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.
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
Definition of Forensic AccountingForensic 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.
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.
There are 14,000 publicly traded companies in the United States. Expecting all of them to be honest is unrealistic. Like any town of 14,000, the market is bound to have its share of grifters and shoplifters. But the deception at Computer Associates was dangerous precisely because it wasn’t an aberration.
By January 2001, all manner of companies were abusing accounting rules to mislead their investors, seemingly without fear of being caught. A strange madness had gripped the market. Even its most solid citizens were running red lights and breaking windows. And the police were nowhere in sight.
Alex Berenson, The Number, Random House, 2003, p. xxiii.
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.
• 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
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.
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.
“ 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.”
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.
Asset Tracing Three Italian lawyers said in a filing to be presented to
a bankruptcy court that they had traced $7.7 billion in missing Parmalat funds.
“We are preparing a filing in which we are asking for the insolvency status to be revoked because the money was robbed and not lost,” lawyer Carlo Zauli told Reuters.
But he said it would be an illusion to believe proof of electronic transfers of the funds could be found and the lawyers representing the Parmalat Creditors Committee did not say where the money was being held or if it was recoverable.
An Italian website, TGfin (www.tgfin.it), said a company linked to Parmalat founder Tanzi was holding the funds in the form of U.S. bonds in an account with Bank of America.
Source: Emilio Parodi and Stefano Bernabei, “Wrap-up 2: Paramalat Fraud Probe Widens to Auditors, Ex-Banker, “forbes.com, January 8, 2004.
The main difference between fiction and reality is that instead of using mask and gun, today’s villains use mouse and keyboard. Instead of hiding behind a lamppost in a trench coat and fedora, today’s forensic accountants are more likely to be hiding behind their own computers, searching for clues amid mountains of data.
Source; “Book ‘EM! Forensic Accounting in History and Literature,” The Kessler Report, Vol.1, No. 2.
“Every investigation I did as a prosecutor, you have a particular target, but it always branches off because something else gets your attention. And that’s what is going to happen with a forensic accountant.”
“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.
•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
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.
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.
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.
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.
“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.
The Essence of Forensic Accounting by Maurice Peloubet (1946):
“The preparation of data for and the appearance before government agencies as a witness to facts, to accounting principles, or to the application of accounting principles is essentially forensic accounting practice rather than advocacy.”
Modern Version “Let’s face it, we in the forensic profession labor in an obscure corner of the vineyard. We are the carefully selected, trusted, highly trained guardians of one of the last great secrets remaining on the face of the earth - - the $600 billion[now $660], more or less annual problem nobody knows about.”
Joseph W. Koletar, Fraud Exposed, John Wiley & Sons, Inc 2003, p. 228.
“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.
• 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].
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.
Forensic-Type Organizations• American College of Forensic Examiners (2750 E. Sunshine,
Springfield, MO 65804; 800-423-9737; www.acfei.com. DABFA and Cr.FA; 2000)
• Certified Fraud Examiners (Association of CFEs, The Gregor Bldg., 716 West Avenue Austin, TX 78701; 800-245-3321; www.cfenet.com).
• Certified Insolvency and Reorganization Accountant (CIRAs). Accountants, lawyers, consultants included in insolvency and bankruptcy matters. 3-part exam. 4,000 hours. 541.858.1665. AIRA, 221Stewart Avenue, Suite 207, Medford, Or. 97501. [email protected]
• Society of Financial Examiners. Financial examiners of insurance companies, banks, savings & loans, and credit unions. About 1,600. 174 Grace Blvd., Altamonte Springs, Fl. 32714. www.sofe.org.
• Certified Forensic Financial Analyst (NACVA, Salt Lake City, Utah 84106; 801-486-0600). Also, Certified Fraud Deterrence (CFD) analyst.
• National Litigation Support Services Association (NLSSA, III East Wacker Drive, Suite 990, Chicago, IL 60601; 800-869-0491). Not-for-profit. About 20 firms. $1,825.
• Canadian Institute of Chartered Accountants (CICA) – CA.IFA – Alliance for Excellence in Investigative Accounting.
• Certified Forensic Investigator (CFI) – Canada Early 1980’s. www.homewoodave.com
• Certified Fraud Specialist (CFS), not-for-profit, educational anti-fraud corporation located in Sacramento, Calif., for those dealing in white-collar crime, fraud, and abuse issues. Association of Certified Fraud Specialists. http://acfsnet.org.
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.
Federal Sentencing Guidelines Monitoring Mechanism
Systems reasonably designed to detect criminal conduct by its employees and other agents and by having in place and publicizing a reporting system whereby employees and other agents could report criminal conduct by others within the organization without fear of retribution.
• Most significant change since 1934 Securities Exchange Act
• New five-member Public Company Accounting Oversight Board (PCAOB)
• Authority to set and enforce auditing, attestation, quality control and ethics (including independencies) standards for auditors of public companies.
• Empowered to inspect the auditing operations of public accounting firms that audit public companies as well as impose disciplinary and remedial sanctions for violations of the board’s rules, securities laws and professional auditing and accounting standards.
• Rotation of lead audit partner every five years.
Sarbanes-Oxley Act of 2002• If you are going to be an auditor, you have to be an
auditor, not an auditor and a consultant [Senator Jack Reed].
• In order to be independent, an accounting firm should not
– Audit ones own work.
– Function as part of management or an employee.
– Act as an advocate.
• No limitations are placed upon accounting firms in providing non-audit services to public companies they do not audit or any private companies.
• Audit services and non-audit services (e.g., tax) must be pre-approved by the audit committee, if not prohibited by the Act (before the non-audit service commences).
• Auditor must report to the audit committee on a timely basis.
• Cooling off period of one year for hiring an auditor if CEO and other senior officers worked for the auditor.
• There is no requirement to rotate the auditors.
• There is discussion of requiring a forensic audit irregularly. Harvey Pitt suggested this proposal.
• Many of the Sarbanes-Oxley’s provisions became effective July 30, 2002.
• www.tnwinc.com The Network• Thus, SEC will control the accounting standards, not
the AICPA.• Auditors to report to audit committee, and audit
committee must approve all services.• Crime to corruptly alter, destroy, mutilate, or conceal
any document with the intent to impair the object’s integrity or availability (up to 20 years).
• Statute of limitations for the discovery of fraud is now two years from the date of discovery and 5 years after the act.
• Maximum penalty for mail and wire fraud is increased from 5 to 10 years.
• Financial statement filed with SEC: certified by CEO and CFO. Maximum penalties for willful and knowingly violation: fined not more than $5 million and/or imprisonment of up to 20 years.
• Sense of Congress: CEO should sign the Federal income tax return.
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?
• 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.
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.
1. Control environment – management’s attitude toward controls, or the “tone at the top.”
2. Risk assessment – management’s assessment of the factors that could prevent the organization from meeting its objectives.
3. 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.
4. Information and communication – system that allows management to evaluate progress toward meeting the organization’s objectives.
5. Monitoring – continuous monitoring of the internal control process with appropriate modification made as deemed necessary.www.erm.cosous.org
Source: erm.coso.org. See Apostolou and Crumbley, “ Sarbanes-Oxley Fall-out Leads to Auditing Standards No. 2: Importance of Internal Controls,” The Value Examiner, November/December 2004, pp. 55-60.
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
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.
4. Assess likelihood of fraud•Remote (1 out of 20)•Reasonably possible•Probable5. Assess significance of risk•Inconsequential•More than inconsequential•Material6. 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.
• Audit fees have increased about 50%.• First year spending around $10 billion. Steve Watkins,
“For Some, SOX Is No Hassle at All,” IBD, January 14, 2005, p. A6.
• About $100,000 each year for insuring Board members.
• Bob Ross: Section 404 of SOX, which requires companies to document their controls, cost his company (Urban Outfitters) at least a penny per share in 2004, turning his job into a “struggle to explain common sense.”
Tim Reason, “Feeling the Pain,” CFO, May 2005, p. 51.
Specialist defined: a professional service firm or individual who possesses special skills or knowledge in a particular field other than accounting and auditing
To reply on specialist’s findings, auditor Must understand the objectives and scope of
work performed. Assumptions used must be clear to auditor. Auditor must consider the appropriateness of
utilizing the specialists findings. Auditor must test the data that client provides
to the specialist. Auditor must evaluate whether findings
support the assertions in the financial statements.
If specialist’s findings inconsistent, SAS No.73 provides additional procedures which auditor must follow.
Auditor will need copies of work-papers of specialists.
In 1938, police discovered a massive fraud at McKesson & Robbins, a big drug company traded on the New York Stock Exchange and audited by Price Waterhouse. Executives at McKesson embezzled more than $18 million, hiding their theft by creating a fake division.
The fictitious unit represented almost one-fifth of McKesson’s total assets, but Price Waterhouse somehow had managed to miss the fact that it didn’t exist.
(Clues to the fraud included a shipment that supposedly had been sent from Canada to Australia – by truck.)
Alex Berenson, The Number, Random House, 2003, p.33
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
Employee Fraud = $ for $ reduction in net income Suppose $100,000 bottom line reduction. Suppose 20% profit margin How much new revenue needed to offset the lost income? $100,000 = $500,000 20% So ACFE says $660 billion lost per year. $660 billion = $3.3 trillion needed revenue 20%.-----------------------------------------------------
This amount lost to fraud and abuses is twice the size of the U.S. military budget.
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.
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.
• Survey to several hundred of the largest companies (with 91 responses).
• Half of the detected economic crimes at responding companies were found by auditors, but it did not distinguish between internal audits. Another 36 percent of the frauds were reported by whistle-blowers
• Although 76 percent of the United States respondents were covered by insurance, fewer than half were able to recover from their insurers. And less than a third of insured companies affected by fraud collected more than 20 percent of the amount lost.
• The average amount lost was $2.2 million, and the highest levels of economic crime were reported in Africa and North America (including Canada and the United States).
Source: J.D. Glater, “Survey Finds Fraud’s Reach in Big Business” www.nytimes.com/2002/07/08/business/08CHIE.html.
• To prove any type of fraud, prosecutors must show that scienter was present.
• That is, the fraudster must have known that his or her actions were intended to deceive.
------------------------------------------------- Important to know that fraud is not limited
by amount but rather by intent. If someone’s intent was to defraud someone of $10 or $10 million, it is still fraud.
Staff Accounting Bulletin No. 99
If someone makes an incorrect entity of $10,000 (against GAAP) to give a company the one cent to meet its earnings target, such an entry is a material misrepresentation.
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.
Superseded SAS No. 82Accounting Fraud Referred To As
“Misstatement”
Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users.
----------------------------------------------------------Three most important red flags according to
external/internal auditors (total of 40.1%):1) Known history of securities law violations
(14.6%)2) Significant compensation tied to aggressive
accounting practices (12.9%)3) Management’s failure to display appropriate
attitude about internal controls (12.6%)
Source: B.A Apostolou et.al, “The Relative Importance of Management Risk Factors,” Behavioral Research in Accounting, January 1, 2001, pp. 1-24.
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
Business Fraud Survey (1999)1. Nearly 15 percent reported management
misappropriation as the greatest fraud risk to their organization.
2. Sixty percent of the respondent reported their department’s fraud risk analysis process as being reactive in nature.
3. The majority of respondents (72 percent) reported that their organization did not have fraud detection and deterrence programs in place.
4. The majority of respondents (68 percent) reported that they never felt pressured to compromise the adherence to their organization’s standard of ethical conduct.
5. The majority of the respondents reported their organization’s external auditors as being ineffective in preventing and detecting fraud.
6. The majority of the respondents believed that more budgets should be devoted to fraud-related activities and training in department.The Institute of Management and Administration (IOMA) and the Institute of Internal Auditors(IIA). “Business Fraud Survey.” (1999). Available at http://www.theiia.org
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.
A Michigan woman received an e-mail from a Nigerian asking her to set up a bank account in the U.S. in order to help him steal $18 million.
She set up the bank account (to help pay the so-called bribes and fees) by allegedly embezzling $2 million from her employer during seven months in 2002.
Guess what? She never received a penny. She was indicted on 13 counts of wire fraud.
Fraud schemes are much like derivatives. They spring up, die out, and new ones are started each week.
Source: Kim Komando, “Delete These Scams – Now,” MSN Business, www.bcentral.com/articles/komando/109.asp. Reviewed June 15, 2003.
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, 2003, p. A-6.
Well, I left Kentucky back in '49An' went to Detroit workin' on a 'sembly lineThe first year they had me puttin' wheels on cadillacs
Every day I'd watch them beauties roll byAnd 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 planThat should be the envy of most any manI'd sneak it out of there in a lunchbox in my handNow gettin' caught meant gettin' firedBut I figured I'd have it all by the time I retiredI'd have me a car worth at least a hundred grand.
CHORUS I'd get it one piece at a timeAnd it wouldn't cost me a dimeYou'll know it's me when I come through your townI'm gonna ride around in styleI'm gonna drive everybody wild'Cause I'll have the only one there is a round.
So the very next day when I punched inWith my big lunchbox and with help from my friendsI left that day with a lunch box full of gearsNow, I never considered myself a thiefGM wouldn't miss just one little pieceEspecially if I strung it out over several years.
The first day I got me a fuel pumpAnd the next day I got me an engine and a trunkThen I got me a transmission and all of the chromeThe little things I could get in my big lunchboxLike nuts, an' bolts, and all four shocksBut 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 nightAnd that's when we noticed that something was definitely wrong.
The transmission was a '53And the motor turned out to be a '73And when we tried to put in the bolts all the holes were gone.
So we drilled it out so that it would fitAnd with a little bit of help with an A-daptor kitWe had that engine runnin' just like a songNow the headlight' was another sightWe had two on the left and one on the rightBut when we pulled out the switch all three of 'em come on.
The back end looked kinda funny tooBut we put it together and when we got thruWell, that's when we noticed that we only had one tail-finAbout that time my wife walked outAnd I could see in her eyes that she had her doubtsBut she opened the door and said "Honey, take me for a spin."
So we drove up town just to get the tagsAnd I headed her right on down main dragI could hear everybody laughin' for blocks aroundBut up there at the court house they didn't laugh'Cause to type it up it took the whole staffAnd when they got through the title weighed sixty pounds
CHORUS I got it one piece at a timeAnd it didn't cost me a dimeYou'll know it's me when I come through your townI'm gonna ride around in styleI'm gonna drive everybody wild'Cause I'll have the only one there is around.
(Spoken) Ugh! Yow, RED RYDER This is the COTTON MOUTHIn the PSYCHO-BILLY CADILLAC Come on
Huh, This is the COTTON MOUTHAnd negatory on the cost of this mow-chine there RED RYDERYou might say I went right up to the factoryAnd picked it up, it's cheaper that wayUgh!, what model is it?
Missing Fraud Auditors will continue to miss fraud because much of their work is predicted on the assumption that separation of duties prevents fraud (i.e., one person hold the money and another person keeps track of it).
The Equity Funding case shakes the foundations of auditing in that so much is based on the assumption that people don’t collude very long.
These people work together as an efficient team for a very long time [9 years].
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).
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.
When speaking about the fraud of HealthSouth, a spokesman for Ernst & Young emphasized the difficulty of detecting accounting fraud in the midst of a conspiracy of senior executives and false documentation.
An accountant testified that HealthSouth employees would move expenses of $500 to $4,999 from the income statement to the balance sheet throughout the year. Overall the SEC said about $1 billion in fixed assets were falsely entered. The employees moved only those expenses less than $5,000, because Ernst & Young automatically looked at those expenses over $5,000.
An ex-bookkeeper even sent Ernst & Young an e-mail flagging one area of the fraud, but E & Y still did not catch it. Employees actually produced false invoices when the accounting firm asked for back-up.
Source: Charles Mollenkamp, “Accountant Tried in Vain to Expose HealthSouth Fraud,” Wall Street Journal, May 20, 2003, pp. A-1 and A-13.
More forensic techniques should become a part of both external and internal auditing. But Stephen Seliskar says that “in terms of the sheer labor, the magnitude of effort, time and expense required to do a single, very focused [forensic] investigation -- as contrasted to auditing a set of the financial statements -- the difference is incredible.” It is physically impossible to conduct a generic fraud investigation of an entire business.
Source: Eric Krell, “Will Forensic Accounting Go Mainstream?” Business Finance Journal, October 2002, pp. 30-34. www.investigation.com/artilces/library/2002Articles/15.htm.
Once a forensic accountant [e.g., Cr.FA, CFE, CFFA] is engaged, Michael Kessler says that they should not be disruptive. Most employees are not aware that an investigation is taking place. We go in as just another set of auditors, favoring a Columbo-esque investigative style. “We don’t wear special windbreakers that say ‘forensic accountant.’”
Source: Eric Krell, “Will Forensic Accounting Go Mainstream?” Business Finance Journal, October 2002, pp. 30-34. www.investigation.com/articles/library/2002Articles/15.htm
• 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.
• 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.
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 OliphantSource: 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
• 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.
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.
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
Sherron Watkins provides an excellent comment about rationalization with respect to Enron’s Jeff Skilling and Andy Fastow.
At what point did they turn crooked? “But there is not a defining point where they became corrupt. It was one small step after another, with more and more rationalizations. There was a slow erosion of values over time.”
Source: Pamela Colloff, “The Whistle-Blower,” Texas Monthly, April 2003, p. 141.
Several Strategies1. 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, over-reliance, or lack of dedication.
Source: Crumbley, Razaee, Ziegenfuss, U.S. Master Auditing Guide, Chicago, CCH, pp. 689-690.
• 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.
• Open brainstorming: unstructured; few rules; free-for-all; someone should record ideas.
• Round-robin brainstorming: start with no talking, silent period; assigned homework ahead; each individual presents own ideas; each member has a turn.
• Electronic brainstorming: shortens meetings, increases ideas, and reduces personalizing ideas because an idea’s author remains anonymous.
Source: M.S. Beasley and J.G. Jenkins, “A Primer for Brainstorming Fraud Risks,” Journal of Accountancy, December 2003, pp. 33-34.
• 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
• 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.
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.
Magic ChangesApparently, 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 $629,000,000Construction in Progress $142,000,000
Operating Line Costs $771,000,000
The support for this entry was a yellow post-it note.WorldCom’s outside auditors refused to respond to some of Cynthia Cooper’s questions and told her that the firm had approved of some of the accounting methods she questioned.
• Fourth Quarter of 1999: "The $239 million [international line cost accrual release] was entered in WorldCom's general ledger ... The only support recorded for the entry was '$239,000,000,' written on a Post-it Note and attached to a printout of the entry." • Third Quarter of 2001: "Myers gave Sethi a Post-it Note that said 'Assume $742 million.' Later, Myers and Sethi had a conversation confirming that $742 million identified on the Post-it Note was the line cost capitalization entry for the quarter.”
• 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
“ Today’s Sergeant Joe Friday does not write in a small notebook in the course of solving crimes; he now reconstructs the data from imaging hard drives.” Source: Joe Anastasi, The New Forensics, John Wiley & Sons, 2003.
“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
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.
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.
• Parmalat, an Italian diary company, had a nonexistence Bank of America bank account worth $4.83 billion. A SEC lawsuit asserts that Parmalat “engaged in one of the largest and most brazen corporate financial frauds in history.”
• Apparently, the auditors Grant Thornton relied on a fake Bank of America confirmation prepared by the company.
• SAS No. 99 does not prohibit clients from preparing confirmations.
• The fraud continued for more than a decade. At least $9 billion unaccounted for.
• Therefore, the audited company should not be in control of the confirmation process.
• The owner treated the public company as if it was his own bank account.
• An unaware phone operator was the fake chief executive of more than 25 affiliated companies.
• Some $3.6 billion in bonds claimed to be repurchased had not really been bought.
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.
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.
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
“ During one investigation, we found in the auditing working papers written in the margin of the internal audit working papers by the internal audit manager: ‘Conceal from bankers,’ says Nicholas L. Feakins, CPA, partner at San Mataeo, Calif based forensic accounting firm Feakins & Feakins. “ It sounds amazing, but the [third-party] auditors has put B-level staff on the project who simply didn’t read the documents and missed it.”
----------------------------------------------------------------- MiniScribe, one of the world’s largest disk-drive
makers, which in the late 1980s was surreptitiously shipping bricks instead of disk drives to the Far East and receiving credit from the bank for the amount of the shipments. “After all,” he says “it’s going to be 90 days until they ship the brick back to you. “MiniScribe’s public accounting firm, Coopers & Lybrand, didn’t catch the false-revenue scam during its regular audits-but a forensic accountant did.”
Jake Poinier, “ Fraud Finder,” Future Magazine, Fall 2004,http://www.phoenix.edu/students/future/oldissues/Winter2004/fraud.htm
Forensic accountants play a key role in bridging the gap between an audit and an investigation. Every audit cannot, and should not be conducted as a full-fledged forensic investigation. GAAS states, “An auditor typically works within economic limits; the auditor’s opinion, to be economically useful, must be formed within a reasonable length of time and at reasonable cost.” [SAS No. 31]
Forensic investigations also may be subject to such constraints, but the parameters are often vastly different. As a result, a forensic investigation might represent a large multiple, in both cost and elapsed time, of what an audit would normally entail. This approach will undoubtedly reduce the likelihood of undetected fraud. However, such an approach also might reduce the likelihood of completing the engagement in time for meeting the filing deadline for an SEC Form 10-K. [SAS No. 99]
“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.
“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.”
“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.
The PCAOB believes that an attestation is an expert’s communication of a conclusion about the reliability of someone else’s assertion (e.g., a financial statement audit is a form of attestation). [p. A-6]
S-O Act Section 404(b) states that an auditor’s attestation of management’s assessment of internal controls is not a separate engagement. Instead, PCAOB states that an “integrated audit results in two audit opinions: one on internal control over financial reporting and one on the financial statements.” Both require the same level of work.PCAOB 2004 Budget: $103 million.PCAOB 2005 Budget: $152.8 million
Even the PCAOB believes that internal controls “cannot provide absolute assurance of achieving financial reporting objectives because of inherent limitations (e.g., a process that involves human diligence and compliance can be intentionally circumvented).” [p. A-12].
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]
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.
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.
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,
PCAOB provides several strong indicators that material weaknesses exist in internal controls:
• Ineffective oversight of the company’s external financial reporting and internal control over financial reporting by the company’s Board of Directors.
• Board of Directors must be responsible for evaluating the performance and effectiveness of the audit committee.
• Material misstatement in the financial statements not initially identified by the company’s internal controls.
• Significant deficiencies that have been communicated to Board of Directors and the audit committee but that remain uncorrected after a reasonable period of time.
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).
An auditor's own work must provide the principal evidence for the auditor's opinion is one of the boundaries within which the auditor determines the work he or she must perform himself or herself in the audit of internal control over financial reporting.
In all audits of internal control over financial reporting, an auditor must perform enough of the testing himself or herself so that the auditor's own work provides the principal evidence for the auditor's opinion. The auditor may, use the work of others to alter the nature, timing, or extent of the work he or she otherwise would have performed.
As these factors increase in significance, the need for the auditor to perform his or her own work on those controls increases. As these factors decrease in significance, the need for the auditor to perform his or her own work on those controls decreases.• The materiality of the accounts and disclosures that the control addresses and the risk of material misstatement.• The degree of judgment required to evaluate the operating effectiveness of the control (that is, the degree to which the evaluation of the effectiveness of the control requires evaluation of subjective factors rather than objective testing).• The pervasiveness of the control.
• If internal auditors have performed an extensive amount of relevant work and the auditor determines they possess a high degree of competence and objectivity, the auditor could use their work to the greatest extent an auditor could use the work of others.
• On the other hand, if the internal audit function reports solely to management, which would reduce internal auditors' objectivity, or if limited resources allocated to the internal audit function result in very limited testing procedures on its part or reduced competency of the internal auditors, the auditor should use their work to a much lesser extent and perform more of the testing himself or herself.
• The auditor should test some of the work of others to evaluate the quality and effectiveness of the work. The auditor's tests of the work of others may be accomplished by either (a) testing some of the controls that others tested or (b) testing similar controls not actually tested by others.----------------------------------------------
Moral: Reduce external audit fees by beefing up the internal auditing department.
Test of Detail• Because of management overriding controls, substantive analytical procedures alone are not well suited to detecting fraud.• The auditor’s substantive procedures must include reconciling the financial statements to the accounting records. The auditor’s substantive procedures must also include reconciling the financial statements to the accounting records. The auditor’s substantive procedures also should include examining material adjustments made during the course of preparing the financial statements. Also, other auditing standards require auditors to perform specific tests of detail in the financial statement audit.
• For instance, AU sec. 316, Consideration of Fraud in Financial Statement Audit, require the auditor to perform certain tests of detail to further address the risk of management override, whether or not a specific risk of fraud has been identified.• Paragraph .34 of AU Sec 330, The Confirmation Process, states that there is a presumption that the auditor will request the confirmation of accounts receivable.•Similarly, paragraph .01 of AU Sec. 331, Inventories, states that observation of inventories is a generally accepted auditing procedure and that the auditor who issues an opinion without this procedure ‘has the burden of justifying the opinion expressed.”
• Companies reporting problems with internal controls have not seen a big increase in class-action lawsuits, according to a study by Deloitte & Touche between November 2003 and August 2004.
• Deloitte said only 6% of the 290 companies reporting internal-control flaws were sued.
• 52% of the firms had material weakness in their internal controls.
• These internal control announcements did not seem to send prices downward.
• Highest incidence of internal controls:-computer-software firms-manufacturers-health-care and pharmaceutical companies.- financial-services firms-telecommunication companies.
•The newsletter Compliance Week said that 582 companies acknowledged problems in 2004.
Source: Judith Burns, “Few Firms Are Sued Over Flaws in Internal Controls, Study Finds, WSJ, December 29, 2004, p. B-5.
“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.”
• 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
• 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.
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.
1. Notify management or the board when the incidence of significant fraud has been established to a reasonable certainty.
2. 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.
3. A written report should include all findings, conclusions, recommendations, and corrective actions taken.
4. A draft of the written report should be submitted to legal counsel for review, especially where the internal auditor chooses to invoke client privilege.
The audit committee is the subcommittee of an organization’s board of director’s charged with overseeing the organization’s financial reporting and internal control processes. The audit committee’s biggest responsibility is monitoring the component parts of the audit process.------------------------------------------------------------- The board of directors and its representative audit committee should oversee (1) the integrity, quality, transparency, and reliability of the financial reporting process; (2) the adequacy and effectiveness of internal control structure in preventing, detecting, and correcting material misstatements in the financial statements; and (3) the effectiveness, efficacy, and objectivity of audit functions.
• Independence of audit committee from management.
• The clarity with which the audit committee’s responsibilities are articulated, such as in the charter, and how well the audit committee and management understand those responsibilities;
• The audit committee’s interactions and involvement with the independent and internal auditor; and
• Whether the audit committee raises and pursues with management and the independent auditor the appropriate questions, including questions that indicate an understanding of the critical accounting policies and judgmental accounting estimates.
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.
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.
Eight of the ten recent scandals had board chairs who were also CEO:1.Enron 5. HealthSouth2.Adelphia 6. Quest3.Tyco 7. Homestore4.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.
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.”
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.
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.
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?
“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.
For someone who earned a salary of just $1,000 a month, Rana Koleilat managed to live a pretty nice life. She traveled by private jet, took along her servant and hairdresser, and stayed at poshest locality in London and Paris. Back home in Beirut, Lebanon, she lived in three-story penthouse. To anyone who asked how she lived so well, she replied that she had a “rich uncle.”
Actually, Koleilat helped manager a private bank in Beirut, and thereby hangs a tale. The chairman of the bank said he lost $1.2 billion, and depositors lost another several hundred million dollars.
E.T. Pound, “Following the Old Money Trail,” U.S. News & World Report, April 4, 2005, p. 30
2. The concealment of the fraud (in financial statements).
3. Conversion of stolen assets to personal use.
One can study any one of these phases.
Examples:
Things being stolen: conduct surveillance and catch perp.
If liabilities being hidden, look at financial statements for concealment.
If perp has unexpected change in financial status, look for source of wealth.
Source: Cindy Durtschi, “The Tallahassee Bean Counters: A Problem-Based Learning Case in Forensic Audit,” Issues in Accounting Education, Vol. 18, No. 2, May 2003, pp. 137-173.
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
Here a forensic accountant attempts to pro-actively 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
Fake Diplomas At least 28 high-level federal employees
have degrees from bogus colleges or unaccredited schools, only a slice of a problem that ranges from worker quality to national security, congressional investigators say.
Three unaccredited schools investigated-Pacific Western University, California Coast University and Kennedy-Western University-reported that 463 current or former students were federal employees. Most of those listed were in the Defense Department. The bill to taxpayers at just two of the schools was $169,471.
One of those workers paid $5,000 for a master’s degree from LaSalle University, an unaccredited school unrelated to LaSalle University in Pennsylvania. The worker attended no classes, took no tests and told the GAO his degree was a joke.
Source: Ben Feller, “GAO: Some U.S. Workers Have Fake Degree,” Las Vegas Sun, May 11, 2004.
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
Auditing Hints• SAS No. 99 does not require auditors to make inquiries of “others,” as opposed to management. Auditors must talk to and interview others below management level. If asked, employees may be willing to report suspicious activities.
• Use independent sources for evaluating management (e.g., financial analysts). Surf the internet.
• Auditors need to follow the performance history of managers and directors.
• If a company has an anonymous reporting system, obtain information about the incidents reported and consider them when assessing fraud risk.
• Be sure to perform analytical procedures, and the work should be reviewed by senior members of the audit team.
• Auditors should select sample items below their normal testing scope.
• Fraud procedures should be more than checklists. Audits should focus on finding and detecting fraud.
Lavish Executive Pay Many of the companies indicted by
the SEC after Enron had one thing in common: CEOs were making about 75% above their peers.
The common thread among the companies with the worst corporate governance is richly compensated top executives, as per the Corporate Library, Portland, Maine governance-research firm. Hefty pay checks and perks to current or former chief executives.
Poor BODs have in common: an inability to say no to current or former chief executives.
Source: Monica Langley, “Big Companies Get Low Marks for Lavish Executive Pay,” Wall Street J., June 9, 2003, p. C-1.
In Dennis Kozlowski’s $18 million apartment on Fifth Avenue in Manhattan paid from Tyco International funds.• $6,000 shower curtain in maid’s room.• Art work by French Impressionists.• $15,000 umbrella stand.• $70,000 salary for maid, with two $10,000 bonuses.•Borrowed $13.5 million for a yacht and $5 million for a diamond ring for his wife.•$2 million birthday party for wife.•$30,000 worth of opera glasses.---------------------------------------------------Although a PWC auditor testified that he reviewed some of the disputed loans and compensation, he did not determine if approved by the BOD. “That wasn’t part of our auditing procedures.”
• 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
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.
• We estimate that the median firm sacrificed eight cents in additional income taxes per dollar of inflated pretax earnings. In aggregate, we estimate that the firms in our sample paid $320 million in taxes on overstated earnings of about $3.36 billion.
• These results indicate now far managers of firms are willing to go when allegedly inflating earnings.
Source: M. Erickson et. al, “How Much Will Firms Pay for Earnings That Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings,” Accounting Review, Vol. 79, No. 2, 2004, pp. 387.
Companies that consist solely of independent directors and meet at least four times a year are likely to have lower non-audit service fees. L.J. Abbott et.al, “An Empirical Investigation of Audit Fees, Non-Audit Fees, and Audit Committees,” Contemporary Accounting Research, Summer, 2003, p. 230.
An auditor who is also an industry specialist further enhances the credibility of accounting information (e.g., less earnings management). G.V. Krishnan, “Does Big 6 Auditor Industry Expertise Constrain Earnings Management?” Accounting Horizons, Vol. 17, Supplement 2003, p. 15.
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.
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.
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.
Types of Financial Statement Fraud Schemes (contd …)
4. Fictitious Assets and/or Reductions of Expenses/Liabilities (e.g., recording consigned inventory as inventory). Cendant Corporation created fictitious revenues, and Knowledge Ware inflated revenues with phony software sales.
5. Overvalued Assets or Undervalued Expenses/Liabilities (e.g., insufficient allowance for bad debts).
6. Omitted or Undervalued Liabilities (e.g., understated pension expenses).
7. Omitted or Improper Disclosures (e.g., stock option expense estimates).
Freddie Mac understated past earnings as much as $5 billion.
Certain transactions and accounting policies were “implemented with a view to their effect on earnings” (e.g., to smooth earnings).
Restatements will result in higher earnings in prior periods but lower earnings in future periods.
Employees appeared to knowingly violate accounting rules in an effort to manipulate earnings.
Source: Patrick Barta and J.D. McKinnon, “Freddie Mac Profits May Have Been Low By Up to $4.5 Billion,” Wall Street J., June 26, 2003, pp. C-1 and C-11. Bethany McLean, “The Fall of Fannie Mae,” Fortune, January 24, 2005, pp. 123-140.
• The company used a so-called linked swaps to shift at least $420 million into the future.
• Internal report said the linked swaps had minimal business justifications other than the shifting of operating earnings.
• CEO Franklin Raines was paid more than $ 60 million over a 6 year period. On Dec. 21, 2004, Raines took early retirement.
• The Board replaced KPMG as Fannie’s auditor.
Source: Dawn Kopecki and J.D. Mckinnon, “IRS Probes Tax Issues at Freddie Mac,” Wall Street Journal, October 22, 2003, p.A-6. Mike McNamee, “Franklin Raines Lost Gamble,” Business Online, December 22, 2004.
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.
• 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.
misrepresent either the identity or the purpose of the contact with a questionable party.
Surveillance is not an activity which accountants normally perform (e.g., may need a private investigator’s license).
Typical state statute requires a PI license for: “the investigation by a person or persons for the purpose of obtaining information with reference to any of the following: the causes and origin of, or responsibility for, … damage or injuries to real or personal property; the business of securing evidence to be used before investigating committees or boards of award or arbitration or in the trial of civil or criminal cases and the preparation therefore….”
In Florida, Legal Opinion 97-9 provides that any person who holds a professional license under the laws of this state, and when such person is providing services or expert advice in the profession or occupation in which that person is so licensed, is exempt from private investigator licensing requirements. Thus, a licensed accountant (e.g., CPA) would be permitted to perform forensic accounting without a private investigator’s license.
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.
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.
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:
• 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).
• Use the ratios for two successive fiscal years.• Convert into indexes for benchmarking.
Day’s Sales in Receivable Index: (Accounts Receivable t / Sales t )
(Accounts Receivable t-1 / Sales t-1)
Index for manipulators: 1.5 to 1--------------------------------------------------------Gross Margin Index:
[(Sales t - Cost of Sales t ) / Sales t]
[(Sales t-1 - Cost of Sales t-1 ) / Sales t-1]
Index for manipulators = 1.2 to 1--------------------------------------------------------Source: M.D. Beneish, “The Detection of Earnings Manipulation,”
Excel Spreadsheet Sherron Watkins discovered the Enron fraud in 2001 when she was again working under Andy Fastow, CFO. She took a simple inventory, using an Excel spreadsheet to calculate which of the division’s assets were profitable and which were unprofitable.
She discovered the special purpose entities called Raptors, off-the-books partnerships. Enron had hidden hundreds of millions of losses by borrowing money from Raptors and promising to pay the loans back with Enron stock. Enron was hedging risks in its left pocket with money from its right pocket.
As the value of Enron stock fell and the losses in the Raptors mounted, Enron had to add more and more stock because Enron had risked 97% of the losses, and Arthur Andersen had agreed to the accounting.
Source: Mimi Swartz and Sherron Watkins, Power Failure, New York: Doubleday, 2003, p. 269.
•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.
--------------------------------------------- For example, $400 million passed from
Bertelmann to AOL, but rather than calling the money a payment to secure amendments in a contract relating to the ownership of AOL Europe, AOL labeled it ad revenue.
“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
• 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.
“Technology was used to commit fraud in selling pools of credit card debt. A cooked formula was embedded in software by the seller of the debt to analyze the quality of debt for the purchaser, so no matter what debt came out, it had a good collection ratio, and the purchaser was willing to pay more. Only by analyzing the software coding was the fraud discovered,”
• 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.
Check 21• Check Clearing for the 21st Century Act takes effect October 28, 2004.
• Authorizes the use of a substitute check where an original check is converted to an image file and transmitted electronically in lieu of physically transporting the original check.
• The substitute check contains images of the front and back of the original along with the endorsements, signatures, and magnetic ink character line.
• There is a memo line: “This is a substitute check. You may use it the same as you would the original check.”
• Will speed up the check clearing process. May reduce check kiting and passing of bad checks.
• Banks may incur higher fraud losses (e.g. Bank One proceeds 11 billion checks per year).
Source: C. Pacini, “Check 21: Fraud Implications of the Check Clearing for the 21st Century, J of FA, July- December, pp. 559-562.
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].
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.
• 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.
• 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.
• 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-in-progress items; separate duties between purchasing and logging receipts of shipments
• 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.
Acquisition/Payment CycleFrom 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
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
• 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
Sales/Collection CycleThese 10 audit procedures were judged as
being more effective for detecting fraud in the sales and collection cycle (in descending order)
• Observe the proper and appropriate segregation of duties.
• Review monthly bank reconciliation and observe independent reconciliation of bank accounts.
• Investigate the difference between accounts receivable confirmation and customer account receivable balances in the subsidiary ledger and describe all these exceptions, errors, irregularities, and disputes.
• Review sales journal, general ledger, cash receipts journal, accounts receivable subsidiary ledger, and accounts receivable trial balance for large or unusual amounts.
• Verify accounts receivable balance by mailing positive confirmations.Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 209
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
Inventory/Warehouse CycleThese 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
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.
Payroll/Personnel Cycle These 12 audit procedures were judged the more effective for detecting fraud in the payroll and personnel cycle (in descending order):
• Sample terminated employees and confirm that they are not included on subsequent payrolls and confirm propriety of termination payments.
• Observe the actual distribution of payroll checks to the employees.
• Observe the duties of employees being performed to insure that separation of duties between personnel, timekeeping, journalizing payroll transactions, posting payroll transactions, and payroll disbursement exists.
• Examine internal controls to verify that hiring, pay rates, payroll deductions, and terminations are authorized by the personnel department.
• Sample personnel files and physically observe the presence of personnel in the work place.Glen D. Moyes and C. Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol. 4, 2003, p. 208.
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.
How can you defraud your own organization, working either from the inside or outside?
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“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
• 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.
• 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.
• 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.
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:
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.
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.
The Market Segment Specialization Program focuses on developing highly trained examiners for a particular market segment. An integral part of the approach used is the development and publication of Audit Technique Guides.
These Guides contain examination techniques, common and unique industry issues, business practices, industry terminology, and other information to assist examiners in performing examinations. A forensic accountant can use this resource to learn about a particular industry.http://www.irs.gov/business/small/article/0,id=108149,00.html
• 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.
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.
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.
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
Total deposits to all accountsLess: Transfers and re-deposits= Net depositsplus: Cash Expenditures= All total receiptsless: Funds from known sources= Funds from unknown sources
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.
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?
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.
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.
Interviewing Executives One way to detect fraud is to interview company personnel. The AICPA
Fraud Task Force provides an interviewing template of 13 questions for CEOs, CFOs, and Controllers.
1. Explain the purpose of interview- need to assess risk and comply with audit responsibilities
2. Inquire whether they are aware of any instances of fraud within their organization- Do they have reason to believe that fraud may have occurred or is occurring?
3. Has the CEO or CFO ever approved an accounting treatment for transactions that were not appropriate?
4. Have there been any instances where someone has attempted to inflate assets or revenue or deliberately understate liabilities and expenses?
5. Is there any member of management that has a direct interest or indirect interest in any customer, vendor, competitor, supplier or lender?
6. Is any member of management related to any other member of management?
7. Does anyone in the company have any personal, financial or other problems that might affect their job performance?
8. If there was an area within the company that might be vulnerable to fraud, what would that be?
9. Has anyone within the accounting department been let go or resigned within the past year?
10.Is there anyone in management that appears to be living a lifestyle beyond their means? – expensive cars, trips, jewelry, vices
11.Has anyone been involved in civil or criminal proceedings or filed bankruptcy
12.Does the company have a strong ethics policy? 13.Has anyone ever been fired for committing fraud against the company?
Source: Ronald L. Durkin et. al, “Incorporating Forensic Procedures in an Audit Environment,” Litigation and Dispute Resolution Services Subcommittee, New York: AICPA, 2003.
“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
• “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.
• 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.
“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. 92-93).
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.”
The Office of Management and Budget reported that in fiscal year 2001 the federal government paid out $20 billion in erroneous payments.
On June 19, 2003: We analyzed a portion of the programs and already know that erroneous payments exceeded $35 billion a year.” Office of Mgt. And Budget
The Internet site of Ashcraft & Gerel indicates that 10 percent of the U.S. annual budget is paid to companies or persons who are defrauding the government.*•Ashcraft & Gerel, “Whistle Blower Litigation Under The Federal False Claims Act - - Qui Tam Claims,” www.ashcraftandgerel.com/whistleb.html#History
•Governmental Accounting Standards Board: nonprofit agency charged with setting GAAP for state and local governments.•Although GASB has no authority to set law, many public agencies follow its standards.•Statement No. 34 retains the fund accounting focus (good for budgeting and short-term focus), but adds government-wide financial statements (e.g., account for all assets and liabilities).•Requires capitalization and depreciation of infrastructure assets.•Goes from the Governmental Funds Statements to the Statement of Net Assets and Statement of Activities.•Goes from the modified accrual statements to the full accrual statements.•New Management Discussion and Analysis (MD & A) Statement – a narrative discussion of any significant changes in the overall financial picture of a given agency.Source: K. Middaugh, “The Great GASB,” Government Technology, October 2003, pp. 50-52.
Measures a government’s ability to provide basic government services
Decreasing
Financial Performance:
Change in Net AssetsTotal Net Assets
(General Revenues + Transfers) / Expenses
Measures a government’s financial performance during the current fiscal year by comparing the change in the Net Assets derived from the Statement of Activities to the total net assets.
Measures the extent to which the cost of services are paid for out of general revenues.
Decreasing
Decreasing
Liquidity: (Cash + Current Investments + Receivables) / Current Liabilities
Measures the extent to which current liabilities are covered by the more liquid current assets.
Decreasing
Solvency: Long-term Debt / Assets
(Change in Net Assets + Interest Expense) / Interest Expense
Measures a government’s long-term financial viability by comparing the extent to which assets are financed by incurring long-term debt.
Measures the government’s ability to generate a stream of inflows sufficient to make interest payments.
Increasing
Decreasing
Source: B.A. Chaney, D.M. Mead, and K.R. Schermann, “The New Governmental Reporting Model,” Journal of Governmental Management, Spring 2002, p. 29.
Early Warning Signals of Possible Trouble for Municipal Entities
1. Current year operating deficit2. Two consecutive years of Operating Fund deficit3. Current year operating deficit that is larger than the previous
year’s deficit4. A General Fund deficit in the current year – balance sheet –
current position5. A current General Fund deficit (two or more years in the last
five)6. Short-term debt outstanding at the end of the fiscal year,
greater than five percent of main Operating Fund Revenues7. A two-year trend of increasing short-term debt outstanding at
fiscal year end8. Short-term interest and current year-end service greater than
20 percent of total revenues9. Property taxes greater than 90 percent of the tax limit10.Debt outstanding greater than 90 percent of the debt limit11.Total property tax collections less than 92 percent of total
levy12.A trend of decreasing tax collections – two consecutive years
in a three-year trend13.Declining market valuations – two consecutive years – three-
year trend14.Expanding annual unfunded pension obligations Source: H.C. Grossman and T.E. Wilson, “Assessing Financial
Health,” Handbook of Governmental Accounting & Finance, Somerset, N.J.: John Wiley & Sons, 1992, pp. 38-1 to 38-13.
c. Recurring Revenues (Gross Revenues – One-Time Revenues)
Population
Negative Trend: Indicator 1b increasing faster than indicator 1a or 1c.
Indicator 2: Real Property Taxes Receivable
Real Property Taxes Receivable
Real Property Tax Revenue
Negative Trend: The percentage increases over time.
Indicator 3: Fixed Costs – Personal Services and Debt Service
a. Salaries and Fringe Benefits
Gross Expenditures
b. Debt Service Expenditures
Gross Expenditures
c. Salaries and Fringe Benefits + Debt Service
Gross Expenditures
Negative Trend: Percentages increasing over time.
Some analysts use a variation of the 3b ratio based upon debt service expenditures as a percentage of revenues. A ratio of 25% for debt service expenditures to “own source” revenues is considered a danger signal.*
* J.R. Razek et. al, Introduction to Governmental and Not-For-Profit Accounting, Prentice-Hall, 2000, p. 412.
b. Gross Revenues – Gross Expenditures – One-Time Revenues
Gross Expenditures
Negative Trend: Percentages decreasing over time.
Indicator 5: Unreserved Fund Balance and Appropriated Fund Balance
a. Unreserved Fund Balance
Gross Expenditures
b. Appropriated Fund Balance
Gross Expenditures
Negative Trend: Percentages decreasing over time.
Deficits in major funds in excess of 1.5% of fund expenditures or $50,000 (whichever is greater) are generally causes for concern. Some analysts use a variation of this ratio: the budgetary cushion. Here the fund balance is compared to revenues. The greater the fund balance as a percentage of revenues, the more likely a local government may weather hard times. A good rule of thumb is that a fund balance should be at least 5% of revenues.[1] [1] J.R. Razek et. al, op. cit., p. 411.
Indicator 6: LiquidityCash and Investment as a Percentage of Current LiabilitiesCash and Investments as a Percentage of Gross Monthly Expendituresa. Cash and Investments
Current Liabilitiesb. Cash and Investments
Gross Expenditures/12Negative Trend: Percentages decreasing over time.
A government should generally have year-end cash equal to about 50% of current liabilities and 75% of average monthly expenditures. A governmental accounting textbook states that this quick ratio (or acid test) omits receivables and amounts due from other funds because of difficulties converting them into cash. They suggest that a large state government should consider a quick ratio of less than 50 percent as an indicator of financial stress.*
Negative Trend: Percentage increase over timeNote: An increase in #7 would likely trigger a future increase in #3 formula as well as a decrease in #8.
Indicator 8: Capital OutlayCapital Outlay Gross Expenditures
Negative Trend: Percentage decreasing over timeNote: This eighth indicator is an early warning sign of financial stress. * Razek and Hosch, ibid., p.411.
Dos and Don’tsIf you volunteer CPA services to an NPO, do• Avoid the appearance of impropriety.• Check the volunteer liability statutes in your state.• Examine the NPO’s internal controls, bylaws and
procedures.• Educate yourself about how the organization operates.• Attend board orientation and understand job descriptions.• Attend as many board meetings as you possibly can and
document votes and discussions.• Make sure the organization has proper insurance coverage.• Be prepared to contribute time, talent and resources.Your follow-through is important, so don’t• Skip board meetings.• Rubber-stamp decisions.• Sign checks without documentation.• Ignore employee complaints of discrimination or sexual
misconduct.• Serve if you are unable to regularly attend meetings.
Source: Joan Sompayrac, “Don’t Volunteer for Trouble,” Journal of Accountancy, January 2003, p. 82.
1. Often exchange small denomination bills for one hundred dollar bills. This techniques reduces the bulk of the currency several fold and makes it easier to conceal and transport.
2. Purchase monetary instruments such as money order, travelers checks, bank drafts, cashiers checks, treasurers checks, and official bank checks with currency in amounts below the $3,000 record-keeping requirement, thereby reducing the bulk of currency.
3. Purchase the monetary instruments mentioned above in increments just below the $10,000 Currency Transaction Report threshold. This will result in the financial institution identifying the purchaser and maintaining a log of these transactions; however, money launderers recognize that the log is not filed with the government.
4. Bulk ship currency to a jurisdiction with bank secrecy laws. Although a Currency and Monetary Instrument Report must be filed with the U. S. Customs Service anytime currency and/or monetary instruments are exported from the U. S. or imported into the U. S. money launderers do not file the report. Section 371 of the USA PATRIOT Act makes bulk shipping cash into or out of the United States a crime.
5. Recognize that financial institutions report repeated deposits of just under $10,000. Therefore many money launderers will open several accounts in the names of family members and possibly friends at several financial institutions and deposit small amounts of currency in each account. The deposited amount in these situations may be less than $1,000 on a daily basis or $2,000 to $3,000 twice or possibly three times a week. These deposited amounts remain below the thresholds of any known internally developed monitoring system and would probably only be detected using comprehensive technology along with a compliance team.
6. May purchase a currency generating business to launder funds. Money launderers have used businesses such as restaurants and service/gasoline stations. These businesses serve as both a method to place and layer dirty money simultaneously.
7. Use electronic transfers to move dirty money. A money launderer may fund an electronic transfer with up to $3,000 in currency without providing identification. These funds can be rapidly transferred anyplace in the world. In many cases the money launderer may request that a representative of a money service business (MSB) execute several wire transfers during the course of a day all below the $3,000 record-keeping threshold. The money launderer will normally offer the MSB employee a bribe for the accommodation.
8. May elect to execute electronic transfers below the $3,000 record-keeping threshold at several financial institutions. Doing this will keep these transfers under the radar screen since they are small increments and they are being distributed to multiple places.
9. Purchase a big-ticket item such as a car and use currency to pay down loans at an accelerated rate. The dealership is required to file a currency report if the money launderer uses currency and/or monetary instruments with a face value of $10,000 or less and the total value of the currency and the monetary instruments aggregates to over $10,000. Financing the automobile and making accelerated payments on the loan will evade the filing of a currency report.
10. Attempt to disassociate themselves from the proceeds of a fraud quickly. Money launders may deposit the fraudulent proceeds into an account and almost immediately withdraw those funds in the form of currency at various branches of an institution or via ATMs.
Source: Don Temple, “Money Laundering 101: Ten Ways to Place Dirty Money,” July 26, 2002, http://www.smartpros.com/x34833.xml
