thus, dispense
machine fraud.
46
Definition
© D.L.
Crumbley
A forensic accountant has extensive
experience in investigations to determine
solutions to disputed accounting matters, to
write expert reports on their investigation,
and to appear in court as expert witnesses.
Zeph Telpner and Michael Mostek
A normal accountant is like a guarddog
(e.g., a bulldog); a forensic accountant is
like a bloodhound; an internal auditor is like
a seeing-and-eye dog (e.g., monitoring and
guiding management), a corporate
accountant is a mix breed, and a
governmental accountant is an afghan.
D. Larry Crumbley
47
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Crumbley
Auditors Blamed: Deep Pockets
•Trustee for United Companies (UC) said that
Deloitte and Touche was guilty of negligence,
malpractice, misrepresentation, breach of duty, and
fraud.
•D & T failed to warn United Companies of all of
the losses it would absorb if the people who took
out the loans defaulted, because the accounting
firm was making millions and millions of dollars
in fees.
•Loan practice called securitization or bundled
high-interest loans.
•$685 million in liability damages.
•Plaintiff’s Attorney: Role of auditors is to act as
watchdogs for companies. “A good watchdog
barks when somebody comes into the yard. D & T
is supposed to bark when there is a problem.”
•Defendant’s Attorney: “The problem was much
larger than a watchdog could handle. Can a
watchdog stop your house from getting hit by a
hurricane? Of course not.”
Source: Adrian Angelette, “Auditors Blamed, “Baton Rouge Advocate, October
23, 2003, pp. A-1 and a-8
48
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Crumbley
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
49
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Crumbley
Find It, or I’ll Sue
Accountants must be attuned to
detecting fraud at every level of
service, including standard
accounting services, compilations,
reviews, and bank reconciliations. If
there is fraud and you don’t detect it,
you are going to be sued, and you
will likely lose, as the public
perception is the accountant is the
watchdog.
Robert J. DiPasquale, Parsippany, N.J.
Source: H.W. Wolosky, “Forensic Accounting to the Forefront,”
Practical Accountant, February 2004, pp. 23-28.
50
© D.L.
Crumbley
Forensic Accounting Knowledge Base
LAW
Criminology
Investigative
auditing
Accounting
Forensic Accountant
Silk, Silk, Silk
51
© D.L.
Crumbley
Threads of Forensic
Accounting
Forensic accounting (or at least
accounting expert witnessing)
can be traced as far back as
1817 to a court decision. [Meyer
v. Sefton]
In 1824, a young accountant by
the name of James McCleland
started business in Glasgow,
Scotland and issued a circular
that advertised various classes
of expert witness engagements
he was prepared to undertake.
In 1856 in England, the audit of
corporations became required.
52
© D.L.
Crumbley
Investigative
Accountants
Initially called investigative
accounting, many of the forensic
techniques, such as the net worth
method, were developed by IRS
agents to detect tax evaders.
Infamous mobster, Al Capone, was
caught when Special Agents of the
IRS stepped in and charged him with
tax evasion.
Accountants caused the crime czar’s
career to come to an end.
53
Al Capone Caper
© D.L.
Crumbley
“Perhaps the most celebrated case
of an accountant nailing a famous
criminal was the case of Al Capone. For
all of Capone’s colorful history of violent
crime, the FBI could never gather
enough evidence to convict him until FBI
agent Eliot Ness had an idea.
He gathered special agents of the
IRS to track the flow of cash from
Capone’s illicit activities. When the
mobster failed to pay taxes on those
earnings, the IRS nailed him for tax
evasion.
Capone went to jail and was never
a factor again. IRS recruitment posters
boast till this day: ‘Only an accountant
could catch Al Capone.’”
Source: “Book ‘Em! Forensic Accounting History and Literature,” The Kessler
Report, Vol. 1, No. 2.
54
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Crumbley
Investigative Techniques
“You know how it goes,” I said. “You get a
case. You just keep poking around, see what
scurries out.” p. 144.
-----------------------------------------------------------“How,” Susan said, “on earth are you going to
unravel all of that?”
“Same way you do therapy,” I said.
“Which is?”
“Find a thread, follow it where it leads, and
keep on doing it.”
“Sometimes it leads to another thread.”
“Often,” I said.
“And then you follow that thread.”
“Yep.”
“Like a game,” Susan said.
“For both of us,” I said.
Susan nodded. “Yes,” she said, “tracking down
of a person or an idea or an evasion.”
pp. 270 – 271.
-------------------------------------------------------------------------------Source: R.B. Parker, Widow’s Walk, Berkley Books, 2002.
55
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Crumbley
Father of Forensic
Accounting:
Maurice E. Peloubet (1946)
Pretenders:
– Max Lourie (1953)
– Robert Lindquist (1986)*
* Repeated, First sentence in N. Brennan and J.
Hennessy, Forensic Accounting, 2001, p. 5.
56
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Crumbley
The Essence of Forensic Accounting
by Maurice Peloubet (1946):
“The preparation of data for and the
appearance before government agencies as a
witness to facts, to accounting principles, or
to the application of accounting principles is
essentially forensic accounting practice rather
than advocacy.”
Modern Version
“Let’s face it, we in the forensic profession
labor in an obscure corner of the vineyard.
We are the carefully selected, trusted, highly
trained guardians of one of the last great
secrets remaining on the face of the earth - the $600 billion[now $652], more or less
annual problem nobody knows about.”
Joseph W. Koletar, Fraud Exposed, John Wiley &
Sons, Inc 2003, p. 228.
57
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Crumbley
Be like
58
Fictional Hero
© D.L.
Crumbley
“Forensic accounting is turning up more
frequently in the world of fiction, too. The
financial intrigue of fraud and the investigative
process of forensic accounting are a natural fit with
mystery of suspense novels. Add exotic locations,
colorful characters and a murder or two, and you
have all the elements of a classic thriller.
There is a selection of books featuring
forensic accountants as the heroes of their own
stories, as well. Lenny Cramer, perhaps the most
prominent of this fictional group, is the star of a
series of novels written by I.W. Collett and various
co-authors.
In one of these novels, Cramer tracks forged
receipts to uncover a plot to steal Burmese religion
treasures. Another features Cramer, while
conducting an audit at Coca-Coca, uncovering a
scheme to steal the company’s secret formula. In
yet another, Cramer uses his forensic accounting
skills to solve a series of murders in the New York
art world.”
Source: “Book ‘em! Forensic Accounting in History and Literature,”The
Kessler Report, Vol. 1, No. 2.
59
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Crumbley
Panel on Audit Effectiveness
• In 1998, the Public Oversight Board
appointed the Panel on Audit Effectiveness
to review and evaluate how independent
audits of the financial statements of public
companies are performed and to assess
whether recent trends in audit practices serve
the public interest.
• In 2000, the Panel issues a 200-page report,
Report and Recommendations, which
includes a recommendation that auditors
should perform forensic-type procedures
during every audit to enhance the prospects
of detecting material financial statement
fraud.
• Did not believe a GAAS audit should
become a fraud audit.
• In all audits the degree of audit effort in
forensic- type steps should be more than
inconsequential [p. 24].
60
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AICPA Fraud Task Force
Report
In 2003, the AICPA’s Litigation and
Dispute Resolution Services
Subcommittee issued a report of its
Fraud Task Force entitled,
“Incorporating Forensic Procedures in
an Audit Environment.”
The report covers the professional
standards that apply when forensic
procedures are employed in an audit and
explains the various means of gathering
evidence through the use of forensic
procedures and investigative techniques.
61
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Crumbley
Required Forensic Audits Coming?
• The accounting profession may be
making a strategic shift as they see that
SAS No. 99 and the other rules are not
protecting them from being the insurer of
last resort.
• The Big Four along with Grant Thornton
and BDO International recently released a
report entitled “Serving Global Capital
Markets and the Global Economy.”
• In the report, one of the things they are
suggesting is for companies to have a
forensic audit. Companies would be
required to have such an audit every five
years or face these audits on a random
basis.
“Auditing Firms Urge New Ways to Detect Fraud,” NYSSCPA.org News
Staff. Posted on November 11, 2006.
62
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Crumbley
Fraud Strategies Differ
1.
2.
3.
4.
5.
Forensic Accountants
Internal Auditors
External Auditors
Fraud Examiners
Certified Fraud Deterrence
Analysts (CFD) or CFFAs
6. Forensic CPA Society (FCPA)
63
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Crumbley
Opportunities for Forensic Accountants
FAs may provide perspective in
situations evaluating whether accounting
information is presented fairly without
GAAP – based constraints:
•
•
•
•
•
Identification of financial issues.
Knowledge of investigating techniques.
Knowledge of evidence.
Interpretation of financial information.
Presentation of finding.
Sources: G. Bologna and R. Lindquist, Fraud Auditing and Forensic Accounting,
New York City: John Wiley, 1995. F. T. DeZoort and J. D. Stanley, “Fair
Presentation in the SOX Era: An Assessment Framework and Opportunities for
Forensic Accountants,” J of FA, Vol. 7, 2006, p. 289.
64
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Crumbley
Predication
•
•
•
The ACFE group indicates that in
the private sector, a fraud
investigation should not be
conducted without proper
predication.
Examples: Anonymous tips,
complaints, audit inquires,
conflict of interest.
Thus, predication is the basis for
undertaking a fraud investigation.
65
Who Do You Call?
© D.L.
Crumbley
Detection v. Deterrence
Proactive v. Reactive
66
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Crumbley
Two Major Types of Fraud
Investigations
• Reactive: Some reason to suspect
fraud, or occurs after a significant
loss.
• Proactive: First, preventive
approach as a result of normal
operations (e.g., review of internal
controls or identify areas of fraud
exposure). There is no reason to
suspect fraud. Second, to detect
indicia of fraud.
Source: H.R. Davia, “ Fraud Specific Auditing,” Journal of
Forensic Accounting, Vol. 111, 2002, pp. 111-120
67
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Crumbley
Proactive Is Beneficial
• The threat of a future investigation reduces
the occurrence of fraudulent behavior from
75% to only 43%.
• The larger the pay-off, the more likely a
person will commit fraudulent behavior.
• Give the fox a key to the hen house and he/
she is going to eat hens.
Source: S. L. Tate et. al, “The Small Fraud Paradigm: An
Examination of Situational Factors That Influence the Non-Reporting
of Payment Errors,” J. of Forensic Accounting, Vol.7, 2006, p. 406.
68
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Crumbley
Three Classes of Controls
Preventive controls: These controls are first in line to prevent
errors, omissions, or security incidents from occurring.
Examples include controls that restrict access to systems to
authorized persons such as intrusion prevention systems and
firewalls, and integrity constraints that are embedded within a
Database Management System. Most Efficient
Detective controls: These controls detect errors or incidents
that have eluded the preventative controls. Examples include
controls that test whether authorization limits have been
exceeded, or an analysis of activity in previously dormant
accounts. Important when preventive controls weak.
Examples include situations where the transactions are derived
from third party reports such as sales reports from franchisees,
warranty claims reported by auto dealers, baggage claims
reported by passengers at airports, and reports of coupons or
rebates redeemed by redemption processors.
Corrective controls: These controls correct errors, omissions,
or incidents after detection. They vary from simple correction
of data-entry errors, to identifying and removing unauthorized
users from systems or networks. Corrective controls are the
actions taken to minimize further losses.
Sources: IIA, 2005, Global Technology Audit Guide: IT Controls,
Altamonte Springs, Fl; M. J. Nigrini, “Monitoring Techniques
Available to the Forensic Accountants,” J. of Forensic Accounting,
Vol. 7, 2006, p. 322.
69
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Crumbley
Where Fraud Prevention and Security Meet
Fraud Prevention
Sarbanes-Oxley
Compliance
Data Mining for
Fraud
Ethics Policy
Anonymous
Tip Line
Risk Assessment
Fraud Policy
Security
Background Checks
Site Security Survey
Loss Prevention Strategy
Information Security
Investigations
Interviews
Screening Tools for
External Fraud
Guards
Closed Circuit TV
Swipe Cards
Locks
Fences
Badges
Disaster Recovery
Source: M.T. Biegelman and J. T. Bartow, Executive Roadmap to Fraud
Prevention and Internal Controls, John Wiley, 2006, pp. 325-326.
70
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Crumbley
Balancing Risks and Controls
Excessive Risks
•
•
•
•
•
Loss of Assets
Poor Business Decisions
Noncompliance
Public Scandals
Increased Regulations
Excessive Controls
•
•
•
•
•
Increased Bureaucracy
Reduced Productivity
Increased Complexity
Increased Cycle Time
Increase of no-value activities
71
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Crumbley
Types of Controls
Preventive controls
• Segregation of duties
• Required approvals
• Securing assets
• Passwords
• Using document control numbers
• Drug testing
• Job rotation
• Computer backup
Detective controls
• Reconciliations
• Reviews
• Event notifications
• Surprise cash count
• Counting inventory
Corrective controls
• Training
• Process redesign
• Additional technology
• Quality circle teams
• Budget variance reports
72
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Crumbley
James Bond – Type Security
The TIAA-CREF’s Charlotte building is covered
with green faux windows and comes with security
features such as a revolving door that weighs
visitors when you go in and out, cameras that
track them throughout the building and security
badges that won’t let them leave if they stay longer
than expected.
The James Bond technology protects a financial
service entity’s most precious commodity:
cartridges containing customer data. “These are our
crown jewels.” CTO Sue Kozik said.
The data center could be guarded better only if it
was buried underground.
Source: Rick Rothacker, “Charlotte Site Has Quickly Become
the Firm’s Largest,” Charlotte Observer, December 28, 2006,
p. 2D.
73
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Crumbley
Forensic-Type Organizations
•
•
•
•
•
•
•
•
•
American College of Forensic Examiners (2750 E. Sunshine,
Springfield, MO 65804; 800-423-9737; www.acfei.com. DABFA
and Cr.FA; 2000)
Certified Fraud Examiners (Association of CFEs, The Gregor
Bldg., 716 West Avenue Austin, TX 78701; 800-245-3321;
www.cfenet.com).
Certified Insolvency and Reorganization Accountant (CIRAs).
Accountants, lawyers, consultants included in insolvency and
bankruptcy matters. 3-part exam. 4,000 hours. 541.858.1665. AIRA,
221Stewart Avenue, Suite 207, Medford, Or. 97501.
[email protected]
Forensic CPA Society (FCPA); formed in July 2005, Spokane, WA.
[email protected].
Certified Forensic Financial Analyst (NACVA, Salt Lake City,
Utah 84106; 801-486-0600). Also, Certified Fraud Deterrence
(CFD) analyst.
National Litigation Support Services Association (NLSSA, III
East Wacker Drive, Suite 990, Chicago, IL 60601; 800-869-0491).
Not-for-profit. About 20 firms. $1,825.
Canadian Institute of Chartered Accountants (CICA) – CA.IFA –
Alliance for Excellence in Investigative Accounting.
Certified Forensic Investigator (CFI) – Canada Early 1980’s.
www.homewoodave.com
Certified Fraud Specialist (CFS), not-for-profit, educational antifraud corporation located in Sacramento, Calif., for those dealing in
white-collar crime, fraud, and abuse issues. Association of Certified
Fraud Specialists. http://acfsnet.org.
74
Fraud
© D.L.
Crumbley
Some accountants believe that
ethics is a place in England.
Essex, U.K.
-----------------------------------------------------A statement made by Mark Twain about
New England weather applies to fraud
and corruption:
“It’s hard to predict, but everyone agrees
there’s plenty of it.”
----------------------------------------------As Sherlock Holmes said, “the game is
afoot.”
-------------------------------------------------------Read My Lips; It’s The Fraud, Stupid.
75
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Crumbley
Termites, Rust, and Fraud
• Just as termites never sleep, fraud never
sleeps.
• Just like termites, fraud can destroy the
foundation of an entity.
-------------------------------------------------------Like rust, fraud never sleeps.
76
Quality Staff An Issue
© D.L.
Crumbley
 Bruce Dubinsky emphasizes that although forensic
accounting is currently on the “hot” list of client
services, there are plenty of accountants getting
involved who shouldn’t be, because they don’t
understand the ins and outs of the niche. “The only
limit to our size is finding competent professionals.”
He explains that just being an accountant is no longer
enough to do this work – the person has to
understand the legal system, and what the law says.
How to interrogate and interview people are musts.
Tracking leads and obtaining legally usable
intelligence is also crucial. “Many accountants think
it is simply fraud investigation and it’s not. It really
is much more than dealing with the numbers. It’s no
longer just basic fraud work.”
 Laurie Hotz admits that there are fewer and fewer
people to do it: “It’s simply very hard to find
qualified people.” He looks for a good auditor who
has a solid background for forensic accounting. He
says there must be awareness of public fraud, and
notwithstanding some teeth being put into new
regulations, there is still plenty of fraud going on.
Stuart Kahan, “Sherlock Holmes Enters Accounting,” WebCPA,
February 11, 2007.
77
Fraud is Possible
© D.L.
Crumbley
The motto of a fraudster:
Anything is possible. The impossibility
simply takes longer.
--------------------------------------------Biggleman’s Safe – a safe builder wrote
blueprints of a unbreakable safe and
locked the blueprints inside the safe.
-----------------------------------------------Internal controls can be broken, often by
top executives.
-----------------------------------------------Just as a pitcher tries to fool batters,
financial statements may be
misleading or wrong (baseball or
cricket).
78
© D.L.
Crumbley
White-Collar Crime: Rich
People Steal
• Edwin Sutherland coined the term
“white-collar crime.” [Indiana
University sociology professor.]
• Sutherland believed that white-collar
crime is a learned behavior, a
consequence of corporate culture
where regulations are regarded as
harassment, and profit is the measure
of the man.
• “White-collar crime violates trust and
thus creates distrust, and this lowers
social morale and produces social
disorganization on a large scale.
Cynthia Crossen, “A Thirties Revelation: Rich People Who
Steal are Criminals, Too,” Wall Street Journal, October 15,
2003, p. B-1.
79
© D.L.
Crumbley
White-Collar Crime By the Advantaged
“Crime is the most flourishing and
lucrative business in America… I
speak now not only of the crime in the
streets, the burglaries and the
robberies, which represent tens of
billions of dollars each year; I speak of
the crime which we call ‘white collar’ –
the crimes committed by the
advantages, not the disadvantaged;
the crimes committed with pen and
pencil, not with gun or ‘jimmy’; under
the bright lights of the executive
offices, not by stealth in the dark.”
Herbert Stern, from his discussion of prosecutorial philosophy in
the 1973 book Tiger in the Court, by Paul Hoffman.
80
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Crumbley
Tyco Prosecutor’s Closing
Argument
“Remember, these are two very,
very smart men; they are not charged
with being stupid men,” she said of
Mr. Kozlowski and Mr. Swartz. “These
crimes have an element of
sophistication so you can be sure that
when they were committing them they
built in an element of deniability.” She
added: “Every good scheme has it.
That is how white-collar criminals
work.”
• Mistrial on April 2, 2004.
Source: A.R. Sorkin, “Talk of Greed and Beyond at Tyco Trial,” N.Y.
Times, March 17, 2004, p. C-1.
81
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Crumbley
Michael Comer’s Types of Fraud
1. Corruptions (e.g., kickbacks).
2. Conflicts of interest (e.g., drug/alcohol
abuse, part-time work).
3. Theft of assets.
4. False reporting or falsifying
performance (e.g., false accounts,
manipulating financial results).
5. Technological abuse (e.g., computer
related fraud, unauthorized Internet
browsing).
Comer’s Rule: Fraud can happen to
anyone at anytime.
Source: M.J. Comer, Investigating Corporate Fraud,
Burlington, Vt.: Gower Publishing Co., 2003, pp. 4-5.
82
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Crumbley
How Corruption Occurs
Category
Conflicts of Interest
Bribery
Illegal Gratuities
Extortion
%
61.6%
42.7%
29.8%
16.9%
Source: 2006 Wells Report, ACFE.
83
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Crumbley
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.
84
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Crumbley
Starwoods Hotels Poll of Executives
Starwoods Hotels interviewed 401 top
executives who golf. The results are
surprising.
Consider themselves to be honest in
business
Played with someone who cheats at golf
Cheated themselves at golf
Hated others who cheated at golf
Believe that business and golf behaviors
are parallel
99%
87%
82%
82%
72%
Source: Del Jones, “Many CEOs Bend The Rules (of Golf),” USA
Today, June 26, 2002, p. A-1.
85
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Crumbley
The Cost of Fraud
 Organizations lose 5 percent of
annual revenue to fraud and
abuse.
 Fraud and abuse costs U.S.
organizations more than $652
billion annually (about $4,500
per employee).
 The average organization loses
more than $12 a day per
employee due to fraud and abuse.
Source: 2006 Wells Report
86
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Crumbley
The Trillion Dollar Gorilla
(in Billions)
U.S. Business1
$256.32
Federal Government2
239.75
State Government3
354.21
Tax-exempts4
134.5
Local Government5
Annual Fraud (trillion)
68.4
$ 1.053
1. 2002 Statistics of Income, $1,281.6 trillion time 20%.
2. $2.3975 trillion budget times 10%
3. $3,542.1 million times 10%
4. $897 billion in revenue times 15%.
5. $684.6 billion times 10%.
87
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Crumbley
Fraud Multiplier
Employee Fraud = $ for $ reduction in net
income
Suppose $100,000 bottom line reduction.
Suppose 20% profit margin
How much new revenue needed to offset the
lost income?
$100,000 = $500,000
20%
So ACFE says $652 billion lost per year (2006).
$652 billion = $3.26 trillion needed revenue
20%.
----------------------------------------------------The FBI estimates that white collar crime is
$300 billion each year in the U.S.
88
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Crumbley
The Cost of Fraud (cont.)
 Over 90% of occupational frauds
involve asset misappropriations.
 Average length of a fraud scheme is
15 to 24 months.
 Most common way of detecting
occupational fraud is by tips from
employees, customers, vendors, or
anonymous sources.
 Second way, by accident.
 Third most common detection:
internal audit (2nd in 2004).
 The most targeted asset is cash.
Source: 2006 Wells Report
89
© 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.
90
© D.L.
Crumbley
Ernst & Young 2002 Survey
• More than 20 percent of the respondents were aware
of fraud in their workplace.
• Nearly 80 percent would be willing to turn in a
colleague thought to be committing a fraudulent act.
• Employers lose a staggering 20 percent of every
dollar earned to some type of workplace fraud.
• More frequently committed frauds are theft of office
items, claiming extra hours worked, inflating expense
accounts, and taking kickbacks from suppliers.
• Women are more likely than men to report
fraudulent activities.
• Older employees were more likely to report
fraudulent activities than younger employees.
Ernst & Young. “American Works: Employers Lose 20 Percent of Every
Dollar to Work Place Fraud.” (2002) Available at
http://www.ey.com/global/Content.nsf/US/Media_Release_-_08-05-02DC
91
© D.L.
Crumbley
Put Fraud In Perspective
The Iraq War may cost as much as
$200 billion. Since fraud and abuse reduce
the bottom lines of businesses as much as
$660 billion per year (assuming a tax rate
of 30%), the federal government loses in
taxes each year $198 billion.
So in less than 13 months, stopping
fraud and abuse would pay for the Iraqi
war.
92
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Crumbley
Advantage of Compliance
Spending
General Counsel Roundtable
says that each $1 of compliance
spending saves organizations, on the
average, $5.21 in heightened
avoidance of legal liabilities, harm to
the organization’s reputation, and lost
productivity.
Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April
2004, p. 47.
93
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Crumbley
Comparison of Selected Fraud Surveys
KPMG
PwC
ACFE
Questionnaire
Interview
Questionnaire
2005-2006
2005
2006
4,056 (6,797)
3,634
1,134 (11,112)
59.7%
Unknown
10.2%
Not given
$1.7 million per company
$652 billion (revenue)
74% reporting misconduct
45% tangible fraud
Unclear (100%)
Public sector
Retail/ Consumers
Banking/ Financial Services
Second highest fraud industry
Global Manufacturers
Financial Services
Government
Top – Fraud detection – Tips
Not given
28%
34.2%
Fraud detection – Internal audits
Not given
26%
20.2%
Fraud detection – by accident
Not given
6%
25.4%
Some recover of fraud
Not given
47%
57.9%
Gender to perps - male
Not given
87%
61%
Likely age
Not given
31-40 (38%)
41-50 (34.6%)
Fraud by senior mgt.
Not given
24%
20.9%
Fraud by Accounting dept.
Not given
Not given
30.3%
Fraud with undergraduate degree
Not given
52%
45.6%
Best control measure
External audits
Hotlines/ surprise audit
Second best control measure
Internal audits
Internal audit
Type
Time Period
Number of participants (population)
Response
Estimated fraud in U.S.
% of companies experiencing fraud
Highest fraud industry
94
Scienter Necessary
© D.L.
Crumbley
• To prove any type of fraud, prosecutors
must show that scienter was present.
• That is, the fraudster must have known
that his or her actions were intended to
deceive.
------------------------------------------------The allure of numbers to most of us, is
like the excitement of settling sand--a
narcoleptic surety. Crafty criminals
prey on this boredom. They pile on
the numbers, spewing meaningless
records in the false books.
Cory Johnson
95
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.
96
© D.L.
Crumbley
How Fraud Occurs
Source: KPMG Fraud Study
97
© D.L.
Crumbley
Types of Fraud
Source: KPMG Fraud Study
98
© D.L.
Crumbley
Certain Fraud is Increasing
Source: KPMG Fraud Study
99
© D.L.
Crumbley
Occupational Fraud Re Industry
Median Loss
($)
Banking/ Financial Services
14.3%
258,000
Government/ Public Administration
11.5%
82,000
Manufacturing
9.7%
413,000
HealthCare
8.6%
160,000
Insurance
7.5%
100,000
Retail
7.2%
80,000
Education
7.0%
100,000
Service (General)
5.8%
163,000
Service (Professional, etc.)
5.6%
300,000
Construction
3.4%
500,000
Utilities
3.3%
124,000
Oil/ Gas
3.1%
154,000
Real Estate
2.9%
200,000
Wholesale trade
2.9%
1,000,000
Mining
.01%
17,000,000
Source: 2006 Wells Report, ACFE.
100
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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.
101
© D.L.
Crumbley
COSO’s Major Motives for Fraud
1. Cover up assets misappropriated for
personal gain.
2. Increase the stock price to increase the
benefits of insider traders and to
receive higher cash proceeds when
issuing new securities.
3. Obtain national stock exchange listing
status or maintain minimum exchange
listing requirements to avoid de-listing.
4. Avoiding a pretax loss and bolstering
other financial results.
102
COSO Survey (1999)
© D.L.
Crumbley
• Financial pressures were important contributory
factors for the commitment of financial statement
fraud (FSF).
• Top executives (e.g., CEOs, CFOs) were commonly
involved in FSF.
• The majority of alleged FSF were committed by
small companies.
• Board of directors and audit committees of the fraud
companies were weak and ineffective.
• Adverse consequences for fraud companies were
bankruptcy, significant changes in ownership, and
delisting by national stock exchanges.
• Cumulative amounts of FSF were relatively
significant and large.
• More than half of the alleged FSF involved
overstatement of revenues.
• Most FSF were not isolated to a single fiscal period.
• Fifty-five percent of the audit reports issued in the
last year of the fraud period contained unqualified
opinions.
•The majority of the sample fraud companies (56
percent) were audited by Big Eight/Big Five auditing
103
firms.
© D.L.
Crumbley
Business Fraud Survey (1999)
1. Nearly 15 percent reported management
misappropriation as the greatest fraud risk to their
organization.
2. Sixty percent of the respondent reported their
department’s fraud risk analysis process as being
reactive in nature.
3. The majority of respondents (72 percent) reported
that their organization did not have fraud detection
and deterrence programs in place.
4. The majority of respondents (68 percent) reported
that they never felt pressured to compromise the
adherence to their organization’s standard of
ethical conduct.
5. The majority of the respondents reported their
organization’s external auditors as being
ineffective in preventing and detecting fraud.
6. The majority of the respondents believed that more
budgets should be devoted to fraud-related
activities and training in department.
The Institute of Management and Administration (IOMA) and the Institute of Internal
Auditors(IIA). “Business Fraud Survey.” (1999). Available at http://www.theiia.org104
One Piece at a Time
© D.L.
Crumbley
Johnny Cash (1976)
105
One Piece At A Time
© D.L.
Crumbley
Well, I left Kentucky back in '49
An' went to Detroit workin' on a 'sembly line
The first year they had me puttin' wheels on cadillacs
Every day I'd watch them beauties roll by
And sometimes I'd hang my head and cry
'Cause I always wanted me one that was long and black.
One day I devised myself a plan
That should be the envy of most any man
I'd sneak it out of there in a lunchbox in my hand
Now gettin' caught meant gettin' fired
But I figured I'd have it all by the time I retired
I'd have me a car worth at least a hundred grand.
CHORUS
I'd get it one piece at a time
And it wouldn't cost me a dime
You'll know it's me when I come through your town
I'm gonna ride around in style
I'm gonna drive everybody wild
'Cause I'll have the only one there is a round.
So the very next day when I punched in
With my big lunchbox and with help from my friends
I left that day with a lunch box full of gears
Now, I never considered myself a thief
GM wouldn't miss just one little piece
Especially if I strung it out over several years.
106
One Piece At A Time
© D.L.
Crumbley
The first day I got me a fuel pump
And the next day I got me an engine and a trunk
Then I got me a transmission and all of the chrome
The little things I could get in my big lunchbox
Like nuts, an' bolts, and all four shocks
But the big stuff we snuck out in my buddy's mobile home.
Now, up to now my plan went all right
'Til we tried to put it all together one night
And that's when we noticed that something was definitely
wrong.
The transmission was a '53
And the motor turned out to be a '73
And when we tried to put in the bolts all the holes were gone.
So we drilled it out so that it would fit
And with a little bit of help with an A-daptor kit
We had that engine runnin' just like a song
Now the headlight' was another sight
We had two on the left and one on the right
But when we pulled out the switch all three of 'em come on.
The back end looked kinda funny too
But we put it together and when we got thru
Well, that's when we noticed that we only had one tail-fin
About that time my wife walked out
And I could see in her eyes that she had her doubts
But she opened the door and said "Honey, take me for a spin."
.
107
One Piece At A Time
© D.L.
Crumbley
So we drove up town just to get the tags
And I headed her right on down main drag
I could hear everybody laughin' for blocks around
But up there at the court house they didn't laugh
'Cause to type it up it took the whole staff
And when they got through the title weighed sixty pounds
CHORUS
I got it one piece at a time
And it didn't cost me a dime
You'll know it's me when I come through your town
I'm gonna ride around in style
I'm gonna drive everybody wild
'Cause I'll have the only one there is around.
(Spoken) Ugh! Yow, RED RYDER
This is the COTTON MOUTH
In the PSYCHO-BILLY CADILLAC Come on
Huh, This is the COTTON MOUTH
And negatory on the cost of this mow-chine there RED RYDER
You might say I went right up to the factory
And picked it up, it's cheaper that way
Ugh!, what model is it?
Well, It's a '49, '50, '51, '52, '53, '54, '55, '56
'57, '58' 59' automobile
It's a '60, '61, '62, '63, '64, '65, '66, '67
'68, '69, '70 automobile.
108
Missing Fraud
© D.L.
Crumbley
Auditors will continue to miss fraud because
much of their work is predicted on the
assumption that separation of duties
prevents fraud (i.e., one person hold the
money and another person keeps track of it).
The Equity Funding case shakes the
foundations of auditing in that so much is based
on the assumption that people don’t collude
very long. These people work together as an
efficient team for a very long time [9 years].
Lee Seidler
------------------------------------------“When the sun goes down, then the sneaks will
play at night.”
From Porter Wagoner “Sneaks Crawl at Night.”
109
The Perpetrators
© D.L.
Crumbley
 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
110
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).
111
© 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
112
© D.L.
Crumbley
Insights on cheaters and deceivers:










People who have experienced failure are
more likely to cheat.
People who are disliked and who dislike
themselves tend to be more deceitful.
People who are impulsive, distractible, and
unable to postpone gratification are more
likely to engage in deceitful crimes.
People who have a conscience (fear,
apprehension, and punishment) are more
resistant to the temptation to deceive.
Intelligent people tend to be more honest
than ignorant people.
Middle- and upper-class people tend to be
more honest than lower-class people.
The easier it is to cheat and steal, the more
people will do so.
Individuals have different needs and
therefore different levels at which they will
be moved to lie, cheat or steal.
Lying, cheating, and stealing increase when
people have great pressure to achieve
important objectives.
The struggle to survive generates deceit.
Source: Gwynn Nettler, Lying, Cheating, and Stealing,
Cincinnati, Ohio: Anderson, 1982.
113
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
114
© D.L.
Crumbley
“Finding fraud is like trying to load frogs on to a
wheelbarrow.”
Larry Crumbley
It’s easy to fall in love;
It’s easy to commit fraud;
It’s hard to catch the fraud.
115
© 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.
116
© D.L.
Crumbley
How Fraud Is Detected
1. Tips
2. By accident
3. Internal audit
2006
34.2%
25.4%
20.2%
2004
39.6%
21.3%
23.8%
4. Internal controls
5. External audits
19.2%
12.0%
18.4%
10.9%
3.8%
0.9%
6. Notification by police
Source: 2006/ 2004 Wells Reports, ACFE.
A British publication suggests that prosecutors think that
accountants have x-ray vision. “It is assumed that if an
accountant stares really hard at a set of accounts, then
somehow, magically, information will appear before his/ her
eyes that are invisible to lesser mortals.”
NIFA News, Number 10, p.1.
117
© D.L.
Crumbley
Sources of Tips
1. Employees
2. Anonymous
3. Customers
4. Vendors
64.1%
18.1%
10.7%
7.1%
Source: 2006 Wells Report, ACFE.
118
© D.L.
Crumbley
Tips Are Important
Some of the biggest recent accounting
scandals (e.g., HealthSouth, Xerox, Waste
Management) involve situations where the
auditors were tipped off or otherwise alerted
to possible frauds but they failed to
investigate them deeply enough.
In her book Power Failure, Sherron
Watkins says she talked to Jim Hecker, at
Arthur Andersen, on the phone about the
dangers of the Raptors and Fastow’s inherent
conflict. Hecker wrote a memo to the files
and forwarded copies to David Duncan and
Enron’s audit partner, Debra Cash. His note:
“Here is my draft memo, for your review,
for ‘smoking guns’ that you can not
extinguish.” p. 285.
119
© D.L.
Crumbley
Finding Fraud In The Midst of a Conspiracy
When speaking about the fraud of HealthSouth, a
spokesman for Ernst & Young emphasized the
difficulty of detecting accounting fraud in the
midst of a conspiracy of senior executives and
false documentation.
An accountant testified that HealthSouth employees
would move expenses of $500 to $4,999 from the
income statement to the balance sheet throughout
the year. Overall the SEC said about $1 billion in
fixed assets were falsely entered. The employees
moved only those expenses less than $5,000,
because Ernst & Young automatically looked at
those expenses over $5,000.
An ex-bookkeeper even sent Ernst & Young an email flagging one area of the fraud, but E & Y still
did not catch it. Employees actually produced false
invoices when the accounting firm asked for backup.
Source: Charles Mollenkamp, “Accountant Tried in Vain to Expose
HealthSouth Fraud,” Wall Street Journal, May 20, 2003, pp. A-1 and
A-13.
120
Quotes
© D.L.
Crumbley
You should attack fraud problems
the way the fictional Sherlock
Holmes approached murder cases
D. Larry Crumbley
--------------------------------------------
To be a good fraud auditor, you have
to be a good detective.
Source: Robert J. Lindquist
-------------------------------------------------------
Many lap-dog internal and external
auditors need to be replaced with
junkyard dogs.
D. Larry Crumbley
121
Difficult Task
© D.L.
Crumbley
More forensic techniques should become
a part of both external and internal auditing.
But Stephen Seliskar says that “in terms of
the sheer labor, the magnitude of effort, time
and expense required to do a single, very
focused [forensic] investigation -- as
contrasted to auditing a set of the financial
statements -- the difference is incredible.” It
is physically impossible to conduct a generic
fraud investigation of an entire business.
Source: Eric Krell, “Will Forensic Accounting Go
Mainstream?” Business Finance Journal, October 2002, pp. 3034.
www.investigation.com/artilces/library/2002Articles/15.htm.
122
© D.L.
Crumbley
Stealth
Once a forensic accountant [e.g., Cr.FA,
CFE, CFFA] is engaged, Michael Kessler
says that they should not be disruptive.
Most employees are not aware that an
investigation is taking place. We go in as just
another set of auditors, favoring a Columboesque investigative style. “We don’t wear
special windbreakers that say ‘forensic
accountant.’”
Source: Eric Krell, “Will Forensic Accounting Go
Mainstream?” Business Finance Journal, October 2002, pp. 3034. www.investigation.com/articles/library/2002Articles/15.htm
123
© D.L.
Crumbley
Kessler Survey (2001)
• About 13% of employees are
fundamentally dishonest.
• Employees out-steal shoplifters.
• About 21% of employees are honest.
• But 66% are encouraged to steal if
they see others doing it without
repercussion.
Source: “Studies Show 13% of employees are fundamentally dishonest,”
KesslerNews, November 1, 2001,
www.investigation.com/articles/library/2001articles.
---------------------------------------------------------------------------------------
• 30% of people in U.S. are dishonest.
• 30% situational dishonest.
• 40% are honest all of the time.
Source: R.C. Hollinger, Dishonesty in the Workplace, Park Rider, N.Y.:
London House Press, 1989, pp. 1-5.
124
© D.L.
Crumbley
Little Has Changed: CFO Survey
• Nearly half of CFOs – 47 percent – report
they still feel pressure from their superiors to
use aggressive accounting to make results
look better.
• What is worrisome is that the pressure to
make the numbers hasn’t abated much. Of
these who have felt pressure in the past, only
38 percent think there is less pressure today
than there was three years ago, and 20
percent say there is more.
• Few finance executives have much
confidence in the numbers their colleagues
are reporting. Only 27 percent say that if they
were investing their own money, they would
feel “very confident” about the quality and
completeness of information available about
public companies.
Source: Don Durfee, “It’s Better (and Worse) Than You Think,” CFO Magazine, May 3, 2004.
125
© D.L.
Crumbley
Some Infamous Financial Statement Frauds

Tyco
•
•
•
•
•
•
•

Large interest-free loans to officers; then forgiven ($87.1 million).
Unauthorized bonuses (no approval of BOD).
Fake documents showing no loans outstanding.
SEC found that PwC had prior knowledge of fraud back to 1998.
Undisclosed real estate transaction with related parties.
False entries in books to cover-up bribes given to foreign officials.
If numbers did not meet expectations, Richard Scrushy told
employees to “fix them.”
Adelphia [Greek for brothers]
• Moved debt to subsidiaries which were not consolidated.
• Personal loans to the Rigas family (self-dealing).
• Falsified operations statistics and inflated earnings.

Xerox
• Accelerated revenues from leasing equipment.
• Cookie jar reserves.

Sunbeam
•
•
•
•
Cookie-jar restructuring reserves.
Channel stuffing.
Guaranteed sales.
Improper bill and hold.
126
© D.L.
Crumbley
Some Infamous Financial Statement Frauds

Waste Management
• Reduced depreciation expense by inflating salvage value and
extending useful lives.
• No write-offs for unsuccessful land projects.
• Improperly capitalized a number of expenses.
• Made top drawer adjustments.

HPL Technologies (2001-2002)
• Created many fake purchase orders from Canon sales (a Japanese
distributor). Printed and pasted Canon signatures on the
documents.
• Altered bank records to create millions of dollars in nonexistence
customer payments.
• Borrowed millions from his brokerage account (secured by HPL
stock) and channeled the funds into the company in the form of
payments.

Baptist Foundation of Arizona
• Set up subsidiaries owned by insiders to buy real estate (which had
crashed in value) from BFA.
• BFA then recorded notes receivables in the amount of the book
values.
• Ran a ponzi scheme using new investors’ money to pay old
investors high returns.
• Refused to give Arthur Anderson financial statements of the
subsidiaries.
127
© D.L.
Crumbley
D.R. Cressey’s Fraud Pyramid
Don’t think you’re the only ones
Who bend it, break it, stretch it some.
We learn from you.
Girls lie, too
Terri Clark
128
© D.L.
Crumbley
SAS No. 99 Characteristics of Fraud
Incentives / pressures
Attitude /
Rationalization
Opportunity
129
© D.L.
Crumbley
Everyone Has A Price?
President Abraham Lincoln is supposed to have thrown a man
out of his office after being offered a bribe. The bribe involved
a substantial sum, and Lincoln was very angry. His anger was
directed at the man in question, but also at himself. He is reputed
to have said, “Every man has his price, and he was getting too
close to mine.”*
The “price” where a person will act dishonestly (e.g., steal, cook
the books) varies from person to person.
What is your price?
In a scene from the movie, The Family Man, an angel stands
behind the counter of a convenience store and takes a $1 bill
from a young woman who is purchasing a $0.99 beverage. The
angel counts out change for $10 and hands the overpayment to
the woman. The customer stares blankly at the clerk, takes the
money and the beverage, and leaves. The angel is left to lament
the lack of ethical behavior for just $9. “Character, and for
what, $9; that is so disappointing”.**
* From a speech by Lynn Turner, former chief accountant of U.S. Securities and
Exchange Commission, given at the 39th Annual Corporate Counsel Institute,
Northwestern University School of Law, October 12, 2000.
** MCA Home Video 2000.
130
Fraud Pyramid



© D.L.
Crumbley
Motive
 Excessive spending to keep up appearances of
wealth.
 Other, outside business financial strains.
 An illicit romantic relationship.
 Alcohol, drug or gambling abuse problems.
Opportunity
 Lack of internal controls.
 Perception of detection = proactive
preventative measure.
Rationalization (reduces offender’s inhibitions)
 “Borrowing” money temporarily.
 Justifying the theft out of a sense of being
underpaid.(“I was only taking what was
mine”)
 Depersonalizing the victim of the theft. (I
wasn’t stealing from my boss; I was stealing
from the company.”)
131
Psychology of Fraud

© D.L.
Crumbley
Fraud can be explained by three factors:
• Supply of motivated offenders.
• Availability of suitable targets.
• Absence of capable guardians (e.g., internal
controls).

The three B’s -- babes, booze, and bets.

Some fraudsters wish to make fools of their
victims. They take delight in the act itself.

Risk of fraud is a product of both
personality and environmental (or
situational) variables.
Grace Duffield and Peter Grabosky, “The Psychology of Fraud,” Australian
Institute of Criminology, No. 19.
132
© D.L.
Crumbley
The Fraud Diamond
Incentive/ Pressures
Capacity
Opportunity
Rationalization/ Integrity
Capacity: Necessary traits; abilities; can pull it off;
positional authority
D.T. Wolfe and D.R. Hermanson, “The Fraud Diamond: Considering
The Four Elements of Fraud,” The CPA J., December, 2004, pp. 3842.
133
Greed
© D.L.
Crumbley
“I don’t see many ways to eliminate
greed; it is an inherent part of the
human character. So antifraud
measures must be aimed at
educating people on the risks and the
type of technical controls that they
can implement.”
Alan Oliphant
Source: David G. Banks, “The Fight Against Fraud,” Internal Auditor,
April 2004, pp. 36-37.
------------------------------------------------“It was definitely the perfect fraud……..
unfortunately they hired the perfect
investigator.”
Cartoon in M.J. Comer’s book
134
© D.L.
Crumbley
Example of Greed (or Incentive)
• Three Duke Energy employees were charged
in April 2004 for allegedly ginning up “phony
electricity and material-gas trades to boost
trading volumes” and inflating “profits in a
trading book that was the basis of their annual
profits.”
• “The trading schemes are alleged to have
inflated their bonuses by at least $7 million”
between March 2001 and May 2002. There
were 400 rigged trades that produced a $50
million profit in the trade books.
• Duke used mark-to-market accounting to
record profit and loss contracts that might not
be settled for years.
• So called “round-trips trades (or wash sales)
were used to jack up reported trading volumes.
Source: Rebecca Smith, “Former Employees of Duke Charged Over Wash
Trades,” WSJ, April 22, 2004, p. A-15.
135
© 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
136
© 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.
137
© 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.
138
© 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.
139
© 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.
140
© D.L.
Crumbley
Importing Sarbanes-Oxley?
 One-size-fits-all approach.
 Resulted in a loss of foreign listings on
U.S. exchanges.
 U.S. exchanges seek to acquire foreign
exchanges.
 Market consolidations may impose U.S.
regulatory standards across national
boundaries.
 Foreign companies listed on U.S.
exchanges are subject to SOX.
 Once 500 Americans hold shares in a
foreign-listed company, if separate
platforms not maintained, subject to U.S.
laws and rules (including SOX).
Harvey Pitt, “Sarbanes-Oxley Is An Unhealthy Export,”
Financial Times, June 21, 2006, p.15.
141
© D.L.
Crumbley
Sarbanes-Oxley Act (7-30-2002)
• Most significant change since 1934
Securities Exchange Act
• New five-member Public Company
Accounting Oversight Board (PCAOB)
• Authority to set and enforce auditing,
attestation, quality control and ethics
(including independencies) standards for
auditors of public companies.
• Empowered to inspect the auditing
operations of public accounting firms that
audit public companies as well as impose
disciplinary and remedial sanctions for
violations of the board’s rules, securities
laws and professional auditing and
accounting standards.
• Rotation of lead and concurring audit
partners every five years (5 year time-out
period).
142
© D.L.
Crumbley
Sarbanes-Oxley Act (7-30-2002)
• Eight types of services outlawed:
+Bookkeeping.
+Information systems design and
implementation
+Appraisals or valuation services, fairness
opinions, or contribution-in-kind-reports.
+Actuarial services
+Internal audit outsourcing
+ Management and human resources services
+ Broker/dealer, investment adviser, and
investment banking services
+ Legal or expert services related to audit
services
• Applies to foreign accounting firms filing
with SEC after July 15, 2006.
• http://www.pcaob.us, to get free
subscription to PCAOB Update.
143
© 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 service commences).
• Auditor must report to the audit committee on a timely
basis.
• Cooling off period of one year before a member of the
audit engagement team can begin working for the
registrant in certain positions.
• There is no requirement to rotate the auditors.
• There is discussion of requiring a forensic audit
irregularly. Harvey Pitt suggested this proposal.
144
Sarbanes-Oxley (contd.)
© D.L.
Crumbley
• Many of the Sarbanes-Oxley’s provisions became
effective July 30, 2002.
• www.tnwinc.com
• Thus, the SEC will control the auditing 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.
145
© D.L.
Crumbley
Sarbanes-Oxley Act Creates Need For
Forensic Accounting
1. To assist corporations in their quest to
ensure compliance with the mandates
of S-O.
2. Public accounting firms must introduce
forensic techniques into audits, and
they may request help from forensic
experts.
------------------------------------------------Robbers do not need guns. Pencil and
paper will do. Opportunity and greed
are thievery’s driving forces. Put
enough zeroes behind a number, and
it’s amazing how flexible morals
become. How many years in prison
would you do to accumulate a half a
billion dollars in your bank account?
John H. Bolt
146
© D.L.
Crumbley
Section 404-Sarbanes-Oxley
• Beginning June 2004, large
companies must have in place
tight internal controls, assess the
effectiveness of these controls
annually (and issue a report of
their effectiveness), and pay for
an independent assessment by
external auditors.
• Need an internal control
framework (e.g., COSO or
similar).
• Companies are paying steep fees
to fund the PCAOB.
• Audit fees have increased by as
much as 30% since S/O.
147
Source: Financial Executive Institute
© D.L.
Crumbley
FEI’s Costs of Compliance
Revenue
First-Year Costs
First-Year Hours
Less than $25 million
$.28 million
1,996
$25 to $99 million
$.74 million
3,080
$100 to $499 million
$.78 million
5,118
$500 to $999 million
$1.04 million
6,950
$1 to $4.9 billion
$1.83 million
13,355
Over 5 billion
$4.67 million
41,201
Source: Financial Executive Institute
• Audit fees have increased about 50%.
• First year spending around $10 billion. Steve
Watkins, “For Some, SOX Is No Hassle at All,”
IBD, January 14, 2005, p. A6.
• About $100,000 each year for insuring Board
members.
148
© D.L.
Crumbley
Six-Legged Table of Financial Statements
External Auditors
Audit Committee
Top
Board of Directors
Management
Internal
PCAOB and SEC
External
Auditor
Auditors
In a baseball analogy, think of the pitcher as
the auditee, the catcher as the internal auditor,
the manager as top management, the
scorekeeper as the external auditor, and the
umpire would be PCAOB (SEC). The
scoreboard could be the general ledger.
The Big “R”
149
© D.L.
Crumbley
Parallel Universe: Two Opinions
External auditors must do a regular
audit of a company (e.g., financial
statements are fairly stated) and must also
audit the internal controls that are to ensure
that the financial statements are accurate
(e.g., issue two opinions).
Prior to the external auditors’ arrival, the
company itself must review its internal
controls and issue a report on the
effectiveness of these controls.
There will be two external opinions: on
management’s assessment of the internal
controls over financial reporting and another
one on the effectiveness of the internal
controls themselves (e.g., statements are
fairly stated).
PCAOB Release 2004-001.
150
© D.L.
Crumbley
Anti-Fraud Strategy
•
•
•
•
•
The company’s stance on fraud
and other breaches of the
ethical code.
What will be done and by
whom in the case that frauds
or other breaches are
suspected.
The key initiatives which the
company proposes;
Who will lead these initiatives.
Clear deadlines and measures
for monitoring effectiveness of
implementation.
Source: David Davies, Fraud Watch, 2nd Edition., London, ABG
Professional Information, 2000, p. 77.
151
© D.L.
Crumbley
Anti-Fraud Program
An auditor must perform
“company-wide anti-fraud programs and
controls and work related to other
controls that have a pervasive effect on
the company, such as general controls
over the company’s electronic data
processing.”
Further, the auditor must “obtain
directly the ‘principal evidence’ about the
effectiveness of internal controls.”
PCAOB endorses the COSO
Cube [pp. 24-26 and A-25 and A-26]
Source: PCAOB Release 2004-001.
152
Several Strategies
© D.L.
Crumbley
1. Establishment of responsible corporate
governance, a vigilant board of directors and audit
committees, diligent management, and adequate
and effective internal audit functions.
2. Utilization of an alert, skeptical external audit
function, responsible legal counsel, adequate and
effective internal control structure, and external
regulatory procedures.
3. Implementation of appropriate corporate
strategies for correction of the committed financial
statement fraud, elimination of the probability of its
future occurrences, and restoration of confidence in
the financial reporting process.
-------------------------------------------------------------Financial statement fraud occurs when one or a
combination of these strategies are relaxed due to
self-interest, lack of due diligence, pressure, overreliance, or lack of dedication.
Source: Crumbley, Razaee, Ziegenfuss, U.S. Master Auditing Guide,
Chicago, CCH, pp. 689-690.
153
© D.L.
Crumbley
Frameworks Being Used by CFOs
• COSO
82%
• Auditing Standard No. 2
28%
• COBIT (Control/ Objectives
for Inf./ Related Technology)
33%
• SAS 55/78 (AICPA)
13%
• Others
2%
Source: Helen Shaw, “The Trouble with COSO,” CFO,
March 2006, p.75.
154
© D.L.
Crumbley
COSO CUBE
(5 components of internal controls)
155
© D.L.
Crumbley
HIERARCHY OF
INTERNAL CONTROL
NEEDS
156
The COSO Model
1.
2.
3.
4.
5.
© D.L.
Crumbley
Control environment – management’s
attitude toward controls, or the “tone at the
top.”
Risk assessment – management’s
assessment of the factors that could prevent
the organization from meeting its objectives.
Control activities – specific policies and
procedures that provide a reasonable
assurance that the organization will meet its
objectives. The control activities should
address the risks identified by management
in its risk assessment.
Information and communication – system
that allows management to evaluate progress
toward meeting the organization’s objectives.
Monitoring – continuous monitoring of the
internal control process with appropriate
modification made as deemed necessary.
www.erm.cosous.org
157
© D.L.
Crumbley
COSO New Cube: Enterprise Risk
Management
Source: erm.coso.org. See Apostolou and Crumbley, “ Sarbanes-Oxley Fall-out
Leads to Auditing Standards No. 2: Importance of Internal Controls,” The Value
158
Examiner, November/December 2004, pp. 55-60.
© D.L.
Crumbley
Management Control Philosophy
Fraudulent Financial Reporting more
likely to occur if
• Firm has a poor management control philosophy.
• Weak control structures.
• Strong motive for engaging in financial statement
fraud.
Poor management philosophy:
• Large numbers of related party transactions.
• Continuing presence of the firm’s founder.
• Absence of a long-term institutional investor.
Source: Paul Dunn “Aspect of Management Control Philosophy that
contributes to fraudulent Financial Reporting,” Journal of Forensic
Accounting, Vol. IV (2003), pp. 35-60
159
© D.L.
Crumbley
CONTROL
ACTIVITIES
• Segregation of Accounting Duties
– Effective segregation of accounting duties
is achieved when the following functions
are separated:
• Authorization—approving transactions and
decisions.
• Recording—Preparing source documents;
maintaining journals, ledgers, or other files;
preparing reconciliations; and preparing
performance reports.
• Custody—Handling cash, maintaining an
inventory storeroom, receiving incoming
customer checks, writing checks on the
organization’s bank account.
– If any two of the preceding functions are
the responsibility of one person, then
problems can arise.
Source: Accounting Information Systems, 10e Romney/Steinbart, PH
160
© D.L.
Crumbley
CONTROL
ACTIVITIES
RECORDING
CUSTODIAL
•
•
•
•
•
•
FUNCTIONS
Handling cash
Handling inventories,
tools, or fixed assets
Writing checks
Receiving checks in
mail
•
•
•
•
FUNCTIONS
Preparing source
documents
Maintaining journals,
ledgers, or other files
Preparing
reconciliations
Preparing
performance reports
EXAMPLE OF PROBLEM: A person who has custody of cash
AUTHORIZATIO
receipts and the recording
for those receipts can steal some of the
N the theft.
cash and falsify accounts to conceal
FUNCTIONS
SOLUTION: The pink fence
(segregation of custody and
• Authorization
recording) prevents employees
from falsifying records to conceal
transactions
theft of assets entrusted toofthem.
Source: Accounting Information Systems, 10e Romney/Steinbart, PH
161
•
© D.L.
EXAMPLE OF
PROBLEM:Crumbley
A person
who has custody of
checks for transactions
that he has authorized
can authorize fictitious
transactions and then
steal the payments.
RECORDING
SOLUTION:
The
FUNCTIONS
green fence
Preparing source
(segregation of custody
documents
and authorization)
Maintaining
journals,
prevents
employees
ledgers,
or other files
from
authorizing
Preparing
fictitious
or inaccurate
reconciliations
transactions
as a
means
of concealing a
Preparing
theft.
performance reports
CONTROL
ACTIVITIES
CUSTODIAL
•
•
•
•
FUNCTIONS
Handling cash
Handling inventories,
tools, or fixed assets
Writing checks
Receiving checks in
mail
•
•
•
•
•
AUTHORIZATION
FUNCTIONS
• Authorization of
transactions
Source: Accounting Information Systems, 10e Romney/ Steinbart, PH
162
•
© D.L.
EXAMPLE OF
Crumbley
PROBLEM: A person
who can authorize a
transaction and keep
records related to the
transactions can
authorize and record
fictitious payments
RECORDING
CUSTODIAL
that might,
for
FUNCTIONS
FUNCTIONS
example,
be sent to the
• Preparing source
•employee’s
Handlinghome
cash
documents
or the
address
•address
Handling
inventories,
• Maintaining journals,
of atools,
shellor
company
he
fixed assets
ledgers, or other files
•creates.
Writing checks
• Preparing
• •SOLUTION:
The in
Receiving checks
reconciliations
purple
mailfence
(segregation of
• Preparing
recording and
performance reports
authorization) prevents
employees from
falsifying records to
cover up inaccurate or
false transactions that
were inappropriately
authorized.
AUTHORIZATION
FUNCTIONS
• Authorization of
transactions
CONTROL
ACTIVITIES
Source: Accounting Information Systems, 10e Romney/Steinbart, PH
163
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.
164
© D.L.
Crumbley
Fraud Risk Assessment
Ernst & Young report found that
organizations that had not performed
fraud vulnerability reviews were
almost two-thirds more likely to
have suffered a fraud within the past
12 months. J.W. Koletar, p. 167.
A company should have a fraud
risk assessment performed of their
controls, procedures, systems, and
operations. J.W. Koletar, p. 166.
Sources: J.W. Koletar, Fraud Exposed, John Wiley & Sons,
2003
165
© D.L.
Crumbley
Fraud Risk-Assessment Process
1. Organize the assessment – integrate into
organization’s existing business cycle or
establish a separate cycle.
2. Determine areas to assess – conduct at
company wide, business-unit, and significantaccount levels.
3. Identify potential schemes and scenarios –
typically affecting the industry or locations.
• Fraudulent financial reporting.
•Misappropriation of assets.
•Expenditures and liabilities for an improper
purpose (cash kickbacks and corruption).
•Organization commits a fraud against
employees or third parties.
•Tax fraud.
•Financial misconduct by senior management.
166
© D.L.
Crumbley
Fraud Risk-Assessment Process
4. Assess likelihood of fraud
•Remote
•Reasonably possible
•Probable
5. Assess significance of risk
•Inconsequential
•More than inconsequential
•Material
6. Link antifraud controls – identify the
control activities for fraud risks that are both
more than likely to occur and more than
inconsequential in amount.
7. Apply assessment results to the audit plan
– consider and document the results of the
fraud assessment when developing the audit
plan.
Source: Jonny Frank, “Fraud Risk Assessments,” Internal Auditor, April,
2004, pp. 43-47.
167
Swimming Lanes
Mary Larry Jane
Controls
Cash
X
Entries in
Books
X
Deposits
Checks
Does
Reconciliation
Controls
Account
Receivable
© D.L.
Crumbley
Sam
X
X
X
X
X
X
X
X
X
X
168
© D.L.
Crumbley
Sophisticated Approaches
1. The Quad Method
2. The Staggered Box Method
3. The Chessboard Method
169
© D.L.
Crumbley
COSO Guidance
Risk Assessment Matrix
See COSO, “Guidance for Smaller
Public Companies,”
www.ic.coso.org
170
© D.L.
Crumbley
PCAOB’s AS2 Report: Hindrances
1.
2.
3.
4.
5.
6.
7.
Failure to coordinate or integrate the
AS2 audit of internal controls with the
financial audit.
Doing detail testing before the top
down audit looking for the high risk
areas (e.g., fishing).
Inadequate consideration of the unique
risk factors of the company (e.g., avoid
the checklist mentality). Do not audit
the low risk areas.
Inefficient walkthroughs of transaction
controls.
Too little reliance on others.
Insufficient evaluation of compensating
controls when there is a discovery of
control deficiencies.
Inadequate testing of controls over
financial statement presentation and
disclosures.
171
GAP Analysis
© D.L.
Crumbley
Actual Internal Controls
Organization’s Stated Internal
Controls
Best Practice Internal Controls
172
© D.L.
Crumbley
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.
173
© D.L.
Crumbley
Fraudulent financial reporting may
occur by the following:
 Manipulation, falsification, or
alteration of accounting records,
or supporting documents from
which financial statements are
prepared.
 Misrepresentation in or
intentional omission from the
financial statements of events,
transactions, or other significant
information.
 Intentional misapplication of
accounting principles relating to
amounts, classification, manner
of presentation, or disclosure.
Source: SAS No. 99, “Consideration of Fraud in a Financial
Statement Audit,” New York: AICPA
174
© D.L.
Crumbley
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.
175
© D.L.
Crumbley
SAS No. 99 Ways to Overcome the
Risk of Management Override of
Controls
 Examining journal entries
and other adjustments.
 Reviewing accounting
estimates for bias, including a
retrospective review of
significant management
estimates.
 Evaluating the business
rationale for significant
unusual transactions.
176
Parmalat Deceptions
•
•
•
•
•
•
•
•
© D.L.
Crumbley
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
177
repurchased had not really been bought.
Examples
© D.L.
Crumbley
 Enron issued $1.2 billion of stock to special
purpose entities and recorded a $1.2 billion
notes receivable (rather than a contra
account to stockholders equity). Both assets
and owners equity were overstated by $1.2
billion.
 HealthSouth allegedly overstated profits
by at least $14 billion by billing Medicare
for physical – therapy services the company
never performed. The company submitted
falsified documents to Medicare to verify
the claims over 10 years.
 E&Y collected $2.6 million from
HealthSouth (as audit-related fees) to check
the cleanliness and physical appearances of
1,800 facilities. A 50- point checklist was
used by dozens of junior-level accountants
in unannounced visits. For 2000, E&Y
audit fee, $1.03 million; other fees, $2.65
million.
178
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Embezzlement and Slush Funds





Chung Mong-Koo, chairman of Hyundai
Motor, South Korea’s largest carmaker, was
sentenced to three years in prison in February
2007, for embezzlement, breach of trust, and
secretively setting up slush funds.
Mr. Chung embezzled about $100 million of
company funds and inflicted about $224
million of damage on group affiliates during
rights issues.
Convicted of using deals to boost his
financial gains and those of his son, who runs
affiliate Kia Motors.
Welcomed by corporate governance
campaigners which showed that Korea would
no longer tolerate chaebol owners using their
companies to pursue their personal interests.
Although he owned only 5%, he ran it as a
family business. Employees were terrified of
him. Whistleblower alerted authorities of the
slush funds.
Song Jung-a, “Hyundai Chief’s Prison Term Compounds Woes of Car
Giant,” Financial Times, February 6, 2007, p. 15.
179
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Journal Entries at Year End: Those
Magic Changes
Apparently, Arthur Andersen was given
limited access to the general ledger at
WorldCom, which had a $11 billion fraud
(largest accounting fraud in history). Most of
the original entries for online costs were
properly placed into expense accounts.
However, near the end of the period these
entries were reversed. One such entry was as
follows:
Other Long-term Assets
$629,000,000
Construction in Progress
$142,000,000
Operating Line Costs
$771,000,000
The support for this entry was a yellow postit note.
WorldCom’s outside auditors refused to
respond to some of Cynthia Cooper’s
questions and told her that the firm had
approved of some of the accounting methods
she questioned.
180
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Those Magic Changes: Yellow Peril
• Fourth Quarter of 1999: "The $239 million
[international line cost accrual release] was entered
in WorldCom's general ledger ... The only support
recorded for the entry was '$239,000,000,' written
on a Post-it Note and attached to a printout of the
entry."
• Third Quarter of 2001: "Myers gave Sethi a Postit Note that said 'Assume $742 million.' Later,
Myers and Sethi had a conversation confirming that
$742 million identified on the Post-it Note was the
line cost capitalization entry for the quarter.”
http://thestreet.com/pf/markets/dumbestgm/10093441.html
----------------------------------------------------Those Magic Changes
“Oh my heart arranges, oh those magic changes,
oooh yeah.”
Grease
181
Yellow Peril
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• First Quarter of 2002: "In Capital Reporting,
Myers told Sethi to go see Vinson, who would
have the amount to be capitalized. When Sethi
did so, Vinson handed him a Post-it Note that
had the $818 million adjustment on it. Brian
Higgins once again refused to make the
necessary allocation for the first-quarter 2002
capitalization entry. Despite his growing
concerns, Sethi made the allocation because he
was concerned that his immigration status would
be jeopardized if he lost his job."
• First Quarter 2002: "$109.4 million was taken
from the general accrual account that Vinson set
up and reclassified to several SG&A balance
sheet accounts in five large, round-dollar
amounts. The only supporting documentation
that we were able to locate for these entries was
a Post-it Note listing the various SG&A
accounts and the amounts that should be taken
from the Vinson account."
http://thestreet.com/pf/markets/dumbestgm/10093441.html
182
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WorldCom Fraud Massive
 At least 40 people knew about the fraud.
 They were afraid to talk.
 Scott Sullivan handed out $10,000 checks
to 7 involved individuals.
 Altered key documents and denied
Andersen access to the database where
most of the sensitive numbers were stored.
 Andersen did not complain about denied
access.
 Company officials decided what tax rates
they wanted and then used the reserves to
arrive at the tax rates.
Source: Rebecca Blumenstein and Susan Pullian,
“WorldCom Fraud Was Widespread,” Wall Street
J., June 10, 2003, p. 3.
183
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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.
184
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Differences Between Auditing/Forensic Accounting
Auditing
Forensic Investigation
1. Recurring
2. Express an
opinion
3.
4.
5.
6.
7.
1. Non-recurring
2. Resolve an
allegation or
deterrence review
Follow GAAS
3. Follow consulting
and SAS 99
standards
Materiality
4. Materiality not
important
important
Sampling activity 5. Detailed financial
analysis
Use professional 6. Establish scienter
skepticism
Audit program 7. No set of rules
185
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Financial Audit v. Forensic Audit
The typical financial audit is a sampling
activity that doesn’t look at every transaction
and can therefore be exploited by someone who
knows how to rig the books.
Forensic accounting focuses on a
specific aspect of the books and examines
every digit. While the average accountant is
trying to make everything add up, a forensic
accountant is performing a detailed financial
analysis to find out why everything doesn’t or
shouldn’t add up.
It’s a far more time-consuming enterprise
and can be significantly more expensive than
regular auditing work.
Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004,
http://www.phoenix.edu/students/future/oldissues/Winter2004/fraud.htm
186
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Pre SAS 99
Consulting
Standards
Auditing
Standards
Traditional
Investigation
Traditional
Audit
Post SAS 99
Auditing
Standards
Consulting
Standards
Traditional
Investigation
Forensic
Procedures in
the Audit
Environment
SAS 99
Source:AICPA, “Forensic Services, Audits, and Corporate
Governance: Bridging the Gap,” Discussion Memorandum, 2004.
187
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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 CFD).
As audit moves toward forensic
investigation, auditor must comply
with litigation services standards
(consulting).
188
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Inexperienced Forensic Auditors
• Find out who did it. Do not worry
about all the endless details.
• Be creative, think like the fraudster,
and do not be predictable. Lower the
auditing threshold without notice.
• Take into consideration that fraud
often involves conspiracy.
• Internal control lapses often occur
during vacations, sick outages, days off,
and rest breaks, especially when
temporary personnel replace normal
employees.
H. R. Davia, Fraud 101, New York: John Wiley & Sons, 2000, pp.
42-45.
189
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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.”
190
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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.
191
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Engagement Letters Are Important
•For claims to Continental Casualty Company the
national provider of CPA malpractice insurance, in
2003:
Tax, 48%
Compilation and bookkeeping, 15%
Consulting, 11% Audit, 10%
Fiduciary, 6% All Others, 5%
• Most accounting malpractices claims involve
inadequate documentation.
• In claims re business tax, 54% of the time no
engagement letter.
• For individual tax claims, no engagement letters
78% of the time.
• Estate-related tax services, none, 63%.
• The most costly malpractice claims area is audit
practice.
• Almost 40% of all audit claims allege that an auditor
either failed to detect fraud or failed to inform the client
of internal control weakness to reduce the risk of fraud.
Source: Joseph Wolfe, “Accounting for Malpractice,” AICPA,
http://www.cpai.com/newsletter_indexadminP.php?id=107
192
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Two Major Types of Fraud
Investigations
• Reactive: Some reason to suspect
fraud, or occurs after a significant
loss.
• Proactive: First, preventive
approach as a result of normal
operations (e.g., review of internal
controls or identify areas of fraud
exposure). There is no reason to
suspect fraud. Second, to detect
indicia of fraud.
Source: H.R. Davia, “ Fraud Specific Auditing,” Journal of
Forensic Accounting, Vol. 111, 2002, pp. 111-120
193
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Proactive vs. Reactive Approaches
Proactive approaches include
Effective internal controls,
Financial and operational audits,
Intelligence gathering,
Logging of exceptions, and
Reviewing variances.
Reactive detection techniques
include
Investigating complaints and
allegations,
Intuition, and
Suspicion.
Jack Bologna and Robert Lindquist, Fraud Auditing and Forensic Accounting, 2d
Edition, New York: John Wiley, 1995, p. 137.
194
Proactive Is Best
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 When the IRS began requiring banks
to issue Form 1099s reporting interest,
the reported interest income increased
by $8 billion (even though for 3 years
the IRS did not have computer
matching capacity).
 When the IRS began to require
taxpayers to list a social security
number for dependents, the next year
the number of reported dependents
dropped by seven million. More than
11,000 of these taxpayers claimed
seven or more dependents in 1986, but
they claimed none in 1987.
 When the IRS began to require
taxpayers to list a name, address, and
social security number for babysitters,
two years later 2.6 million babysitters
disappeared.
195
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Fraud Deterrence Better Than Fraud
Investigation
1. Fraud deterrence less expensive.
2. Deterrence is more
comprehensive.
3. Fraud deterrence produces
greater savings.
4. Deterrence is faster.
5. Fraud deterrence promotes better
customer relations.
Daniel Finnegan, “Deterring Fraud,” Quality Planning
Corporation, 1991.
196
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Insurance Fraud Equations
1st Law of Fraud Control:
An illusion of effective investigation deters
fraud, in turn making possible the reality of
effective investigation, thereby perpetuating
deterrence.
Evil Twin Corollary:
When deterrence fails, fraud grows to levels
that overwhelm enforcement capacities, in turn
undermining deterrence.
2nd Law of Fraud Control:
Fraud happens when anticipated income is
greater than expected costs.
Anticipated income = Award x Opportunity x
Racketeering
2nd Corollary:
Fraud is eliminated when potential perpetrators
believe the costs of fraud are greater than
income.
Daniel Finnegan, “Deterring Fraud,” Quality Planning Corporation, 1991.
197
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Is Company Proactive?
 Fraud hotline (reduce fraud losses
by 50% re Wells 2002 Report).
 Suggestion boxes.
 Make everyone take vacations.
 People at top must set ethical tone.
 Widely known code of conduct.
 Check those employee references.
 Reconcile all bank statements.
 Count the cash twice in the same
day.
 Unannounced inventory counts.
 Fraud risk assessment (CFD).
198
Some Hints
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 Need to really understand the
business unit. What they really do.
 Have a mandatory vacation policy.
 Rotation of assignments.
 Have a written/signed ethics policy.
 Do things differently each time you
audit a unit.
 Do not tell client what you are
doing.
 Hard to find fraud in the books.
Look/listen. Look for life style
changes.
 Do not rely on internal controls to
deter fraud.
 Auditors must have control of the
confirmation process.
 Careful of related parties.
 Careful of “trusted” employees.
199
Related Parties
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
Nikko Cordial (Japan) fined for
failure to consolidate a specialpurpose entity that was 100%
owned by its subsidiary and for
falsifying the timing of an exchange
bond issue (2007).

Created Y14.5 billion in net profit.

Independent panel reviewed
507,000 e-mails.
200
Stamp Mates
•
•
•
•
•
•
•
© D.L.
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Afinsa, a Spanish stamp company, controls
72% of Escala, a U.S. company (formerly
Greg Manning Auctions).
Escala says all sales to Afinsa takes place
at independent established prices.
But Escala’s reported gross margin on
stamp sales to Afinsa exceeds 44% [like
land flipping].
Compared to less than 14% on those to
other clients.
Therefore, Escala was manipulating the
value of stamps sold to Afinsa to
artificially boost its own bottom line.
Escala’s stock fell from $32 to $5 in five
days after the May 8, 2006 arrests of seven
executives. Police found $12.6 million
behind one dealer’s freshly plastered walls
in his home (e.g., unreported profits?).
Escala owns A-Mark Precious Metals,
which buys and distributed more than onehalf of the gold coins handed each year by
the U.S. mint.
201
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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.]
202
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Fraud Detection Process
1.
Discuss facts and objectives with client/attorney (e.g.,
conflict of interests).
2.
Evaluation whether to accept the engagement.
3.
Prepare a work program.
4.
Develop time and fee schedule.
5.
Obtain approval of work program, staff assignments, and
fee estimates.
6.
Obtain an engagement letter.
7/8. Identify fraud exposures and symptoms.
9/10. Evaluate evidence obtained and determine if more
evidence is needed.
11/12. Search for and evaluate additional evidence.
13. Discuss preliminary findings with client/attorney.
14. Draft a final report.
15. Review the report and work papers.
16. Resolve professional disputes.
17. Clear review points and open items.
18. Communicate report or findings.
19. Help attorney prepare court case/testify.
20. Perform follow-up procedure.
21. File work papers/report.
Source: Carmichael et. al, PPC Fraud Detection, Vol.1, Ch. 2 (2002).
203
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Financial Audit v. Forensic Audit
“ During
one investigation, we found in the auditing
working papers written in the margin of the
internal audit working papers by the internal
audit manager: ‘Conceal from bankers,’ says
Nicholas L. Feakins, CPA, partner at San Mataeo,
Calif based forensic accounting firm Feakins &
Feakins. “ It sounds amazing, but the [third-party]
auditors has put B-level staff on the project who
simply didn’t read the documents and missed it.”
----------------------------------------------------------------MiniScribe, one of the world’s largest disk-drive
makers, which in the late 1980s was surreptitiously
shipping bricks instead of disk drives to the Far
East and receiving credit from the bank for the
amount of the shipments. “After all,” he says “it’s
going to be 90 days until they ship the brick back to
you. “MiniScribe’s public accounting firm,
Coopers & Lybrand, didn’t catch the falserevenue scam during its regular audits-but a
forensic accountant did.”
Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004,
http://www.phoenix.edu/students/future/oldissues/Winter2004/fraud.htm
204
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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.
205
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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.
206
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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.
207
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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.”
 “Things are not always as they
appear, sonny boy.” James Patterson,
Honeymoon, Warner Books, 2006.
208
SKEPTICISM
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Ronald Reagan said with respect to
Russia, “Trust, but verify.”
FA’s motto should be “Trust no one;
question everything; verify.”
-----------------------------------------------------
This ain’t my first rodeo
I didn’t make it all the way through
school.
But my mama didn’t raise no fool.
I may not be the Einstein of our time.
But honey, I’m not dumb and I’m not
blind.
Vern Gosdin
209
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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.
210
BE SKEPTICAL
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 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.
211
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SAS No. 99: Brainstorming
Aims to make the auditor’s consideration
of fraud seamlessly blended into the
audit process and continually updated
until the audit’s completion.
Brainstorming is now a required
procedure to generate ideas about how
fraud might be committed and concealed
in the entity.
No ideas or questions are dumb.
No one owns ideas.
There is no hierarchy.
Excessive note-taking is not allowed.
Source: Michael Ramos, “Auditors’ Responsibility for Fraud
Detection,” J. of Accountancy, January, 2003, pp. 28 – 36.
212
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More Brainstorming
• Best to write ideas down, rather than say
them out loud.
• Take plenty of breaks.
• Best ideas come at the end of session.
• Important to not define the problem too
narrow or too broad.
• Goal should be quantity, not quality.
• Geniuses develop their most innovative ideas
when they are generating the greatest number
of ideas.
• No such things as bad ideas.
• Many companies are great at coming up with
good ideas, but lousy at evaluating and
implementing them.
Source: A.S. Wellner, “Strategies: A Perfect Brainstorm,” Inc. Magazine,
October 2003, pp. 31-35
213
Potential Pitfalls
•
•
•
•
© D.L.
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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.
214
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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. 3334.
215
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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.
216
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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?
217
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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.
By the end of 2002, a total of 4.47
billion barrels cut; another 1.4 billion
barrel cut in 2003.
Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil Reserves
Prove Unrefined,” Wall Street Journal, January 14, 2004, p. C-4.
Chip Cummins, “Shell Slashes Oil Reserves Again, News
Overshadows Profit Surge,” WSJ, February 4, 2005, p. A-3
218
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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 and
C-4.
219
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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.
220
Walkthroughs
© D.L.
Crumbley
An auditor must perform a walkthrough of a
company’s significant processes (each major class
of transactions).
Can not be achieved secondhand.
According to PCAOB, in a walkthrough an
auditor traces “company transactions and
events – both those that are routine and
recurring and those that are unusual – from
origination, through the company’s accounting
and information systems and financial report
preparation processes, to their being reported
in the company’s financial statements.”
Auditors should perform their own walkthroughs
which provides auditors with appropriate evidence
to make an intelligent assessment of internal
controls.
Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.
221
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Slot Machine Example
222
Revenue Flows
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Crumbley
223
Wandering Around
© D.L.
Crumbley
• Informal observations while in the business.
• Especially valuable when assessing the
internal controls.
• Observe employees while entering and
leaving work and while on lunch break.
• Observe posted material, instructions, job
postings.
• Observe information security and
confidentiality.
• Observe the compliance with procedures.
• Appearance is not necessarily reality. Man of
La Mancha
224
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New Terms in Financial Reports:
Deficiencies Have No Bright Lines
Control deficiency – one that might allow a
bad number to get into the financial
reports (e.g., the likelihood that a
company misstates reports is remote– 1
out of 20).
Example: company does not check
changes made by a salesman in a minor
contract.
Significant deficiency – more serious flaw
or a number of flaws that increase the
chances that wrong numbers will
significantly distort financial statements
(e.g., more than remote).
Example: company not checking for
changes to terms of several key contracts.
Need only to report to BOD, but some
companies are making them public.
225
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Deficiencies Have No Bright Lines
Material weakness – deficiencies are so
bad that there is more than a remote
change of a material misstatement in
financial statements.
Example: a bank does not regularly
check for errors in estimating loan-loss
expenses (i.e., Fannie Mae reported a $1.3
billion error from its computer model,
many in an uncontrolled environment).
They must be reported.
David Henry, “How Clean Are the Books?” Business Week, March 7,
2005, pp. 108-109.
----------------------------------------------------Firms that reported material weaknesses
in tax accounting lost an average of 5.8%
of their stock value 60 days after the
announcement.
----------------------------------------------------As of 11-14-05, 695 companies have
disclosed material weaknesses in their
annual report.
226
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Material Weakness Areas
AREAS OF FAILURE
2005
2004
Tax accruals/ deferrals
34.5%
32.0%
Revenue recognition
28.4
31.3
Inventory/ vendor cost of sales
23.7
27.4
Fixed/ Intangible assets
16.0
18.6
Leases or contingencies
9.3
16.8
Cash flow (FAS 95 error)
8.8
--
Consolidation (Fin 46 issues)
6.7
9.0
* 10% of corporate filers in 2005 and 16% in 2004.
Source: AuditAnalytics.com
227
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Law Suits Few So Far
• Companies reporting problems with internal controls
have not seen a big increase in class-action lawsuits,
according to a study by Deloitte & Touche between
November 2003 and August 2004.
• Deloitte said only 6% of the 290 companies reporting
internal-control flaws were sued.
• 52% of the firms had material weakness in their
internal controls.
• These internal control announcements did not seem
to send prices downward.
• Highest incidence of internal controls:
-computer-software firms
-manufacturers
-health-care and pharmaceutical companies.
- financial-services firms
-telecommunication companies.
Source: Judith Burns, “Few Firms Are Sued Over Flaws in Internal Controls,
228
Think Like A Crook
•
•
•
•
© D.L.
Crumbley
Know your enemy as you know yourself,
and you can fight a hundred battles with no
danger of defeat.” Chinese Proverb.
Military leaders study past battles.
Football and basketball teams study game
films of their opponents.
Chess players try to anticipate the moves of
their opponent.
Examples: If contracts above $40,000 are
normally audited each year, check the
contracts between $30,000-$40,000.
• FAs must learn the tricks of the trade as
well as the trade.
229
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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?
230
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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.
231
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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
(interest free loans to Tyco executives
forgiven).
One can study any one of these phases.
Examples:
 Things being stolen: conduct surveillance and
catch perp.
 If liabilities being hidden, look at financial
statements for concealment.
 If perp has unexpected change in financial
status, look for source of wealth.
Source: Cindy Durtschi, “The Tallahassee Bean Counters: A
Problem-Based Learning Case in Forensic Audit,” Issues
in Accounting Education, Vol. 18, No. 2, May 2003, pp.
137-173.
232
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Fraud Hypothesis Testing Approach
Here a forensic accountant attempts to proactively detect fraud that is still undiscovered by
formulating and testing null hypotheses. This proactive
technique requires an forensic investigator to
1. Identify the frauds that may exist in a particular
situation.
2.Formulate null hypotheses stating that the frauds do
not exist.
3.Identify the red flags that each of the frauds would
create.
4.Design customized queries to search for the specific
red flags or combination of red flags.
In a refinery, three authors report that after a formalized
pro-active search for red flags, some unknown frauds
were discovered. But applying generic data mining
programs to the company’s database to detect fraud
resulted in a number of Type II errors. So in order to be
useful the red flags had to be fraud and company
specific.
C.C. Albercht, W.S. Albercht, and J.G. Dunn, “Conducting a Pro-Active Fraud
Audit: A Case Study,” Journal of Forensic Accounting, Vol. 11, 2000, pp. 203-218
233
The Methods
© D.L.
Crumbley
 Asset misappropriation accounted
for more than four out of five
offenses or 91.5% in 2006 (92.7%
in 2004). $150,000
 Bribery and corruption constituted
about 30.8% in 2006 (30.1% in
2004) of offenses. ($538,000)
 Fraudulent statements were the
smallest category of offense 10.6%
in 2006 (7.9% in 2004) (most
costly). $2 million per scheme.
Source: 2006 Wells Report, ACFE.
234
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Fraudulent Disbursements
 Fraudulent disbursements
account for three-quarters of the
losses, and the most expensive
tend to be fraudulent
disbursements through billing
schemes (45%).
 Therefore, internal auditors
seeking to get the biggest bang
for their investigative bucks
should begin by making sure
company vendors are for real.
 Check tampering (30%).
Source: J.T. Wells, “An Unholy Trinity,” Internal
Auditor, April 1998, p. 33.
235
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Restatements of Financial Statements
2005
2004
1,195 (8.5%)
616
2003
514
2002
330
2001
270
1999
216
1998
158
Reasons for 2004 restatements:
1. Revenue recognition.
2. Equity accounting.
3. Revenues, accruals, contingencies.
• 15% were repeat filers.
• Arthur Andersen had averaged 11 restatements
before 2002. In 2002, they had 40, with 26 after
new auditors were retained.
Source: Greg Farrell, “Restatements of Earnings in 2005 to Break
Record,” USA Today 12/29/2005; Stephen Taub, CFO.com, March 3, 2006.
236
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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.”
237
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Measures Helpful in Preventing Fraud
1. Strong Internal Controls (3.66)
2. Willingness of companies to prosecute
(3.44)
3. Regular fraud audit (3.40)
4. Fraud training for auditors (3.33)
5. Anonymous fraud reporting
mechanisms (3.27)
6. Background checks of new employees
(3.25)
7. Established fraud policies (3.12)
8. Ethical training for employees (2.96)
9. Workplace surveillance (2.89)
Source: 2004 Wells Report
238
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Anti-Fraud Measures –
Months to Detect – Median Loss
YES
NO
1.
Hotlines
$100,000 (15)
$200,000 (24)
2.
Internal audits
$120,000 (18)
$218,000 (24)
3.
External audits
$181,000 (23)
$125,000 (18)
4.
Surprise audits
$100,000 (15)
$200,000 (24)
5.
Fraud awareness/ Ethics
Training
$100,000 (15)
$200,000 (24)
Source: 2006 Wells Report, ACFE.
239
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Executions for Fraud?
• In September 2004, Wang
Liming, a onetime accounting
officer at China Construction, and
two other bank employees were
executed for defrauding the bank
of $2.4 million.
• In an unrelated corruption case,
an officer at the Zhuhai branch of
the Bank of China was put to
death.
•
John Goff, “Bank Fraud Brings Executions,” CFO,
November 2004, p.20.
240
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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.
241
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Roadmap For An Embezzler: 14 Ways
1.Sam diverted payroll taxes meant for the IRS to
himself through a dummy account. He switched
the IRS correspondence address to his home,
hiding the default letters. He carried on an
extensive letter-writing campaign with the IRS to
confuse and delay action. He made back
payments, disguising them to us as current
payments.
2.He set up dummy bank accounts to skim funds
before they made their way into legitimate
accounts.
3.Sam got one employee fired for doing “sloppy
management,” which “lost” some deposits. Of
course, Sam gave me the “proof” that this
employee was incompetent.
4.He refocused attention by pointing fingers at
“slow payers” on our accounts receivable. He
claimed that some people had never paid (they
had) and that he had sent them to collections (he
hadn’t). Of course, his records showed that their
payments had never made it into our account (they
went into a dummy account.)
Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm.
242
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Roadmap For An Embezzler: 14 Ways (contd …)
5. He stole postage and then “reported” it, to alert
me that he was honest; if anything was amiss, I
would then blame others (and he offered his
opinions on the least trustworthy employees).
6. He diverted bank statements to his home and
altered them before filing them at the office.
7. Sam volunteered to run daily deposits to the
bank, skimming off the cash and changing the
deposit tickets.
8. He made reimbursements to himself and his
wife for “business expenses” that didn’t exist.
9. Sam set up his landlord, once or twice a year, as
an accounts payable.
10. A fax machine was stolen from the office. Also
a TV and VCR. He was supposedly the first to
arrive; he hastened to point out the broken
window. He personally handled the police
report. (I doubt that anyone broke in; the
window was high up and fairly small.)
Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm.
243
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Roadmap For An Embezzler: 14 Ways (contd …)
11. He put his wife on the payroll (a sweet woman
who divorced him when she found what he
really was). He “miscalculated” withholding to
overpay her, and adjusted her W-2s downward
to match. She was hourly, so he also padded her
hours by $20 to $50 per pay period, and altered
the time log sheets. We figured that over the
course of four years, he overpaid her by at least
$3,000. Of course, he was in charge of their
family finances, and he deposited all her
checks.
12. Sam double-reimbursed himself for legitimate
expenses.
Here’s how:
He would list perhaps four expenditures on one
voucher, three on another. So the first would
say “Office Depot, $21.64; Kinkos, $18.92;
Office Depot, $39.12; Office Depot, $16.10.” A
month or two later, one would show up like
this: “Kinkos, $11.30; Office Depot, $39.12;
Shay Office equipment, $26.20.”
Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm.
244
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Roadmap For An Embezzler: 14 Ways (contd …)
Yes, receipts were stapled to the voucher, and
all the vouchers/receipts added up. Here’s how
he handled that: for some vendors he copied
receipts by running them through an old fax
machine that used thermal paper. He made two
copies for double submissions. Many cash
registers use thermal paper, so the receipts
looked real. This technique survived an outside
audit.
13. Increasingly arrogant, he began making
“phone-authorized” wire transfers out of
company accounts into his personal checking
account.
14. Sam did an amazing job of doctoring the
financial statements. (If this man spent half the
effort on legitimate pursuits that he did on
embezzling, he’d be a millionaire instead of an
ex-con).
Source: Bev Harris, “How to Embezzle a Fortune,” www.talion.com/embezzle.htm.
245
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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.
246
More Hints …
© D.L.
Crumbley
 Check employee references/resume.
 Stop giving the employee/client the
answer when you ask a question.
 Zero tolerance for allowing
employee/executive to get away with
anything.
 Always reconcile the bank
statements.
 Try to think like a criminal.
 Get inside the criminal’s mind. Be a
detective.
 Do not assume you have honest
employees.
 Bond employees.
 Uni-ball gel pens.
Source: Gary Zeune
247
Auditing Hints
© D.L.
Crumbley
• SAS No. 99 does not require auditors to make
inquiries of “others,” as opposed to management.
Auditors must talk to and interview others below
management level. If asked, employees may be
willing to report suspicious activities.
• Use independent sources for evaluating management
(e.g., financial analysts). Surf the internet.
• Auditors need to follow the performance history of
managers and directors.
• If a company has an anonymous reporting system,
obtain information about the incidents reported
and consider them when assessing fraud risk.
• Be sure to perform analytical procedures, and the
work should be reviewed by senior members of the
audit team.
• Auditors should select sample items below their
normal testing scope (e.g., HealthSouth).
• Fraud procedures should be more than checklists.
Audits should focus on finding and detecting fraud.248
Auditing Hints (cont.)
© D.L.
Crumbley
• Auditors should select sample items below their
normal testing scope (e.g., HealthSouth).
• Fraud procedures should be more than checklists.
Audits should focus on finding and detecting fraud.
• Ask for and review all “top drawer” entries.
• Ask for and review all side agreements.
249
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Crumbley
Check References and Resume
Fraud 101: Fraudsters can change
their job and address, but they can
not change who they are.
250
Integrity Testing
© D.L.
Crumbley
 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.
251
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Lavish Executive Pay
 Many of the companies indicted by
the SEC after Enron had one thing in
common: CEOs were making about
75% above their peers.
 The common thread among the
companies with the worst corporate
governance is richly compensated top
executives, as per the Corporate
Library, Portland, Maine governanceresearch firm. Hefty pay checks and
perks to current or former chief
executives.
 Poor BODs have in common: an
inability to say no to current or
former chief executives.
Source: Monica Langley, “Big Companies Get Low Marks
for Lavish Executive Pay,” Wall Street J., June 9,
2003, p. C-1.
252
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Compensation Facts
• CEOs compensation components have increased
dramatically in the 1990 [mean of $1.68 million in
1992 to 43.2 million in 2000] even after the passage of
IRC Section 162 (m) in 1993 [$1 million limit].
Balsam, S. 2002. An Introduction to Executive Compensation. San Diego, CA:
The Academic Press.
• Compensation increases when the CEO has influence
over the outside directors, as measured by the
percentage of outside directors appointed by the CEO.
Core, J.E, Holthausen, R and Larcker, D. 1999. Corporate governance, chief
executive officer compensation, and firm performance, Journal of Financial
Economic 51: 371-406
• CEO compensation is higher when the CEO’s tenure
is greater than the chair of the compensation
committee.
Main, B., O’Reilly, C, and Wade, J. 1995. The CEO, the board of directors and
executive compensation: economic and psychological perspectives, Industrial and
Corporate Change 4: 293-332.
• The relation between the change in CEO cash
compensation and stock returns weaken with tenure.
Hill, C. and Phan, P. 1991. CEO tenure as a determinant of CEO pay. Academy of
Management Journal 34: 707-711
• The greater the percentage of outside board members
appointed after the CEO, the more likely the CEO will
have a golden parachute.
Wade, J., O’Reilly, C, and Chandratat, I. 1990 Golden parachutes: CEOs and the
exercise of social influence. Administrative Science Quarterly 35:587-603
253
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Crumbley
External Fraud-Shoplifting
It’s not just stars (e.g., Bess
Myerson, Hedy Lamarr, and may
be Winona Ryder). Why, each year,
ordinary people shoplift $13 billion
of lipstick, batteries, and bikinis
from stores (last year $26 to $33
billion). May account for one-third
of total inventory shrinkage.
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.
254
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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.
255
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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
256
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Management or Manipulation?
 More than one-half of CFOs say they can
legally influence reported earning by 3% or
more.
 Operational levers: delaying operational
spending, accelerating order processing, and
driving sales force more.
 Accounting steps: changing the timing of an
accounting change and adjusting estimates.
 One-third of CFOs would try to influence
results: 24% upward or 8% would try to cut
them.
 Few CFOs think their auditors would catch
them.
 If the auditors caught it, they probably would
not bring it up to management.
Don Durfee, “Management or Manipulation?” CFO, December, 2006, p. 28.
257
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Financial Statement Fraud Schemes
Category
Concealed Liabilities
Fictitious Revenues
Improper Asset Valuations
Improper Disclosures
Timing Differences
%
45.0%
43.3%
40.0%
37.5%
28.3%
Source: 2006 Wells Report, ACFE.
258
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Good Earnings Management
• Careful timing of capital gains and
losses;
• Use of conferencing technology to
reduce travel costs; and
• Postponement of repair and
maintenance activities when faces with
unexpected cash flow declines.
L. G. Weld et. al, “Anatomy of a Financial Fraud,” The CPA
Journal, October 2004.
259
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Abusive Earnings Management
• Improper revenue recognition (e.g., bill and hold
sales).
• Improper expense recognition.
• Using reserves to inflate earnings in years with
falling revenues (cookie jar accounting).
• Shifting debt to SPE.
• Channel stuffing.
• Capitalizing marketing costs rather than expensing.
• Extending useful lives and inflating salvage values.
• Cookie jar reserves.
• Accelerating revenue from leasing equipment.
• SPEs not consolidated.
260
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Early Warning Signs of
Earnings Management
• Cash flows that are not correlated with
earnings;
•Receivables that are not correlated with
revenues;
• Allowances for uncollectible accounts that
are not correlated with receivables;
• Reserves that are not correlated with balance
sheet items;
• Acquisitions with no apparent business
purpose; and
• Earnings that consistently and precisely
meet analysts’ expectations.
Magrath and Weld, “Abusive Earnings Management and
Early Warning Signs,” The CPA Journal, August 2002.
261
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Some Red Flags of Earnings
Management
1.
CEO is also Chairperson of BOD (e.g.,
Parmalat).
2. Insiders have majority control of BOD.
3. Weak system of internal controls.
4. Performance emphasis on short-term goals.
5. Weak or non-existent Code of Ethics (e.g.,
Parmalat).
6. Questionable business strategies with opaque
disclosures (e.g., special purpose entities).
7. CEO is uncomfortable with criticism (Enron’s
Jeff Skilling).
8. CEO or other senior management turnover
(Qwest’s CFO).
9. Insiders selling stock (Enron’s Ken Lay).
10. Independence problem from large non-audit
fees paid to external auditors (e.g.,
HealthSouth).
11. Company’s investment banker has
independence problems (e.g., Parmalat,
Enron).
262
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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.
263
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Crumbley
Earnings Management
Lower perceptions of earnings quality lead
investors to more thoroughly examine a
firm’s audited financial statements. A more
thorough analysis of a firm’s financial
statements lead investors to lower their
assessment of the firm’s earnings quality.
F.D. Dodge, “Investors perceptions of Earnings Quality, Auditor
Independence, and the Usefulness of Audited Financial Information,” p.
46.
Found no evidence that short sellers trade
on the basis of information contained in
accruals.
Scott Richardson, “Earnings Quality and Short Sellers,” p. 49.
264
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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
265
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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 under-minding orthodox
accounting by not recognizing a variety of
items as expenses.”
•Examples: Goodwill never declines.
Moving expenses and losses from operating
items to so-called nonrecurring items.
•Contrast the income with the firm’s
operating cash flow.
Source: J.E. Ketz, Hidden Financial Risks, John Wiley & Sons, 2003
266
Hiding Debt
© D.L.
Crumbley
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 un-net 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). Enron, REFCO, Adelphia.
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
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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. Cendant Corporation created fictitious
revenues, and Knowledge Ware inflated
revenues with phony software sales.
2. Premature Revenue Recognition (e.g., holding
books open). 35-day month.
3. Misclassified Revenues and Assets (e.g.,
combining restricted cash accounts with
unrestricted cash accounts). School districts
and universities may engage in this strategy
with dedicated funds.
Source: S.E. Bonner, Z. Palmrose, and S.M. Young, “Fraud Types and
Auditor Litigation,” The Accounting Review, October 1998, pp. 503-532.
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Types of Financial Statement Fraud Schemes
(contd …)
4. Fictitious Assets and/or Reductions of
Expenses/Liabilities (e.g., recording
consigned inventory as inventory).
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).
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. REFCO, Adelphia.
10. Financial Fraud Going the Wrong Way (e.g.,
for tax purposes reducing income or
increasing expenses).
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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 C11. Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24,
2005, pp. 123-140.
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Fannie Mae’s Problem
• Fannie Mae was ordered by the SEC [2004] to
a restatement of earnings of $ 9 billion
(reducing earnings since 2001). Misuse of
hedge-accounting transactions and improper
accounting for loans.
• CFO J. Timothy Howard resigned with an
annual pension of $400,000 and lifetime access
to Fannie Mae’s Medical benefits. Plus $ 4
million of stock options.
•CEO Franklin Raines was paid more than
$60 million over a 6 year period. On Dec. 21,
2004, Raines took early retirement. $ 1 million
annually for life.
•The Board replaced KPMG as Fannie’s
auditor.
Source: Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24, 2005,
pp. 123-140. Mike McNamee, “Franklin Raines Lost Gamble,” Business
Online, December 22, 2004.
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Lessons From Enron
• 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 offbalance sheet in the partnerships.
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 92-93.
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Cooking the Books-Symbol Technologies
• From 1998 through February 2003, Symbol used a so-called “Tango
sheet” process through which fraudulent “topside” accounting
entries were made to reserves and other items to conform the
unadjusted quarterly results to management’s projections;
• Fabrication and misuse of restructuring merger and other nonrecurring charges to artificially reduce operating expenses, create
“cookie jar” reserves (overstating inventory write-offs) and further
manage earnings;
• Channel stuffing and other revenue recognition schemes, involving
both product sales and customer services; stuffed the channel by
granting resellers return rights and contingent payment terms in side
agreements.
• Manipulation of inventory levels and accounts receivable data to
conceal the adverse side effects of the revenue recognition schemes.
• Warehouse arrangement with a large foreign distributor that served
as a vehicle for improperly recognizing several millions of dollars.
• Directed employees to refrain from scanning new components or
returned goods into the automated accounting system.
• Backdated (cherry picked) stock option exercise dates.
• When “days sales outstanding’ because too large because of
fraudulent revenue recognition, reclassified past due trade accounts
receivable into notes receivables. A growing DSO figure is often a
sign that receivables are impaired due to channel stuffing, etc.
• Deferred $3.5 million of FICA insurance costs to a later year.
• Recognized revenue that was processed in one quarter, but shipped
the next quarter.
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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
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Crumbley
• Interviewing the executives
• Analytics
• Percentage analysis
– Horizontal analysis
– Vertical analysis
– Ratio analysis
• Using checklists to help detect fraud
–
–
–
–
SAS checklist
Attitudes/Rationalizations checklist
Audit test activities checklist
Miscellaneous fraud indicator checklist
“Objectively obtaining and evaluating evidence is the
essence of auditing.”
(AAA, Committee on Basic Auditing Concepts, 1973, 2)
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Investigative Techniques
Public Document Review
• Real and personal property records.
• Corporate and partnership records.
• Civil and criminal records.
• Stock trading activities.
• Check vendors.
Laboratory Analysis
• Analyzing fingerprints.
• Forged signatures.
• Fictitious or altered documents.
• Mirror imaging or copying hard
drives/company servers.
• Use clear cellophane bags for paper
documents.
276
Analytical Procedures
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Crumbley
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.
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Beware Inter-company Entries
• HealthSouth used PeopleSoft, with at least
2,000 different ledgers.
Suspense Account
Revenue
xx
Accounts Receivable
xx
Inventory
xx
Property
xx
Suspense Account
xx
xxx
Most of the entries were inter-company
entries.
During 2005, 2004, and 2003, professional
fees associated with the reconstruction of
HealthSouth’s financial records and
restatement of 2001 and 2002 consolidated
financial statements approximated $206.2
million and $70.6 million, respectively.
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Financial Statement Fraud Audit
1.
2.
3.
4.
5.
6.
7.
8.
Obtain current year’s financial
statements.
Obtain prior 3 years’ financial
statements.
Perform vertical/ horizontal analysis of
the 4 years, plus all current quarters.
Pay attention to footnotes.
Analysis of %s and footnotes by senior
auditors.
Nonsense %s and footnotes inquire
explanations from financial
management.
Interview lower level financial
employees who approved questionable
journal vouchers.
Combine explanations with visits to
accounting records/ source documents.
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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%
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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.
• 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).
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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 at least 12 years).
• Check for regular changes to reserves,
depreciation, amortization, or comprehensive
income policy.
• Related-party transactions (e.g., Enron).
• Complex financial products (e.g.,
derivatives).
• Unsupported top-side entries (e.g.,
WorldCom).
• Under-funded defined pension plans.
• Unreasonable management compensation.
Source: Scott Green, “Fighting Financial Reporting Fraud,”
Internal Auditor, December 2003, pp. 58-63.
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Five Statistically Significant Ratios
• Use the ratios for two successive fiscal years.
• Convert into indexes for benchmarking.
Day’s Sales in Receivable Index:
(Accounts Receivable t / Sales t )
(Accounts Receivable t-1 / Sales t-1)
Index for manipulators: 1.5 to 1
-------------------------------------------------------Gross Margin Index:
[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]
[(Sales t - Cost of Sales t ) / Sales t]
Index for manipulators = 1.2 to 1
-------------------------------------------------------Source: M.D. Beneish, “The Detection of Earnings Manipulation,”
Financial Analysts Journal, September/October, 1999. t-1 =
prior year.
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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.
286
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A Charles Lundelius Example
Comparison to peer group benchmarks:
Characteristic
DSRI
GMI
AQI
SGI
TATA
MPS Peer group
1.56
1.03
2.00
1.10
1.23
1.04
1.50
1.20
0.10
0.05
% over peers
51%
82%
18%
25%
100%
Source: C.R. Lundelius, Financial Reporting Fraud, AICPA, 2003, p.
129.
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Exercises
1. In order to determine how risky a particular company is that
you are auditing, you prepare these five ratios along with
the same ratios of this company’s peers:
Company
Peers
Day’s Sales in Receivable Index
1.51
1.05
Gross Margin Index
1.98
1.11
Asset Quality Index
1.21
1.01
Sales Growth Index
1.53
1.19
Total Accruals to Total Assets
0.11
0.06
What are your thoughts about the risk potential of this
company?
2. You are provided the following information about a
company for two years (in millions):
Sales
Cost of Sales
Accounts Receivable
2005
2006
$23,000
32,000
11,960
17,600
4,830
10,560
Calculate:
a. Days Sales in receivable index.
b. Gross margin index.
c. Sales growth index.
Any thoughts about this company?
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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
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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
291
Problems
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Crumbley
The following information is taken from the
accounting records of Donald Company:
Average receivables
Cost of goods sold
Sales
Average inventory
Net credit sales
Operating income
$700,000
2,900,000
8,000,000
1,100,000
1,200,000
900,000
The inventory turnover is
• 1.81
• 2.2
• 2.64
• 2.92
• None of the above.
Using the facts above, the operating margin is
• .1125
• .32
• 1.1
• 1.6
• None of the above.
292
Excel Spreadsheet
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Crumbley
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.
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Investigative Technique: Videotapes
 Average big city resident caught on videotape about 75
times a day. Common in workplaces and stores (USA).
 Former Coca-Cola secretary convicted of conspiring to
steal and willing to sell confidential Coca-Cola
documents and samples of products that the company
was developing to Pepsi.
 Coca-Cola security expert testified that surveillance
cameras were monitoring Joya Williams’ movements.
The surveillance was a key part of the government’s
evidence.
 She stole the materials and was attempting to sell for at
least $1.5 million.
 Deeply in debt, unhappy at job, and seeking a big
payday.
Could face 10-years in prison.
Myway, “Video Shows Coke Worker Taking Documents,” January 26, 2007.
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Fraud Awareness Auditing:
Unrefined Oil
295
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Problems
Solution:
Inventory Turnover =
C of GS
Average Inventory
= $2.9 million = 2.64%
1.1 million
Operating Margin = Operating Income
Sales
= $900,000 = .1125
$8 million
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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.
298
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Life Styles Important
For someone who earned a salary of just
$1,000 a month, Rana Koleilat managed to live a
pretty nice life. She traveled by private jet, took along
her servant and hairdresser, and stayed at luxurious
locality in London and Paris. Back home in Beirut,
Lebanon, she lived in a three-story penthouse. To
anyone who asked how she lived so well, she replied
that she had a “rich uncle.”
Actually, Koleilat helped manage a private
bank in Beirut, and thereby hangs a tale. The chairman
of the bank said he lost $1.2 billion, and depositors
lost another several hundred million dollars.
E.T. Pound, “Following the Old Money Trail,” U.S. News & World Report, April 4, 2005,
p. 30
299
Be An Investigator
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Crumbley
“Because I was an investigator,” he said.
“O.K.,” she said. “Investigators investigate. That, I
can follow. But don’t they stop investigating? I
mean, ever? When they know already?”
“Investigator never know,” he said. “They feel, and
they guess.”
“I thought they dealt in facts.”
“Not really,” he said. “I mean, eventually they do, I
suppose. But ninety-nine percent of the time it’s
ninety-nine percent about what you feel. About
people. A good investigator is a person with a feel
for people.”
Lee Child, Echo Burning, N.Y.: Jove Books, 2001, p. 281.
300
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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.
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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.
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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.
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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.
304
Barter Deals
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Crumbley
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.
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Management’s Role
The Sarbanes-Oxley Act of 2002
mandates that CEOs and CFOs certify in
periodic reports containing financial
statements filed with the SEC the
appropriateness of financial statements
and disclosures.
--------------------------------------------------------
In March 2005, the SEC said that
executives are gatekeepers. Thus, an
executive can be in trouble if in a
position to detect wrongdoing below
them and do not move forcefully to
prevent the fraud. It does not matter if
the executive has been lied to. An
executive has the responsibility to cut
through the lies and try to root out the
truth.
Carol. J. Loomis, “The SEC Turns the Screws on
Gatekeepers,” Fortune, April 18, 2005, p. 38.
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Pressures On All Sides
CEOs are now being squeezed as a result
of SOX by BODs, auditors, and lawyers
because these watchdogs are finally
facing genuine liability for their failures.
These watchdogs are trying to protect their
hides.
Arthur Andersen is out of business, and
directors at WorldCom and Enron are
paying off fraud claims out of their own
pockets. Hank Greenberg, former
Chairman and CEO of AIG said that the
balance of power in corporate America has
shifted.
Diane Brady and Joseph Weber, “The Boss on the Sidelines,”
Business Week, April 25, 2005, p. 88.
307
Significant Variables of
Fraudulent Companies
© D.L.
Crumbley
• Percentage of total Board of Directors
holdings held by insiders.
• Insiders having greater than 50%
control of the BOD.
• CEO also being chairman of the BOD.
• CEO being the company’s founder.
• Lack of an audit committee.
SEC Accounting and Auditing Enforcement Releases (1982-1992).
308
CEO Duality
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Crumbley
Eight of the ten recent scandals had
board chairs who were also CEO:
1.Enron
5. HealthSouth
2.Adelphia
6. Quest
3.Tyco
7. Homestore
4.Waste Management
8. Sunbeam
WorldCom and Global Crossing had different
Chairman and CEO.
-------------------------------------------------------Aging Board of Directors. “Easier for
Management to get away with misdeeds.”
Enron’s Audit Committee chairman was 72.
“They can be hard of hearing.” Nearly 10% of
directors in the S & P’s 500 stock index are 70
or over.
Source: Louis Lavelle, “Directors: Know When to Fold Them, “Business Week, May 24, 2004, p.14.
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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”
310
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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.
311
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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.
312
Audit Committee
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The audit committee is the subcommittee of an
organization’s board of director’s charged with
overseeing the organization’s financial reporting and
internal control processes. The audit committee’s
biggest responsibility is monitoring the component
parts of the audit process.
---------------------------------------------------------------The board of directors and its representative audit
committee should oversee (1) the integrity, quality,
transparency, and reliability of the financial reporting
process; (2) the adequacy and effectiveness of the
internal control structure in preventing, detecting,
and correcting material misstatements in the financial
statements; and (3) the effectiveness, efficacy, and
objectivity of audit functions.
313
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Audit Committee Red Flags
• Independence of audit committee from
management. Audit committee should report to
BODs.
• The clarity with which the audit committee’s
responsibilities are articulated, such as in the
charter, and how well the audit committee and
management understand those responsibilities;
• The audit committee’s interactions and
involvement with the independent and internal
auditor; and
• Whether the audit committee raises and pursues
with management and the independent auditor the
appropriate questions, including questions that
indicate an understanding of the critical
accounting policies and judgmental accounting
estimates.
314
Computer Forensics
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“Today’s Sergeant Joe Friday does not write in a small
notebook in the course of solving crimes; he now
reconstructs the data from imaging hard drives.”
Joe Anastasi, The New Forensics, John Wiley & Sons, 2003.
“Corporate criminals don’t always tell the truth.
Their computers usually do.”
Thomas Talleur, KPMG
• “The need for computer forensics has dramatically
increased. This represents the use of computer science
principles and investigative techniques to obtain digital
evidence from computer systems that is admissible in a
court of law,” says Bruce Dubinsky.
• Statistics indicate that 92 percent of new data is
created electronically and that 70 percent of this data
never migrates to paper. When investigators ignore
electronics evidence, it’s analogous to only reviewing
three out of 10 boxes containing potentially relevant
and discoverable information.
S. Kahan, “Sherlock Holmes Enters Accounting,” WebCPA, February,
2007.
315
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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.
316
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Technology Knowledge Important
•
Ruby Sharma, at E&Y, says that computer forensic services, as
well as electronic discovery and forensic data analysis, are
provided by its legal technology services practice, which currently
consists of 52 professionals, around one-fourth of whom are
primarily devoted to computer forensics and closely related
disciplines.
These computer forensics professionals provide a range of services
to clients beyond the traditional identification, preservation and
extraction of electronic evidence from digital media, she says.
They also provide forensic investigations and analysis of digital
media to determine the circumstances surrounding the creation,
deletion or modification of specific documents; determine the
provenance of documents; locate and recover evidence that has
been either intentionally or unintentionally deleted; and determine
timelines and event sequences of computer activity that may be of
value to the investigation.
•
Frank Piantidosi, at Deloitte, says that technology is the heart of
most financial investigations, and electronic data drives the
investigation. He says that this group provides repositories of all
the data to the legal teams electronically, rather than through the
antiquated system of boxes and boxes of hard copy files.
•
We have developed technology solution that can quickly find and
accumulate data from various sources anywhere in the world, then
read the data files using software from India, then store the data
using Australian technology for 5 to 10 years.
S. Kahan, “Sherlock Holmes Enters Accounting,” WebCPA, February 11, 2007.
317
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Using Technology to
Gather Evidence
•
•
•
•
Drill-down functionality
Electronic imaging
Benford’s law
Digital Analysis Tests and Statistics
(DATAS)
• Data warehousing/mining
• Inductive vs. deductive method
318
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Technology is Here
“Extensive knowledge and use of technology is
an absolute necessity. The ability to go into
an electronic image and download
information, and to get information from
systems that don’t talk to each other. All the
accumulated information can then be
reviewed for financial improprieties.”
Bert Lacativo, Southlake, Texas
------------------------------------------------------“We use off-the-shelf software (IDEA) to
import large databases, read different data
files, set up queries, and compare database
files such as addresses, telephone numbers,
and Social Security numbers. This process
will tell us, for example, if a purchase order
was done on Saturday or Sunday when the
company isn’t open.”
Cal Klausner, Bethesda, Md.
H.W. Wolosky, “Forensic Accounting to the Forefront,” Practical
Accountant, February 2004, pp. 23-28
319
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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.
320
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Wiz Rule Data Auditing Tool
• Based upon data mining.
• Performs complex analysis of data,
finding errors, inconsistencies, and
situations that require further
investigation.
• WizRule reveals all the if-then rules,
mathematical formula rules, and
spelling irregularities.
• Divides situations deviating from the
rules into data entry errors and
suspicious errors.
• Can be used in auditing, fraud
detection, data scrubbing, and due
diligence reviews.
• Learning curve is short.
• Cost license is $1,395 and yearly
maintenance fee is $279.
Source: Irina Sered, “Software,” kdnuggets.com/news/2001/n24/13i.html.
321
Who Uses IDEA?
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• External and Internal
Auditors
• Forensic Accountants/ Fraud
Investigators
• Financial managers
• General and systems
consultants
• Educators
• Statisticians
• Information systems
professionals
322
IDEA Benefits
•
•
•
•
•
•
Sort
Compare
Manipulate
Sample
Extract data
Mathematical
testing
• Exception
reports
• Aging
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• Statistics
• Find missing
data
• Analytics
• Convert test
files to data base
• Create summary
reports
323
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Using Data Mining
• Match employee addresses against
vendor addresses.
• Sort vendor list by size to determine
the most highly paid suppliers.
• Review the structure of vendor
names.
• Uncover indications of ghost
employees (e.g., N.O. Police dept.).
• Fraudulent expense reports (even
amounts, $6).
• Repeated withdrawals of even
amounts from petty cash.
324
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Computer Forensics
“I need you to step away from your
computer please,” Lee Altschuler said.
Morgan Fay’s chief financial officer glanced up
from her computer screen. She regarded the
man standing at her office doorway for a
moment. “Excuse me?” Cindy Shalott asked.
“We’d like you to please conclude your
business for the day.” Lee Altschuler said.
“I’d appreciate it if you could complete
whatever you’re doing as quickly as you can.
Please leave your computer in the way that it is
now. Don’t turn it off.”
The chief financial officer swung her desk
chair around.
“Just move away from your computer
please,” Altschuler repeated.
“Who are you?” Cindy Shalott asked.
Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003, p. 91
325
Ink Analysis
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 Martha Stewart was undone by a blue
ballpoint pen.
 Stockbroker belatedly inserted a note to
help cover up Ms. Stewart’s improper stock
trading. Blue ballpoint ink used is different
from ink elsewhere on the trading
worksheet.
 Prosecutors used forensic ink analysis in
Rite Aid case to show that certain
documents were backdated (ink used to
sign letter was not commercially available
until 3 months after the letter was dated).
 Xerox laser printers now encode the serial
number of each machine in tiny yellow dots
in every printout, nestled within the printed
words and margins. It tracks back to you
like a license plate.
 Advice for fraudsters: use pencils.
Source: Mark Maremont, “In Corporate Crimes, Paper Trail
Often Leads to Ink Analysts’ Door,” Wall Street J., July 1,
2003, p. A-1.
326
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Deductive vs. Inductive
 Deductive: one goes from general to
specific; fairly simple and economical.
 Inductive: one starts with specific
experiences and then draws inferences.
Deductive Approach
Inductive Approach
Generic data mining
Custom data mining
Digital analysis
Analysis of all data
Discovery sampling
Generic software
Custom software
For smaller organizations
For larger organizations
Basic features
Sophisticated features
Easy to learn
Requires advanced skills
Relatively inexpensive
More expensive
Source: W.S. Albrecht and C.C. Albrecht, “Root Out Financial
Deception,” Journal of Accountancy (April 2002), p. 33.
327
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Benford’s Law
•
•
Distribution of initial digits in natural numbers is not random
Predictable patterns:
0= ----1= 30.1%
2= 17.6%
3= 12.5%
4= 9.7%
5= 7.9%
6= 6.7%
7= 5.8%
8= 5.1%
9= 4.6%
12%
11.4%
10.9%
10.4%
10%
9.7%
9.3%
9%
8.8%
8.5%
10.2%
10.1%
10.1%
10.1%
10%
10%
9.9%
9.9%
9.9%
9.8%
There is software to detect potentially invented numbers in many situations.
Compare actual frequency with Benford’s frequency.
328
Benford’s Law Uses
•
•
•
•
•
•
•
•
•
•
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Investments sales/purchases
Check register.
Sales history/Price history.
401 contributions.
Inventory unit costs.
Expenses accounts.
Wire transfer information.
Life insurance policy values.
Bad debt expenses.
Asset/liability accounts.
Source: Richard Lanza, “Digital Analysis- Real World Example,” IT
Audit, July 1, 1999,pp. 1-9.
329
Spreadsheet Fraud
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• Spreadsheets can be excellent tools for
committing fraud.
• There is little or no security in
controlling changes within the
worksheets.
• Aside from fraud, they are ripe
grounds for errors because of their
open nature for change.
• For examples, see European
Spreadsheet Risks Interest Group:
www.eusprig.org/stories.htm
Source: R. B. Lanza, “The Spreadsheet: The Easiest Place for
Committing Financial Statement Fraud,” Fraud Magazine,
July/August 2005, p. 15.
330
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Some Spreadsheet Frauds
• AIB/Allfirst Trading Fraud – The fraudster
substituted links to his private manipulated
spreadsheet which exaggerated bonuses by
more than half a million dollars.
• HealthSouth – Two ex-HealthSouth
executives admitted that they prepared a
false spreadsheet for auditors that inflated
HealthSouth’s assets and made the
company appear to be worth more than it
was.
• CFX – The Internal Audit Department
noted in its investigation that management
created spreadsheets showing desired
results first and then adjustments were
made to the accounting system to match the
spreadsheet.
Source: R. B. Lanza, “The Spreadsheet: The Easiest Place for Committing
Financial Statement Fraud,” Fraud Magazine, July/August 2005, p. 15.
331
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Combating Spreadsheet Fraud
• Use techniques native in
Microsoft Excel [enormous
resources, time, money,
manpower]
• EXChecker™ (does not allow
any editing to the Excel
spreadsheet)
Source: R. B. Lanza, “The Spreadsheet: The
Easiest Place for Committing Financial
Statement Fraud,” Fraud Magazine,
July/August 2005, p. 15.
332
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When Benford Analysis Is or Is
Not Likely Useful
When Benford Analysis is Likely Useful
Examples
Sets of numbers that result from
mathematical combination of numbersResult comes from two distributions.
Accounts receivable (number
sold times price). Accounts
payable (number bought times
price).
Transaction-level data – No need to sample.
Disbursements, sales,
expenses.
On large data sets – The more observations,
the better.
Full year’s transactions.
Accounts that appear to conform – When
the mean of a set of numbers is greater than
the median and the skewness is positive.
Most sets of accounting
numbers.
When Benford Analysis Is Not Likely Useful
Examples
Data set is comprised of assigned numbers
Check numbers, invoice
numbers, zip codes.
Numbers that are influenced by human
thought.
Prices set at psychological
thresholds ($1.99), ATM
withdrawals.
Accounts with a large number of firmspecific numbers.
An account specifically set up
to record $100 refunds.
Accounts with a built in minimum or
maximum.
Set of assets that must meet a
threshold to be recorded.
Where no transaction is recorded.
Thefts, kickbacks, contract
rigging.
Source: Durtschi, Hillison, and Pacini, p. 24.
333
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Fraudulent Tax Returns
334
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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.
335
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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
336
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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.
337
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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.
338
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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
339
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Market Segment
Specialization Program
The Market Segment Specialization
Program focuses on developing highly
trained examiners for a particular market
segment. An integral part of the approach
used is the development and publication of
Audit Technique Guides.
These Guides contain examination
techniques, common and unique industry
issues, business practices, industry
terminology, and other information to assist
examiners in performing examinations. A
forensic accountant can use this resource
to learn about a particular industry.
http://www.irs.gov/business/small/article/0,i
d=108149,00.html
340
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Minimum Income Probes
• For non-business returns, an agent
question the taxpayer or
representative about possible sources
of income other than reported on the
return. If there is no other information
in the file indicating potential
unreported income, the minimum
income probe is met.
• For taxpayers who are self-employed
and file a Schedule C or F, an analysis
is made of tax return information to
determine if reported income is
sufficient to support the taxpayer’s
financial activities.
341
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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.
342
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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
343
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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.
344
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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
2005
2006
$7,300
15,000
3,700
17,600
2,000
4,200
14,000
11,500
75,300
$29,500
8,400
10,000
38,800
37,000
$123,700
$3,600
49,500
7,000
3,000
0
$63,100
$12,200
$1,700
53,000
13,000
3,000
7,000
$77,700
$46,000
Known sources of funds:
Cash on hand
Salary
Consulting
Dividends and interest
Loan proceeds
Balance
Net unreported funds
345
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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).
346
Net Worth Example
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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
347
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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
$225,000 $421,000
225,000 310,000
0 $111,000
11,000
21,000
2005
$610,000
420,000
$190,000
23,000
____0
$90,000
$167,000
$62,000
51,000
$11,000
$81,000
60,000
$21,000
$87,000
64,000
$23,000
1 Actual Net Worth recalculated based upon actual assets less liabilities.
2 Net Worth based upon reported income less expenses.
348
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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).
349
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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
350
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Crumbley
Formula for Expenditure Method
Expenditures
less: Known sources of income
=
Unknown sources of income
$210,000
115,000
$95,000
351
Percentage of Markup Method © D.L.
Crumbley
Gross Profit on Sales Formula
Sales per books
$100,000
25%
Gross profit percentage
$25,000
Gross profit as recomputed
Sales on Cost of Sales Formula Cost of SalesPercentage of Sales Price
Cost of Product A
$10,000
$20,000
Cost of Product B
Cost of Sales – Percent of Selling Price
Product A
25%
Product B
50%
Recompiled Sales of products A and B
Product A
$40,000
(10,000/.25)
Product B
$40,000
(20,000/.5)
Sales as recomputed
$80,000
Ratio Analysis Formula
Restaurant Sales
$90,000
Number of waiters
3
Average sales per waiter
30,000
Customer’s tip percentage
10%
Waitress tip income as recomputed
$3,000
352
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Crumbley
Unit and Volume of Sales Method
Average sales price per machine
Number of machines manufactured
Total sales as recomputed
Total sales per return
Unreported sales:
$900
1,100
$990,000
720,000
$270,000
Suppose:
Beginning inventory
Ending inventory
$220,000
$250,000
353
Some Exercises
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30) Given the following facts about Sammie Bright,
calculate his preliminary understatement using the CashT 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%
354
Other Techniques
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Crumbley
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.
355
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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.
356
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Crumbley
Management may also engage in
financial statement fraud to obtain
personal benefits of:
1. Increasing compensation
through higher reported
earnings;
2. Enhancing value of personal
holding of company stock
such as stock-based
compensation;
3. Converting the company’s
assets for personal use; and
4. Obtaining a promotion or
maintaining the current
position within the company.
Source: Zab Rezaee, Financial Statement Fraud, New
York: John Wiley & Sons, 2002.
357
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Crumbley
Rest Of The Story:
Fraudsters Should Be Prosecuted
Although large frauds may be reported to law
enforcement agencies, smaller frauds are
often not reported.
This failure to report fraud incidents and the
reluctance of police to aggressively tackle the
issue only empowers the perps and
diminishes the victims. Ultimately, these
unreported incidents are precursors to larger
and larger acts of violence. If we do not
deal with simple crimes, we will eventually
have to deal with homicide.
Source: Stephen Doherty, “How Can Workplace
Violence Be Deterred,” Security Management, April
2002, p. 134.
358
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Use IRS Form 1099 Threat
• For fraudsters and embezzlers, use
the threat of filling a Form 1099 for
amounts stolen.
• Ask for an installment payback.
• If they stop payment, report them to
the IRS on a Form 1099.
359
Some Exercises
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Crumbley
360
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Crumbley
KPMG provides 10 steps to follow when an
organization finds or suspects fraud:
1. Shut the door! Keep assets secure until
you can provide appropriate long-term
security.
2. Safeguard the evidence. Ensure that all
records and documents necessary for an
investigation remain intact and are not
altered by you or anyone else.
3. Notify your insurer. Failure to notify may
negate your coverage.
4. Call a professional. Do not confront or
terminate the employment of a suspected
perpetrator without first consulting your
legal advisor.
5. Prioritize your objectives. What’s most
important: punishment, loss recovery,
prevention, detection of future
occurrences?
361
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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.
362
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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.
363
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Crumbley
Over-all Fraud Plan
• Background checks
• Avoid Nepotism
• Signed Conditions of Employment Agreement
• Noncompete Agreement
• Confidentiality of Information Agreement
• Bonding
• Two-signatures on checks/ wire transfers/ lines
of credit
• Lockbox
• Positive pay
• Check security and restrictive endorsements
• Check stock (can not be scanned and it smears
easily)
• Close out cash registers at unpredictable times
• Back up computer files
• Accounting personnel can not cancel debt
• Have an internal audit
• CEO signs numbered check request form
E.J. McMillan, Policies and Procedures to Prevent Fraud &
Embezzlement, 2006, John Wiley.
364
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
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Crumbley
• 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
365
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Crumbley
How Cash Is Misappropriated
% Median Loss
Inflow:
Skimming
Cash larceny
Disbursements:
Billings
Expense
Reimbursements
Check Tampering
Payroll
Wire transfers
Register Disbursements
18.9%
14.2%
$76,000
73,000
28.3%
19.5%
130,000
25,000
17.1%
13.2%
6.5%
1.7%
120,000
50,000
500,000
26,000
Source: 2006 Wells Report, ACFE.
366
Cash Wheel
Accounts Receivable
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Crumbley
Adjusting Entries
Accounts Payable
Depreciation
Accruals
Cash
Source: Fraud Auditing Small Businesses With The Wheel , James A. Goldstine
367
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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.
368
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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.”
369
Preventive Measures
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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.
370
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Crumbley
Processing Checks Best Procedure
Step 1.
Step 2.
Step 3.
Step 4.
The invoice is approved for payment.
A check request form is completed.
The CEO approves the check request.
The check request is forwarded to
accounting.
Step 5. Accounting processes the check.
Step 6. The CEO signs the check.
Step 7. A second designated employee (who
does not approve the payment and is not
in the accounting department) should
cosign the check.
Therefore, 4 people involved.
E.J. McMillan, Policies & Procedures to Prevent Fraud & Embezzlement,
John Wiley, 2006, p.44.
371
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Crumbley
Processing Checks Best Procedure
• Invoice is approved for payment.
• Check request form is prepared.
• The CEO approves/ signs the numbered check
request form.
• Check request form is forwarded to
accounting.
• Accounting processes the check.
• The check is signed by two authorized
individuals.
• The check is mailed.
• The bank statements are sent to the CEO’s
home (or P.O. box) for review.
• The CEO forwards the reviewed bank
statements to accounting for reconciliation.
E.J. McMillan, Policies & Procedures to Prevent Fraud &
Embezzlement, John Wiley, 2006, p.45.
372
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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].
373
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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.
374
Cash Schemes
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Crumbley
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.
375
Refund Schemes
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Crumbley
• 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.
376
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Crumbley
Accounts Receivable’s Schemes
• Lapping.
• Fictitious receivables [for a
fictitious sale], which is later
written off.
• Borrowing against receivables
(use receivable as collateral).
• Improper posting of credits
against receivables.
377
Lapping
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Crumbley
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.
378
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Crumbley
Warning Signs of Lapping
• Increase in complaints.
• Excessive billing errors.
• Delays in posting customer
payments.
• Trend of decreasing accounts
receivable payments.
• Accounts receivable details do
not agree with the general
ledger.
379
Lapping (cont.)
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Crumbley
Audit Steps
• Independently verifying
customers who do not pay.
• Reviewing write-offs.
• Reviewing customers’
complaints.
• Compare the checks on a sample of
deposit slips to the details of the
customers’ credits that are listed on
the day’s posting to the customer’s
account receivables.
• Closely monitor aging accounts.
380
© D.L.
Crumbley
How Non-Cash Assets are
Misappropriated – 2006
Category
Inventory
Information
Securities
%
16.6%
3.6%
1.5%
Median Loss
$55,000
78,000
1,850,000
Source: 2006 Wells Report, ACFE.
381
Inventory
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Crumbley
Inventory Fraud
• Stealing inventory/supplies for personal use or
for sale at flea markets/garage sales.
• Kickback schemes (vendor/supplier and an
employee). Sale of unreported inventory at
inflated prices.
Audit Steps for Inventory Fraud
• Use renumbered inventory tags matched to
count sheets; use count procedures for work-inprogress items; separate duties between
purchasing and logging receipts of shipments
• Check for same vendors.
• Prices higher than other vendors.
• Purchasing agent does not take vacation.
• Only photocopies of invoices are available.
• Aging of inventory.
• Inventory turnover
• There is data-mining software.
382
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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.
383
Reducing Bad Debts
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 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
384
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Crumbley
Accounts Payable Fraud Red Flags
1.
•
Duplicate payments (2% of total purchases)
$80 million times 2% = $1.6 million loss.
Extract only the numerical digits of an invoice
number and match on only the numbers portion of
the invoice.
Try identifying the dates that are similar such as
dates that are less than 14 days.
Try matching on the absolute value of the amount.
2.
Rounded-amount invoices.
3.
Invoices just below approval amounts.
4.
Abnormal invoice volume activity (two invoices
one month and 60 the next).
5.
Vendors with sequential invoice numbers.
LC 0002, LC 0003, LC 0003
6.
Above average payments per vendor.
•
•
C. Warner and B. G. Dubinsky, “Uncovering Accounts Payable
Fraud,” Fraud Magazine, July/ August 2006, pp. 29-51.
385
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Crumbley
Top 10 Financial Red Flags of Insurance Fraud
• Visible alteration of documents.
• Conflicting dates and/ or information.
• Missing pages of documents.
• Missing key information.
• Significant discrepancies between tax returns and other
financial documentation.
• Poor financial condition prior to loss.
• Business appears to be winding down immediately prior
to loss.
• Discovery or previously undisclosed financial or
business interests.
• Expenses continue while not working or operating.
• Income and/ or ownership is transferred to family.
D. W. Draz, “Insurance Industry Anti-Fraud Insights,” Fraud Magazine,
July/ August, 2006, p.63.
386
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Crumbley
Look For Fraud Symptoms
•Source Documents.
•Journal Entries.
•Accounting Ledgers.
387
© D.L.
Crumbley
Source Documents
•
•
•
•
•
•
•
•
Checks.
Employee time cards.
Sales invoices.
Shipping documents.
Expense invoices.
Purchase documents.
Credit card receipts.
Register tapes.
388
© 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.
•Number of round numbers.
•Too many beginning 9’s.
389
© 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.
•Number of round numbers.
•Too many beginning 9’s.
390
© D.L.
Crumbley
Ledger Fraud Symptoms
•Underlying assets disagree.
•Subsidiary ledger different than
general ledger.
391
Rite Aid Fraud Case
© D.L.
Crumbley
 Former CEO Martin Glass bragged that the
computer used to generate backdated letters had
disappeared at sea. “They have no computer.
The letters that were done on the computer…they
do not have and never will have, unless they use
a Trident submarine.”
 Wrong. President Timothy Noonan was wearing
a wire. He recorded 6 meetings over 10 weeks.
Federal investigators heard everything.
 CFO Franklyn Bergonzi:
 Obtained $30 million in extra profits by dunning Rite
Aid’s suppliers for merchandise that was supposedly
outdated or damaged (but not so).
 Another $75.6 million came from rebates from
pharmaceutical firms that had yet to be earned.
 Failed to report certain expenses properly.
 Increased the useful life of some assets.
 The financial restatements wiped out $1.6 billion
in profits.
 Martin L. Glass was sentenced to 8 years, and his
CFO was sentenced to 2 years and 4 months.
Source: Mark Maremont, “Call To Account: Rite Aid Case
Gives Early View of Fraud on Trial,” Wall Street J., June 11,
392
2003, p. A-6.
© D.L.
Crumbley
Rite Aid’s Bag of Tricks
• Rite Aid overstated its income in
every quarter from May 1997 to
May 1999, by massive amounts.
• Restated its pre-tax income by
$2.3 billion and net income by
$1.6 billion, the largest
restatement ever.
Source: SEC Announces Fraud Charges Against Former Rite
Aid Senior Management.
http://www.sec.gov/news/press/2002-92.htm
393
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Crumbley
Rite Aid’s Bag of Tricks
Wayne M. Carlin, Regional Director of the
Commission's Northeast Regional Office, stated:
"The charges announced today reveal a
disturbing picture of dishonesty and
misconduct at the highest level of a major
corporation. Rite Aid's former senior
management employed an extensive bag of
tricks to manipulate the company's
reported earnings and defraud its investors.
At the same time, former CEO Martin
Grass concealed his use of company assets to
line his own pockets. When the house of cards
teetered on the edge of collapse, Grass
fabricated corporate records in a vain effort
to forestall the inevitable. The Commission's
enforcement action, and the related criminal
prosecutions announced today, demonstrate
that there will be no refuge for corporate
executives who commit this kind of
wrongdoing."
Source: http://www.sec.gov/news/press/2002-92.htm
394
Rite Aid’s (Cont.)
© D.L.
Crumbley
• Up-charges — Rite Aid
systematically inflated the
deductions it took against
amounts owed to vendors for
damaged and outdated products.
For vendors who did not require
the unusable products to be
returned to them, Rite Aid applied
an arbitrary multiplier to the
proper deduction amount, which
resulted in overcharging its
vendors by amounts that ranged
from 35% to 50%. These
practices, which Rite Aid did not
disclose to the vendors, resulted
in overstatements of Rite Aid's
reported pre-tax income of $8
million in FY 1998 and $28 million
in FY 1999.
Source: http://www.sec.gov/news/press/2002-92.htm
395
Rite Aid’s (Cont.)
© D.L.
Crumbley
• Stock Appreciation Rights
(SARs) — Rite Aid failed to
record an accrued expense for
stock appreciation rights it had
granted to employees, in a
program that gave the recipients
the right to receive cash or stock
in amounts tied to increases in
the market price of Rite Aid stock.
Rite Aid should have accrued
an expense of $22 million in FY
1998 and $33 million in FY 1999
for these obligations. When
questioned by Rite Aid's
independent auditors about the
existence of any SARs, Bergonzi
falsely denied that any had
been issued.
Source: http://www.sec.gov/news/press/2002-92.htm
396
Rite Aid’s (Cont.)
© D.L.
Crumbley
• Reversals of Actual Expenses — In
certain quarters, Bergonzi directed
that Rite Aid's accounting staff to
reverse amounts that had been
recorded for various expenses
incurred and already paid. These
reversals were completely unjustified
and, in each instance, were put back
on the books in the subsequent
quarter, thus moving the expenses to
a period other than that in which they
had actually been paid.
The effect was to overstate Rite
Aid's income during the period in
which the expenses were actually
incurred. For example, Bergonzi
directed entries of this nature which
caused Rite Aid's pre-tax income for
the second quarter of FY 1998 to be
overstated by $9 million.
Source: http://www.sec.gov/news/press/2002-92.htm
397
Rite Aid’s (Cont.)
© D.L.
Crumbley
• "Gross Profit" Entries —
Bergonzi directed Rite Aid's
accounting staff to make
improper adjusting entries to
reduce cost of goods sold and
accounts payable in every
quarter from the first quarter of
FY 1997 through the first quarter
of FY 2000 (but not at year end,
when the financial statements
would be audited).
These entries had no
substantiation, and were intended
purely to manipulate Rite Aid's
reported earnings. For example,
as a result of these entries alone,
Rite Aid overstated pre-tax
income by $100 million in the
second quarter of FY 1999.
Source: http://www.sec.gov/news/press/2002-92.htm
398
Rite Aid’s (Cont.)
© D.L.
Crumbley
• Undisclosed Markdowns — Rite
Aid overstated its FY 1999 net
income by overcharging
vendors for undisclosed
markdowns on those vendors'
products. The vendors did not
agree to share in the cost of
markdowns at the retail level,
and Rite Aid misled the vendors
into believing that these
deductions — taken in February
1999 — were for damaged and
outdated products. As a result,
Rite Aid overstated its FY 1999
pre-tax income by $30 million.
Source: http://www.sec.gov/news/press/2002-92.htm
399
Rite Aid’s (Cont.)
© D.L.
Crumbley
• Vendor Rebates — On the last day of FY
1999, Bergonzi directed that Rite Aid
record entries to reduce accounts
payable and cost of goods sold by
$42 million, to reflect rebates
purportedly due from two vendors. On
March 11, 1999 — nearly two weeks after
the close of the fiscal year — Bergonzi
directed that the books be reopened to
record an additional $33 million in credits.
All of these entries were improper, as
Rite Aid had not earned the credits at the
time they were recorded and had no legal
right to receive them. Moreover, due to
Rite Aid's pass-through obligations in
agreements with its own customers, Rite
Aid would have been obligated to pass
$42 million out of the $75 million through
to third parties. The $75 million in inflated
income resulting from these false entries
represented 37% of Rite Aid's reported
pre-tax income for FY 1999.
Source: http://www.sec.gov/news/press/2002-92.htm
400
Rite Aid’s (Cont.)
© D.L.
Crumbley
•Litigation Settlement — In
the fourth quarter of FY 1999,
Grass, Bergonzi and Brown
caused Rite Aid to recognize
$17 million from a litigation
settlement. Recognition was
improper, as the settlement
was not in fact consummated in
legally binding form during the
relevant period.
Source: http://www.sec.gov/news/press/2002-92.htm
401
Rite Aid’s (Cont.)
© D.L.
Crumbley
• "Dead Deal" Expense — Rite Aid
routinely incurred expenses for legal
services, title searches, architectural
drawings and other items relating to
sites considered but later rejected for
new stores. Rite Aid capitalized these
costs at the time they were incurred.
Rite Aid subsequently determined not to
construct new stores at certain of these
sites.
Under Generally Accepted
Accounting Principles, Rite Aid should
have written off the pertinent "dead
deal" expenses at the time that it
decided not to build on each specific
site. Such write-offs would have
reduced reported income in the relevant
periods. Instead, Rite Aid continued to
carry these items on its balance
sheet as assets. By the end of FY
1999, the accumulated dead deal
expenses totaled $10.6 million.
Source: http://www.sec.gov/news/press/2002-92.htm
402
Rite Aid’s (Cont.)
© D.L.
Crumbley
• "Will-Call" Payables — Rite Aid often
received payment from insurance
carriers for prescription orders that were
phoned in by customers but never
picked up from the store. Rite Aid
recorded a "will-call" payable that
represented the total amount of these
payments received from insurance
carriers, that Rite Aid would be
obligated to return to the carriers. In
the fourth quarter of FY 1999, Rite Aid
improperly reversed this $6.6
million payable. When Rite Aid's
general counsel learned of this reversal,
he directed that the payable be
reinstated. Bergonzi acquiesced in the
reinstatement, but then secretly
directed that other improper
offsetting entries be made which had
the same effect as reversing the
payable.
Source: http://www.sec.gov/news/press/2002-92.htm
403
Rite Aid’s (Cont.)
© D.L.
Crumbley
• Inventory Shrink — When the physical
inventory count was less than the
inventory carried on Rite Aid's books,
Rite Aid wrote down its book inventory
to reflect this "shrink" (i.e., reduction
presumed due to physical loss or theft).
In FY 1999, Rite Aid failed to record
$8.8 million in shrink. In addition,
also in FY 1999, Rite Aid improperly
reduced its accrued shrink expense (for
stores where a physical inventory was
not conducted), producing an improper
increase to income of $5 million.
Source: http://www.sec.gov/news/press/2002-92.htm
404
Rite Aid’s (Cont.)
© D.L.
Crumbley
Related-Party Transactions with
Grass
Grass caused Rite Aid to fail to
disclose his personal interest in three
properties that Rite Aid leased as store
locations. Rite Aid was obligated to
disclose these interests as related party
transactions. Even after press reports in
early 1999 prompted Rite Aid to issue
corrective disclosure regarding these
matters, Grass continued to conceal and
misrepresent the facts, which caused
Rite Aid's corrective disclosures to be
false.
Source: http://www.sec.gov/news/press/2002-92.htm
405
Rite Aid’s (Cont.)
© D.L.
Crumbley
Grass never disclosed an additional
series of transactions, in which he
funneled $2.6 million from Rite Aid
to a partnership controlled by Grass
and a relative. The partnership used
$1.8 million of these funds to
purchase an 83-acre site intended
for a new headquarters for Rite Aid.
Rite Aid subsequently paid over $1
million in costs related to this site
even though it was owned by the
partnership, and not by Rite Aid.
After press reports raised questions
about this site, Grass transferred
$2.9 million back to Rite Aid from a
personal bank account, but
continued to conceal the series of
transactions from Rite Aid's Board.
Source: http://www.sec.gov/news/press/2002-92.htm
406
Rite Aid’s (Cont.)
© D.L.
Crumbley
Fabrication of Minutes by Grass
In September 1999, when Rite Aid
was in perilous financial condition, and
in order to obtain a bank line of credit to
keep the company afloat, Grass caused
minutes to be prepared for a meeting of
Rite Aid's Finance Committee, stating
that the Committee had authorized the
pledge of Rite Aid's stock in PCS Health
Systems Inc. as collateral. Grass
signed these minutes even though
he knew that no such meeting
occurred and the pledge was not
authorized.
Source: http://www.sec.gov/news/press/2002-92.htm
407
© D.L.
Crumbley
Which of these statements are false?
a. A high degree of competition accompanied by
declining margins would be an example of an
opportunity for fraudulent financial reporting.
b. Personal guarantees of debt of a company that are
significant to one’s personal net worth is an
example of a pressure/incentive for fraudulent
financial reporting.
c. A heavy concentration of one’s wealth in a
particular company would be an example of a
rationalization condition for fraudulent financial
reporting.
d. An excessive interest by management in
maintaining a company’s stock price is an
example of rationalization for fraudulent financial
reporting.
e. Anticipated future layoff would be an example of
an incentive to misappropriate assets.
f. A large amount of cash on hand would be an
example of a rationalization to misappropriate
assets.
g. Inadequate internal controls is an example of an
opportunity to misappropriate assets.
408
© D.L.
Crumbley
Which of these statements are false?
a. A high degree of competition accompanied by
declining margins would be an example of an
opportunity for fraudulent financial reporting. F
(I/P)
b. Personal guarantees of debt of a company that are
significant to one’s personal net worth is an
example of a pressure/incentive for fraudulent
financial reporting. T
c. A heavy concentration of one’s wealth in a
particular company would be an example of a
rationalization condition for fraudulent financial
reporting. F (I/P)
d. An excessive interest by management in
maintaining a company’s stock price is an
example of rationalization for fraudulent financial
reporting. T
e. Anticipated future layoff would be an example of
an incentive to misappropriate assets. T
f. A large amount of cash on hand would be an
example of a rationalization to misappropriate
assets. F (O)
g. Inadequate internal controls is an example of an
opportunity to misappropriate assets. T
409
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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.
410
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Crumbley
Stop Ghost Employees
• Ensure that the payroll preparation, disbursement and
distribution functions are segregated.
• Look for paychecks without deductions for taxes or
Social Security. Completely fictitious employees
frequently don’t have any.
• Examine payroll checks that have dual endorsements.
Although most of them are legitimate, two signatures
could signal the forgery of a departed employee’s
endorsement, which the thief also endorses and deposits
into his or her own account.
• Use direct deposits. This method, although not
foolproof, can cut down on payroll chicanery by
eliminating paper paychecks and the possibility of
alteration, forgery and most theft, although it doesn’t
prevent misdirection of deposits into unauthorized
accounts.
• Check payroll records for the presence of duplicate
names, addresses and Social Security numbers.
• On occasion, hand-deliver paychecks to employees
and require positive identification. If you have leftover
paychecks, make sure they belong to actual employees,
not ghosts.
• Be wary of budget variations in payroll expense.
Higher-than-budgeted labor costs can indicate ghost
employees.
Source: J. T. Wells, “Keep Ghosts Off The Payroll,” Journal of Accountancy,
December 2002.
411
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Crumbley
Some Employee Schemes (contd …)
Fictitious Disbursements
• Multiple payments to same payee.
• Multiple payees for the same product or
service.
• Inflated invoices.
• Shell companies and/or fictitious persons.
• Bogus claims (e.g., health care fraud and
insurance claims).
• Overstate refunds or bogus refunds at cash
register.
• Many fictitious expense schemes (e.g.,
meals, mileage, sharing taxi, claiming
business expenses never taken).
• Duplicate reimbursements.
• Overpayment of wages.
412
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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.
413
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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.
414
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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.
415
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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.
416
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Crumbley
How Sellers on eBay Fix Auctions
• Seller places bids on own items using
fake identities (shill bidding).
• Shill bidding may be commonplace on
eBay.
• Associates of seller bid up the price.
417
Forensic Auditing Steps
© D.L.
Crumbley
•
•
•
•
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.
418
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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.
419
Vendor Allowances
© D.L.
Crumbley
• In exchange for better shelf space or advertisement
mentioning its products, a merchandise vendor will
pay stores an extra fee--an allowance often based upon
the amount of products sold.
• Employees at OfficeMax “fabricated supporting
documents for approximately 3.3 million in claims
billed to a vendor to its retail business.” Six
employees were fired, and CEO Christopher Milliken
resigned.
• The SEC sued three former executives in December
2004 at Kmart Holding Corp. for their role in a $24
million accounting fraud that booked these allowances
early.
•The SEC settled a case in October 2004 with Ahold
NV involving allegations of fraudulent inflation of
promotional allowances at U.S. Foodservice, Inc. unit.
Source: David Armstrong, “OfficeMax Results To Be Restated; CEO Steps
Down,” WSJ, February 15, 2005, p. A-3.
420
A Valid Contract?
•
•
•
•
•
•
© D.L.
Crumbley
Offer/ Acceptance
Lawful objective
Capacity of parties to perform
Something of value exchanged
Appropriate form (e.g., in writing)
Entered into freely
421
Breach of Contract
© D.L.
Crumbley
• Breach of contract: a party fails to perform or
says he/ she will not perform. Other party can
sue for damages.
• The intentional failure to perform a contract,
however, does not necessarily constitute fraud.
• Must show that the party did not intend to
perform the contract and deliberately misled
the other party.
• Civil or criminal action: party knowingly and
willfully that the contract (or statement) was
false with the intent to deceive or defraud.
• With this extra burden, may not be worthwhile
to try to prove the fraud. Just get rid of the
person because of a conflict of interest.
422
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Crumbley
Some Contract/ Procurement Frauds
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Bribes and kickbacks.
Bid rigging.
Defective pricing.
Phantom vendors [www.picalo.org].
Product substitution.
Conflict of interests.
False claims.
Cost mischarging.
Contract specification failures.
Duplicate, false, or inflated invoices.
Split purchases.
Unnecessary purchases.
Defective delivery.
H.R. Davia et. al, Accountant’s Guide to Fraud Detection and
Control, John Wiley, 2000, p.62.
423
Types of Bid Rigging
1.
2.
3.
4.
5.
6.
© D.L.
Crumbley
Collective bidding.
Exclusive bidders.
Change order requests.
Manipulation of bids.
Leaking bid information.
Unbalanced bidding.
424
Potpourri of Bribes
© D.L.
Crumbley
• Vernon Jackson admitted to bribery of Rep. William
Jefferson, D-LA. More than $400,000 to one million
paid to a company controlled by the congressman’s
wife in exchange for help promoting iGate. Gave 24%
stake in iGate and paid $80,000 in travel expenses to
Africa. [$90,000 found in Jefferson’s freezer.]
• Two prominent Baton Rouge restaurateurs and four
other businessmen accused of bribing a parish tax
auditor and an undercover FBI agent with cash,
diamonds, trips, whiskey and women to avoid
paying taxes on $10 million, face federal charges.
An indictment alleges Laymon offered an undercover
FBI agent posing as an East Baton Rouge Parish
auditor $800, a weekend trip to Costa Rica and two
prostitutes a day if he concluded that Arzi’s didn’t owe
any sales tax. BR Advocate (12-17-06).
425
Potpourri of Bribes
© D.L.
Crumbley
• A Greek prosecutor is investigating claims that
Siemens Greece paid up to $550 million in bribes to
officials at the defense and interior ministries in order
to win a security contract for the 2004 Olympic games
in Athens. A senior Siemens accountant said bribery
was a common practice at Siemens.
• A Paris judge launched an investigation into
allegations that Total, a French oil and gas group, paid
bribes to win a $2 billion gas contract in Iran. The
investigation stems from the discovery of $82 million
in two Swiss bank accounts, allegedly by Total to an
Iranian intermediary to help the French company
consortium to win an Iranian contract.
• A report claims that AWB, the company responsible
for selling Australia wheat, paid over $221 million to
Alia, a Jordanian hauling company, ostensibly to
distribute its wheat in Iraq. In fact, the money was
going to the Iraq government.
426
Potpourri of Bribes
© D.L.
Crumbley
• Armstrong Williams, an American columnist and
television host, was paid $240,000 by the Dept. of
Education to comment regularly on “No Child Left
Behind,” an education-reform bill.
• Nineteen individuals indicated for receiving bribes
and rigging bids for school window washing
contracts.
• Congressman Randy Cunningham, R-Calif., resigned
from Congress (2005), hours after pleading guilty to
taking at least $2.4 million in bribes to help friends
and campaign contributors win defense contracts.
Prosecutors said he received cash, cars, rugs,
antiques, furniture, yacht club dues, moving
expenses, and vacations from four co-conspirators in
exchange for aid in winning defense contracts.
• In January 2007, Peter Hartz was given a two year
suspended prison sentence and fines for bribing the
head of the labor union ($3.25 million) for secret
bonuses and fake consultancy fees. Involved sex
holidays and paying for prostitutes for labor officials.
427
Potpourri of Bribes
© D.L.
Crumbley
• In the 1950s in the U.S., record companies would
pay money for the broadcast of records on radio,
called payola. Now outlawed.
• In England, police interviewed Prime Minister
Tony Blair in February 2007, about allegations
that honors, including seats in the House of Lords
and Knighthoods, were given to individuals who
loaned money to the Labour party ($9.8 million).
• Under Bill Clinton, Democratic National
Committee donors were allowed to spend the
night in the Lincoln bedroom for a contribution of
$150,000 (e.g., Chairman of Occidental
Petroleum). Then in 1997, Clinton made an
exception so that OP could pursue a venture in
Sudan.
• A lawsuit in February 2007, alleged that Intel
provided secret kickbacks to Dell in order to
ensure it remained the computer makers sole
microprocessor supplier.
428
Bribes Are Universal
© D.L.
Crumbley
Give people power and discretion, and whether
they are grand viziers or border guards, some
will use their position to enrich themselves.
The problem can be big enough to hold back a
country’s development. One study has shown
that bribes account for 8% of the total cost of
running a business in Uganda.
Another found that corruption boosted the
price of hospital supplies in Buenos Aires by
15%. Paul Wolfowitz, the head of the World
Bank, is devoting special efforts during his
presidency to a drive against corruption.
“How to Grease a Palm,” The Economist, December 23, 2006, p. 115.
429
© D.L.
Crumbley
Tone at the Top: Germany
A sales director once bragged at an office party about
how he had bribed several large retail customers.
Some only responded to very large gifts, he said,
recalling one case when he discreetly pushed a car
key to the other side of the negotiating table. The
trick was to find out what they liked, and then you
were almost done.
I was one of this man’s employees – during a stint at
this particular company that was mercifully short.
What bothered me the most about his remarks was the
way he bragged about it. In that company, as in
countless others, bribery was not only tolerated, it was
cool. If you wanted to become a successful marketing
executive, this was what they expected of you
Wolfgang Munchau, “A dangerous precedent for corporate corruption,”
Financial Times, December 28, 2006, p. 15.
430
Bribes/ Kickbacks Scenario
© D.L.
Crumbley
Something of Value
Later Influence an Official Act
Cash
Gifts
Trips
Entertainment
Drugs
Sexual favors
Loans
Credit cards
Fees
Spouse’s high salary
Discounts (e.g., house)
Awarding Selection
Higher Prices
Excessive Quantity
Accepting Lower Quality
No, Delayed, or Short Delivery
Prove the corrupting influence circumstantially
through factors on the right, or outsider received
more and more business as the insider gets more
and more value.
431
Kickback Example
© D.L.
Crumbley
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.
432
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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.
433
Some Bribery Red Flags
•
•
•
•
•
•
•
•
•
© D.L.
Crumbley
Lack of standard invoices.
Requests for fund to be routed to a foreign bank.
Requests for checks made payable to “cash” or to
“the bearer.”
Commission substantially higher than going rate.
Requests for a large line of credit from a customer.
Insistence by a government official that a certain
third-party agent or supplier be used.
Lack of staff or facilities to actually perform the
service.
Request by a local agent for a rate increase in the
middle of negotiations.
Suggested need to utilize more than one local
agent.
Source: M. T. Biegelman and J. T. Bartow, Executive Roadmap to
Fraud Prevention and Internal Controls, John Wiley, 2006,
pp. 325-326.
434
Duty to Cooperate
© D.L.
Crumbley
435
Audit Rights
© D.L.
Crumbley
1. Audits under clause 2 may be conducted of:
a)
b)
c)
d)
e)
f)
the Contractor's practices and procedures as they relate to the Contract, including security
procedures;
the manner in which the Contractor performs its obligations under the Contract;
the compliance of the Contractor's invoices and reports with its obligations under the Contract;
the Contractor's compliance with all its obligations under the Contract;
the Contractor's compliance with its confidentiality, privacy, security and Commonwealth
policy obligations under the Contract; and
any other matters determined by [Agency] to be relevant to the performance of the Contractor's
obligations under the Contract.
2. Audits
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
The Contractor must participate in audits of the Contract at the frequency and in relation to the
matters specified by [Agency], (including on an ad hoc basis if requested by [Agency]), for the
purpose of ensuring that the Contract is being properly performed and administered. [Agency]
may appoint an independent person to assist in the audits. Audits may consider all aspects of
the Contractor's performance including but not limited to any performance indicators,
benchmarks or targets.
The Contractor must participate promptly and cooperatively in any audits conducted by
[Agency] or its nominee.
Except for those circumstances in which notice is not practicable or appropriate (eg. caused by
a regulatory request with shorter notice or investigation of theft or breach of contract), and
without limiting any other right, recourse or remedy of [Agency], must give the Contractor
reasonable notice of an audit and where reasonably practicable an indication of which
documents and/or class of documents the auditor may require.
Subject to any express provisions in the Contract to the contrary each party must bear its own
costs of any audits.
Subject to clauses 2.6 and 3.6, the requirement for, and participation in, audits does not in any
way reduce the Contractor's responsibility to perform its obligations in accordance with the
Contract.
[Agency] must use reasonable endeavours to ensure that audits performed pursuant to clause
2.1 do not unreasonably delay or disrupt in any material respect the Contractor's performance of
its obligations under the Contract.
[Any amendments to the Contract resulting from audits must be effected by agreement in
writing between the parties in accordance with the Contract amendment provisions of the
Contract.]
The Contractor must promptly take, at no additional cost to [Agency], corrective action to
rectify any error, non-compliance or inaccuracy identified in any audit in the way the
Contractor has under the Contract:
(a) supplied any goods or services; or
(b) calculated fees, or any other amounts or charges billed to [Agency].
436
© D.L.
Crumbley
Purchasing Agent’s Kickback Checklist
•
•
•
•
•
•
•
•
•
•
•
•
He or she doesn’t take time off.
The purchasing agent has personal financial
problems.
The agent’s lifestyle is too extravagant for his or
her income.
Close personal relationship between purchasing
agent and vendor.
Favoritism toward one vendor.
Excessive purchases from one vendor.
Prices charged are higher than market average.
Expenditures come in just under the review limit.
Multiple purchases over a short period.
Substandard products or services.
Accelerated payment of invoices.
Sole-source purchases of merchandise or services.
Be sure different personnel handle the following duties:
vendor approval, purchase requisitions, purchase
approval, receiving, and payment (e.g., separation of
duties).
Source: J. T. Wells, “The Case of the Pilfering Purchasing Manager,”
Journal of Accountancy, May, 2004.
437
© D.L.
Crumbley
Red Flags for Phantom Vendors
•
•
•
•
•
•
•
•
Invoices for unspecified consulting or other
poorly defined services.
Unfamiliar vendors.
Vendors that have only a post-office-box
address.
Vendors with company names consisting
only of initials. Many such companies are
legitimate, but crooks commonly use this
naming convention.
Rapidly increasing purchases from one
vendor.
Vendor billings more than once a month.
Vendor addresses that match employee
addresses.
Large billings broken into multiple smaller
invoices, each of which is for an amount
that will not attract attention.
Source: J. T. Wells, “Billing Schemes Part I: Shell Companies That
Don’t Deliver,” Journal of Accountancy, July, 2002.
438
© D.L.
Crumbley
More Phony Vendors Red Flags
•
•
•
•
•
•
•
•
Ensure those involved in purchasing cannot approve
vendors.
Before approving a new vendor, evaluate its legitimacy
by
Obtaining its corporate records and other relevant
documents.
Checking its credit rating.
Confirming that it is listed in telephone directories.
Contacting its references from clients and others.
Being particularly cautious about a vendor with a postoffice-box address or a name composed entirely of
initials.
Determining whether its business address matches any
employee’s home address.
Once the company approves a new vendor, the CPA should
closely monitor the account by
•
•
•
Watching for increases in the amount or frequency of
billings.
Observing variances from budgets or projections.
Comparing its prices with those charged by other
sources.
Source: J. T. Wells, “Billing Schemes Part I: Shell Companies That
Don’t Deliver,” Journal of Accountancy, July, 2002.
439
© D.L.
Crumbley
Preventing Procurement Fraud
1.
2.
3.
4.
5.
6.
Create an Approved Vendor List.
Separate job responsibilities.
Look for cliques.
Establish a hot-line for whistle-blowers.
Do the parking-lot test.
Get insurance.
Baseline, “Six Steps to Prevent Procurement Fraud,” June 6, 2006,
http://www.baselinemag.com/article2/0,1540,1972097,00.asp
440
E-mail Evidence
© D.L.
Crumbley
• E-mails may be a prime evidence source
for procurement and contract fraud.
• Obtain subpoenas for the e-mails of all
suspects, persons of interest, and any
other parties that may have e-mail
information.
• In U.S. starting 12-1-06, a company must
recognize, declare, and produce Edocuments whenever it is involved with
civil litigation.
• Courts will no longer accept
incompetence or computer problems as
an excuse for failing to meet E-document
requests.
• Morgan Stanley hit with a $1.45 billion
judgment (2005).
441
© 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.
442
© 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.
443
Interviewing Executives
© D.L.
Crumbley
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.
444
Selecting the Right
Interviewees
© D.L.
Crumbley
“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.
445
© D.L.
Crumbley
Interview vs. Interrogation
• Interview-non-accusatory process
where person asks questions to
develop factual information (e.g.,
who, what, when, where, how).
• Interrogation-accusatory interview to
obtain an admission of guilt.
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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.
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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.
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Nonverbal Language
• 60% of communication is nonverbal.
• Previous contact with person helpful.
• During President Bill Clinton’s testimony
he touched his nose several times when he
was lying, but did not touch his nose during
truthful testimony.
• Two-thirds of truth interviewees cross their
legs.
Source: “Lying 101: There May Be Nonverbal Indicators of Lying,”
http://members.tripod.com/nwacc_communication/id25.htm.
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Posture Language
Truthful
• Frontally aligned.
• Upright or forward.
• Open (perhaps crossed legs).
• Dynamic, comfortable changes.
Deceptive
• Non-frontally aligned.
• Slouched, retracted or leaning.
• Barriers (crossed arms, purse in lap).
• Frozen and rigid.
Source: John E. Reid Associates, Inc.
450
Some Lying Signs
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
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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.
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Lying: James R. Brown Style
• “I lied in person to investors when I
met them. I lied in company’s filings.
I lied in the company’s press
releases.” Adelphia Communications
vice-president of finance.
• He had no formal training in
accounting and finance.
• Adelphia began manipulating its
financial reports soon after the
company went public in 1986.
• We regularly fabricated statistics on
the number of subscribers, cash flow,
cable-system upgrades, and other
closely followed metrics.
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Lying: James R. Brown Style
(cont.)
• Top executives would meet on Saturdays
to determine if we were meeting loan
agreements. If not, we would make other
types of manipulations of either arbitrarily
moving expenses between companies or
adding invented affiliate income or interest
income from one internal company to
another.
• For more than 10 years we kept two sets of
books.
Source: Chad Bray, “Adelphia Witness Lays Out Lies,” WSJ, May 19, 2004,
pp. C-1 and C-2.
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Voice – Analysis Software
• Developed in Israel; can be used over
the phone. Nemesysco system.
• Measures stress levels and displays
them on a screen.
• U.K. insurers are using it, connected
between the telephone and computer.
• Screen flashes “High Stress.”
• 70% O.K. Of 30% high risk, 12%
prove O.K., but 18% rejected as
fraudulent.
Source: Charles Fleming, “Insurers Employ Voice-Analysis Software
to Detect Fraud,” WSJ, May 17, 2004, pp. B-1 and B-4.
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Fewer People Lie in E-mail
• People tell fewer lies in e-mails than
in phone calls and face-to-face
conversations.
• Possible reason: Most people know
that e-mails leave a record.
J. T. Hancock, Corporate Human Interaction
-------------------------------------------------
I got one thing to tell you,
I…oooo, I ain’t tryin’ to sell ya’,
No lies.
Grand Funk Railroad
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Interviewing Techniques
“Bosch didn’t say anything. He knew
that sometimes when he was quiet,
the person he needed information
from would eventually fill the
silence.” (pp. 5-6).
-------------------------------------------“Just listen. You are a detective.
Detectives are supposed to listen.
You once told me that solving
murders are getting people to talk
and just listening to them.” (pp. 9293).
-------------------------------------------------Source: Michael Connelly, The Black Ice, St. Martin’s Paperback,
1993.
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Progression of Interpersonal Communication
Investigative
Communicat
ion 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
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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
interviewin
g 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.
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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
confrontatio
n.
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
uncooperativ
e 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
offense.
Source: William Morrisette, Intuition, 21 Garden Avenue, North Providence, R.I. 02911.
A Thousand Lies
What is a man that stays true to the game
But has to cheat a little to get by
Well that is a person that I know too well
What if a man doesn’t stay true to the game
Don’t care for no one, only cares for his greed.
Machine Head
459
Chance of Confession
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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.”
460
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Fraud Detection
Questions
Question # 1 –
Reason Why? Do you know why
you are here today?
Principle: Innocent subjects will
acknowledge the reason for the
interview, while the guilty
subject will generally avoid
indicating knowledge of the
issue.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
461
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Fraud Detection
Questions
Question #2 –
Know/Suspect: Who do you think
may have taken that $5,000
from the safe?
Principle: Innocent subjects are
more likely to volunteer a name
or offer a suspicion.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
462
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Fraud Detection
Questions
Question #3 –
Vouch: Is there anyone that you work
with that you feel would not have
taken that $5,000 from the safe?
Principle: Innocent subjects will
vouch for others, while the guilty
will vouch for themselves or no one.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s
Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.
463
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Fraud Detection
Questions
Question #4 –
Think: Do you think that the
$5,000 was actually stolen?
Principle: Innocent subjects will
generally agree that the money
was actually stolen.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
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Fraud Detection
Questions
Question #5 –
Opportunity: Who do you think would
have the best opportunity to take
that $5,000 from the safe?
Principle: Innocent subjects will
usually offer a name of an individual
or named position who would have
had the best opportunity.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s
Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.
465
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Fraud Detection
Questions
Question #6 –
Happen: What do you think
should happen to the person
who stole that missing $5,000?
Principle: Innocent subjects will
generally offer harsher
punishment than the guilty.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,”
NACVA’s Twelfth Annual Consultants’ Conference, Philadelphia,
June 1-4, 2005.
466
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Fraud Detection
Questions
Question #7 –
2nd Chance: Would you be inclined to
give someone a second chance?
Principle: Innocent subjects generally
continue to offer harsh punishment,
while the guilty are more likely to
offer a second chance.
Wayne Hoover, “Non-Confrontational Approach to Interviewing,” NACVA’s
Twelfth Annual Consultants’ Conference, Philadelphia, June 1-4, 2005.
467
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Acquisition/Payment Cycle
From 62 standard audit procedures, external
and internal auditors judged these 20 procedures to be
more efficient is detecting fraud in the acquisition and
payment cycle (in descending order).
• Examine bank reconciliation and observe whether they
are prepared monthly by an employee who is
independent of recording cash disbursement or custody
of cash.
• Examine the supporting documentation such as
vendor’s invoices, purchase orders, and receiving reports
before signing of checks by an authorized persons.
• Examine the purchase requisitions, purchase orders,
receiving reports, and vendors’ invoices which are
attached to the vouchers for existence, propriety,
reasonableness and authenticity.
•Examine internal controls to verify the cash
disbursement are recorded for goods actually rendered to
the company.
•Discuss with personnel and observe the segregation of
duties between accounts payable and custody of signed
checks for adequacy.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of
Forensic Accounting, Vol. 4, 2003, p. 204-205
468
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Acquisition/Payment Cycle (Contd.)
• Confirm inventories in public warehouse and on
consignment.
•Examine internal controls to insure the vendor’s
invoices, purchase orders, and receiving reports are
matched and approved for payment.
• Examine internal controls for the following documents:
vendor’s invoices, receiving reports, purchase orders,
and receiving reports.
• Trace a sample of acquisitions transactions by
comparing the recorded transactions in the purchase
journal with the vendor’s invoices, purchase requisitions,
purchase orders, and receiving reports.
• Establish whether any unrecorded vendors’ invoices or
unrecorded checks exist.
• Examine the internal control to verify the proper
approvals of purchase requisitions and purchase orders.
• Reconciled recorded cash disbursement with
disbursements on bank statements.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 204-205
469
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Acquisition/Payment Cycle (Contd.)
• Discover related party transactions.
• Examine the internal control to verify the approvals
of payments on supporting documents at the time that
checks are signed.
• Discuss with personnel and observe the procedures
of examining the supporting documentation before the
signing of checks by an authorized person.
• Examine canceled checks for authorized signatures,
proper endorsements, and cancellation by the bank.
• Account for the numerical sequence of prenumbered
documents (purchase orders, checks, receiving reports,
and vouchers).
• Trace a sample of cash payment transactions.
• Trace resolution of major discrepancy reports.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 204-205
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Sales/Collection Cycle
These 10 standard audit procedures were
judged as being more effective for detecting fraud in the
sales and collection cycle (in descending order)
• Observe the proper and appropriate segregation of
duties.
• Review monthly bank reconciliation and observe
independent reconciliation of bank accounts.
• Investigate the difference between accounts receivable
confirmation and customer account receivable balances
in the subsidiary ledger and describe all these
exceptions, errors, irregularities, and disputes.
• Review sales journal, general ledger, cash receipts
journal, accounts receivable subsidiary ledger, and
accounts receivable trial balance for large or unusual
amounts.
• Verify accounts receivable balance by mailing positive
confirmations.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 209
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Sales/Collection Cycle (Contd.)
• Examine internal controls to verify that each cash
receipts and credit sales transactions are properly
recorded in the accounts receivable subsidiary ledger.
• Examine subsequent cash receipts and the credit file
on all accounts over 120 days and evaluate whether the
receivable are collectible.
• Compare dates of deposits with dates in the cash
receipts journal and the prelisting cash receipts.
• Examine copies of invoices for supporting the bills of
lading and customers’ orders.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 209
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Inventory/Warehouse Cycle
These 14 standard audit procedures were
judged by external and internal auditors as being more
effective for detecting fraud in the inventory and
warehousing cycle 9in descending order):
• Discover related party transactions.
• Follow up exceptions to make sure they are resolved.
• Review major adjustments for propriety.
• Review inventory count procedures: a. Accounting for
items in transit (in and out); b. Comparison of counts
with inventory records; and c. Reconciliation of
difference between counts and inventory records.
• Review adequacy of physical security for the entire
inventory.
• Confirm inventories in public warehouse.
• Review procedures for receiving, inspecting, and
storing incoming items and for shipments out of the
warehouses.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 206-207
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Inventory/Warehouse Cycle (Contd.)
• Trace shipments to sales records, inventory records,
and bill of lading (shipping documents).
• Determine if access to inventory area is limited to
approval personnel.
• Observe the physical count of all location.
• Recount a sample of client’s counts to make sure the
recorded counts are accurate on the tags (also check
descriptions and unit of count, such as dozen or gross)
• Trace inventory listed in the schedule to inventory
tags and the auditor’s recorded counts for existence,
descriptions, and quantity.
• Trace shipments to sales journal.
• Perform compilation tests to insure that inventory
listing schedules agrees with the physical inventory
counts.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 206-207.
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Payroll/Personnel Cycle
These 12 standard audit procedures were judged the
more effective for detecting fraud in the payroll and
personnel cycle (in descending order):
• Sample terminated employees and confirm that they
are not included on subsequent payrolls and confirm
propriety of termination payments.
• Observe the actual distribution of payroll checks to the
employees.
• Observe the duties of employees being performed to
insure that separation of duties between personnel,
timekeeping, journalizing payroll transactions, posting
payroll transactions, and payroll disbursement exists.
• Examine internal controls to verify that hiring, pay
rates, payroll deductions, and terminations are
authorized by the personnel department.
• Sample personnel files and physically observe the
presence of personnel in the work place.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 208.
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Payroll/Personnel Cycle (Contd.)
• Examine internal control over payroll records to
verify that payroll transactions are properly
authorized.
• Discover related party transactions.
• Review the files of new hires for appropriate
approvals, pay rates, and dates of accession.
• Review the payroll journal, general ledger, and
employee individual pay records for large or unusual
amounts.
• Examine internal controls to verify that unclaimed
payroll checks are secured in a vault or safe with
restricted access.
• Examine internal controls to verify that employee
time cards and job order work tickets are reconciled.
Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud
Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic
Accounting, Vol. 4, 2003, p. 208.
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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
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Exercises
1.
2.
3.
4.
5.
You receive a tip on the company’s hot line that
there has been some fraud in the collections area.
What five audit steps would you suggest using in
order to find the fraud?
During a brainstorming session, a suggestion is
made that the most likelihood of fraud in a
particular division is in the area of acquisition and
payment cycle. Outline five audit steps to help
find any potential fraud.
While auditing a company you notice an
employee in payroll who is living beyond his
means (e.g., clothes, automobiles, housing). His
wife does not work. Suggest six audit steps to
help satisfy you there is no fraud in the payroll
and personnel cycle.
An anonymous e-mail is sent to an internal
auditor that there is fraud in the inventory/
warehousing cycle. Suggest some appropriate
audit steps.
What is meant by the hockey stick pattern?
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The End Is Here
480