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Forensic Accounting: Strategies for Detecting & Controlling Fraud D. Larry Crumbley, CPA, Cr.FA, CFFA, FCPA KPMG Endowed Professor Department of Accounting Louisiana State University Baton Rouge, LA 70803 225-578-6231 225-578-6201 Fax dcrumbl@lsu.edu. Dr. Crumbley is the

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    1. Forensic Accounting: Strategies for Detecting & Controlling FraudD. Larry Crumbley, CPA, Cr.FA, CFFA, FCPAKPMG Endowed ProfessorDepartment of AccountingLouisiana State UniversityBaton Rouge, LA 70803225-578-6231225-578-6201 Faxdcrumbl@lsu.edu Dr. Crumbleyis the Editor of the Journal of Forensic Accounting: Auditing, Fraud, and Risk, Former chair of the Executive Board of Accounting Advisors of the American Board of Forensic Accountants, Member of the NACVA’s Fraud Deterrence Board,and On the AICPA’s Fraud Task Force (2003-2004). A frequent contributor to the Forensic Examiner and Value 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. 1

    2. Forensic Report 2

    3. TALLY STICKS “External auditors come down the hill after the battle and bayonet the wounded. Forensic accountants are the guys who follow behind them, going through the soldiers’ pockets looking for money.” 3

    4. Puff Adder “What the use of finger prints was to the 19th century and DNA analysis was to the 20th, forensic accounting will be to the 21st century.” - Gordon Brown, Chancellor of the Exchequer, 10 October 2006. 4

    5. Glimpse Forward Introduction to Forensic Accounting Risk Assessment and Fraudulent Financial Reporting Misappropriation of Assets Forensic Accounting Processes and Techniques Computer Forensics Problem-based learning case study ----------------------------------------------------------- Now John at the bar is a friend of mine. He gets me my drinks for free. Sing us a song, you’re the piano man. “Piano Man”Billy Joel 5

    6. Some Fraud Figures Australia’s annual fraud, 2003, $5.8 billion or 1.147% of GDP. Malaysia’s telecom operators lose 3% of revenue to fraud each year. A KPMG Malaysian survey found that more than a third of the polled companies lost over RM 1 million from fraud in 2 years. Fraud and abuse in U.S. is $652 billion to $1 trillion annually. The quantity of corruption crimes has continued to rise in China after the market liberalizations in 1978 (because so much more money involved). An employee at the Australian mint stole $100,145 over ten months by hiding bills and coins in his lunch box and boots. He carried away on an average 150 coins in each boot every day. 6

    7. Fannie Mae Forensic Probe BOD hired investigators who cleared the current management of Fannie Mae of knowingly participating in any wrongdoing. The report took 17 months; 616 pages plus 2,000 plus pages of supporting documents. Cost of $60 million to $70 million. The fraud was estimated to be $11 billion. Former N.H. Senator Warren Rudman used The Huron Consulting Group. 7

    8. Definition of Forensic Auditor Someone who can look behind the facade--not accept the records at their face value--someone who has a suspicious mind that the documents he or she is looking at may not be what they purport to be and someone who has the expertise to go out and conduct very detailed interviews of individuals to develop the truth, especially if some are presumed to be lying. Robert G. Roche, a retired chief of the IRS Criminal Investigation Division of the IRS 8

    9. Narrow vs. Broad Definition Narrow: Fraud detection is major area. Broad: Employed to seek, interpret, and communicate transactional and reporting event evidence in an objective, legally sustainable fashion, not only in situations where there are specific allegations of wrongdoing, but also in situations where interested parties judge that the risk of loss from wrongdoing is such that proper prudence requires legally sustainable evidence to support the conclusion that no wrongdoing is occurring (James Edwards). 9

    10. Narrow Approach U.S. Dept. of Justice, Education and Training in Fraud and Forensic Accounting: A Guide for Educational Institutions, Stakeholder Organizations, Faculty and Students, Draft Copy, December 23, 2005. Accounting Forensic Accounting Accounting Litigation Matters and Investigations Internal and External Auditing Planning Risk Assessment Internal controls Audit Evidence Reporting Fraud Prevention and Deterrence Detection Investigation Remediation 10

    11. Broad Approach “I liken itto ‘CSI’ or ‘Law & Order,’ but instead of figuring out thetrajectory of a bullet, you’re trying to find out how a transactionoccurred.” Terry McCarthy 11

    12. Definition of Forensic Accounting • Forensic accounting is the application of accounting, tax, auditing, finance, quantitative analysis, investigative and research skills, and an understanding of the legal process for the purpose of identifying, collecting, analyzing, and interpreting financial or other data or issues in connection with: • 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 • Non-litigation services: performing analyses or investigations that may require the same skills used in 1, above, but may not involve the litigation process. 12

    13. Definition of Forensic Accounting Litigation Service Forensic accounting litigation services are the professional assistance accountants provide related to the litigation process. These services may involve accounting, financial, auditing, tax, quantitative analysis, and investigative and research skills, as well as an understanding of the legal process to provide assistance for actual, pending, or potential legal or regulatory proceedings before a trier of fact in connection with the resolution of a dispute between parties. 13

    14. Definition of Forensic Accounting Non-Litigation Services Forensic accounting non-litigation services are the professional assistance accountants provide not related to the litigation process. These services may involve accounting, financial, auditing, tax, quantitative analysis, and investigative and research skill as well as an understanding of the legal process to provide assistance in connection with matter or issues not involving the litigation process. “You’re trying to piece together a puzzle where you do nothave the picture on the box to know what it’s going to look like. The facts are not settled, and actually it’s the facts that are in dispute.” Andrew Bernstein 14

    15. Short History • Late 1800’s – Find fraud • 1930’s- Puff Adder –encyclopedia • 1933-1934-independent audits • 1950’s-Eighth edition Montgomery auditing reduced formal stress on fraud detection. • January 1957- H.W. Bevis, AR, questioned the benefit of discovering minor employee thefts. • 1960s-auditors claimed no responsibility. • Financial audits: Consistency. • Audit surveillance: test of details (disappeared). • Stock market bubble • Panel on Audit Effectiveness (2000) • Enron/ WorldCom/ Parmalat/ HealthSouth • Sarbanes-Oxley/ PCAOB • SAS No. 99 15

    16. Transparency International Corruption Perceptions Index 2006 16

    17. States Corruption Index Most corrupt: Mississippi North Dakota Louisiana Alaska Illinois Montana South Dakota Kentucky Florida New York Least corrupt: • Nebraska • Oregon • New Hampshire • Iowa • Colorado • Utah • Minnesota • Arizona • Arkansas • Wisconsin 17

    18. Forensic Accounting Factors Time: Forensic accounting focuses on the past, although it may do so in order to look forward (e.g., damages, valuations). Purpose: Forensic accounting is performed for a specific legal forum or in anticipation of appearing before a legal forum. Peremptory: Forensic accountants may be employed in a wide variety of risk management engagements within business enterprises as a matter of right, without the necessity of allegations (e.g., proactive). ----------------------------------------------- With a single clue a forensic accountant can solve a fraudulent mystery. 18

    19. One Small Clue 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. 19

    20. Forensic Accounting Areas Investigative Auditing Litigation Support Forensic: Latin for “forum,” referring to a public place or court. Black’s Law Dictionary: Forensic, belonging to the courts of justice. Note: Corporate spooks are used to check on competitors. 20

    21. Forensic Auditing Forensic auditing is a type of auditing that specifically looks for financial misconduct, and abusive or wasteful activity. It is most commonly associated with gathering evidence that will be presented in a court of law as part of a financial crime or a fraud investigation. Source: B.L. Derby, “Data Mining for Improper Payments,” Journal of Government Financial Management, Winter, 2003, pp. 10-13 --------------------------------------------------------------- “ Forget the stuffed white shirt, forensic accountants are more parts Philip Marlowe than Casper Milquetoast. They open the books and crack the code, transforming a dull science of numbers into a suspenseful mystery with a logical, even riveting resolution.” Cory Johnson 21

    22. Top Niche Services 22

    23. Forensic Accounting vs. Fraud Auditing Forensic Accountant: A forensic accountant may take on fraud auditing engagements and may be a fraud auditor, but he or she will also use other accounting, consulting, and legal skillsin broader engagements. In addition to accounting skills, he or she will need a working knowledge of the legal system and excellent communication skills to carry out expert testimony in the courtroom and to aid in other litigation support engagements. Crumbley, Heitger, Smith, Forensic and Investigative Accounting (CCH) 23

    24. AICPA’s Position Public accounting firms could use forensic accountants to help revise their approach to planning and fieldwork on all audits, while requiring forensic accountants only on high risk audit clients to aid in the interpretation of forensic testing results and preventive control enhancements. Does not require auditors to carryout specific forensic procedures, but rather provide guidance on how to include forensic techniques within processes outlines in SAS 99. This combination will enhance the detection and prevention of fraudulent financial statement reporting and misappropriation of assets; thus protect investors and financial statement users. The inclusion of audit procedures focused towards detecting misappropriation of corporate assets may lead to the identification of weaknesses within corporate governance or control weaknesses. Frauds that are identified which represent a material misappropriation of assets could significantly impact public perception. 24

    25. AICPA’s Position (cont.) Professional forensic accountants can best be used by ensuring such procedures are properly developed and executed in-line with internal audit and audit committee concerns. Forensic accountants could then be engaged in high-risk situations, or when a fraud is suspected. Companies should not use the forensic services of their outside audit firm, unless it pertains to the annual audit. Putting a price on a substantive test or forensic auditing procedure may be smart for business; however, the inherent risk is that short-cuts geared towards reducing audit costs may eventually cause investors to question the companies’ true financial position. AICPA – Discussion Memo Question Responses 25

    26. Big-Six's Position A forensic audit is akin to a police investigation. All public companies should have a forensic audit on a regular basis. Companies would be required to have such an audit every three or five years or face these audits on a random basis. Forensic auditors scrutinize all records of companies, including emails, and would be able, if not required, to question all company employees, and to require statements under oath. Might be necessary for an audit network or a specialized forensic auditor to complete a forensic audit with the aid of independent attorneys (not these who have represented the audit client in the other engagements). Source: “Serving Global Markets and the Global Economy: A View from the CEOs of the International Audit Networks, November 2006, p. 13. 26

    27. Forensic vs. Fraud Audit Google result, February 11, 2007 Forensic Audit, 208,000 hits Fraud Audit, 64,500 hits Fraud Examination, 74,800 hits Fraud Accounting, 45,200 hits Forensic Accounting, 1,050,000 hits Fraud Investigation, 932,000 Forensic Investigation, 512,000 Fraud Auditing, 83,500 ---------------------------------------------- I don’t care what they say, but [forensic accounting] is here to stay. Danny & the Juniors ----------------------------------------------------------------------------------- I see skies of blue and clouds of white, and I think to myself, what a wonderful world. Louis Armstrong 27

    28. Specialties Within Forensic and Investigative Accounting Employee Crime Specialist. Asset Tracing Specialist. Litigation Services Specialist and Expert Witness. Insurance Claims. Valuation Analysis. False Claims Act Violations. Due diligence investigations. 28

    29. 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. 29

    30. Finding Unreported Income/Hidden Assets Look at the lifestyles. Look at the expenses. Look at the cash flow. Look at the business operations. Look at the industry ratios. Consider using private investigators. Use the net worth method. Mark Kohn, “Unreported Income and Hidden Assets,” Forensic Accounting in Matrimonial Divorce, Philadelphia: R.T. Edwards, 2005, pp.49-57. 30

    31. Fiction v. Reality The main difference between fiction and reality is that instead of using mask and gun, today’s villains use mouse and keyboard. Instead of hiding behind a lamppost in a trench coat and fedora, today’s forensic accountants are more likely to behiding behind their own computers, searching for clues amid mountains of data. Source; “Book ‘EM! Forensic Accounting in History and Literature,” The Kessler Report, Vol.1, No. 2. ------------------------------------------------------------------------------------ “Every investigation I did as a prosecutor, you have a particular target, but it always branches off because something else gets your attention. And that’s what is going to happen with a forensic accountant.” Tom Carlucci: E-library Rueter Library September 20, 2002 31

    32. Forensic Techniques Become Popular “In many of the large accounting blow-ups, auditors knew what was happening,” says Charles Niemeir, “but they were willing to look the other way.” There is a need to provide “incentives for people finding problems,” says Douglas Carmichael. “Right now there are no incentives for finding problems, and one who does is treated as a trouble maker.” Source: Cassell Bryan Low, “Accounting Firms Attempts to Dispel the Cloud of Fraud,” Wall Street J., May 27, 2003. Doug Carmichael, Chief Auditor for Peek-uh-boo, faults auditors for not adopting forensic techniques. Carmichael wishes more “test of details,” not relying on test of controls. He wishes more shoe-leather work. Shoe-leather work is what we do! Kris Frieswick, “How Audits Must Change,” CFO July 2003, p.48 32

    33. Popular (cont.) E&Y’s forensic accounting team is comprised of 350 practitioners in the U.S. alone, and focuses on strategies to mitigate and manage conflict in bankruptcy disputes, financial and economic damages, fraud and investigations, government contracts and grants, insurance claims, intellectual assets, and legal technology. Deloitte’s forensic accounting expertise includes anti-money laundering, the Foreign Corrupt Practices Act, purchase price disputes, arbitrations, construction fraud, health care fraud, construction oversight, intellectual property theft, and misdirected royalty revenues, to name just a few. They have forensic labs in nine major cities across the U.S. and an additional 18 cities around the world, including Hong Kong, London, Amsterdam, Frankfurt, Cape Town and Melbourne.” All FAS labs meet the FBI’s chain of custody requirements. “They are secure, state-of-the-art, and house advanced systems for storing and accessing data, including dedicated servers and fire-resistant safes. Stuart Kahan, “Sherlock Holmes Enters Accounting,” WebCPA, February 11, 2007. 33

    34. “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. Forensic Accountants 34

    35. Potpourri Deutsche Bank is being sued for $1.3 billion by Bruce Winston (one of the heirs of Harry Winston diamond dynasty) for priceless gems disappearing from a trust under their control. A Burlington, Kentucky city finance director is accused of embezzling more than $1.2 million to support his estranged wife and his girlfriend. Martin Frankel vanished with between $200 million in cash and diamonds one day. He accomplished this insurance fraud by buying poorly capitalized insurance companies, cooking the books to show increased premium value, and by including non-existing real estate and leases on the balance sheet. Bank of China’s Mr. Wu allegedly embezzling up to $18 million from a bank branch, using improper bills of exchange. BoC has a number of cases involving the embezzlement of $737 million from branches in the Southern Guangdong Province. A U.S. Lime officer embezzled nearly $2.2 million by forging signatures of other company officers on checks, and falsifying the company’s check register to create the impression that the amounts he received went to U.S. Lime creditors. 35

    36. Potpourri (contd …) The Chairman of Hyundai Motor, Chung Mong-Koo, was sentenced in February 2007, to 3 years in prison for embezzlement ($100million) and breach of trust at South Korea’s largest carmaker. Spanish authorities shut down Afinsa’s Forum stamp-investing programs with several hundred thousand of small investors. Alleged investments in overvalued stamps and suspected pyramid scheme. Eight officials jailed. In 2000, Rent Way’s CAO artificially reduced the company’s expenses by $127 million. WorldCom’s external auditors missed about $11 billion improperly booked items. Ahold NV, a Dutch company, said a U.S. unit had overstated revenues by $880 million by booking more discounts from suppliers than actually received. One Philippine peso coin has the same size as 1 dirham, but worth only 7 fils. Thus, dispense machine fraud. 36

    37. 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 Auditors Blamed: Deep Pockets 37

    38. As part of the securitization agreement, UC agreed to pay the principal and interest on defaulted loans. Creditors contend that UC failed to account for the interest it was paying, and D&T should have caught the mistake earlier. After UC wrote off $605 million in debt, the company filed for bankruptcy. Confidential mid-court settlement. Source: Adrian Angelette, “United Companies Settlement Reached,” Baton Rouge Advocate, October 31, 2003, pp. A-1 and A-12 Auditors Blamed (cont.) 38

    39. 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. Find It, or I’ll Sue 39

    40. Forensic Accounting Knowledge Base Investigative auditing LAW Accounting Criminology Forensic Accountant Silk, Silk, Silk 40

    41. Threads of Forensic Accounting Forensic accounting (or at least accounting expert witnessing) can be traced as far back as 1817 to a court decision. [Meyer v. Sefton] In 1824, a young accountant by the name of James McCleland started business in Glasgow, Scotland and issued a circular that advertised various classes of expert witness engagements he was prepared to undertake. In 1856 in England, the audit of corporations became required. 41

    42. Investigative Accountants Initially called investigative accounting, many of the forensic techniques, such as the net worth method, were developed by IRS agents to detect tax evaders. Infamous mobster, Al Capone, was caught when Special Agents of the IRS stepped in and charged him with tax evasion. Accountants caused the crime czar’s career to come to an end. 42

    43. Al Capone Caper “Perhaps the most celebrated case of an accountant nailing a famous criminal was the case of Al Capone. For all of Capone’s colorful history of violent crime, the FBI could never gather enough evidence to convict him until FBI agent Eliot Ness had an idea. He gathered special agents of the IRS to track the flow of cash from Capone’s illicit activities. When the mobster failed to pay taxes on those earnings, the IRS nailed him for tax evasion. Capone went to jail and was never a factor again. IRS recruitment posters boast till this day: ‘Only an accountant could catch Al Capone.’” Source: “Book ‘Em! Forensic Accounting History and Literature,” The Kessler Report, Vol. 1, No. 2. 43

    44. Father of Forensic Accounting: Maurice E. Peloubet (1946) Pretenders: Max Lourie (1953) Robert Lindquist (1986)* * Repeated, First sentence in N. Brennan and J. Hennessy, Forensic Accounting, 2001, p. 5. 44

    45. The Essence of Forensic Accounting by Maurice Peloubet (1946): “The preparation of data for and the appearance before government agencies as a witness to facts, to accounting principles, or to the application of accounting principles is essentially forensic accounting practice rather than advocacy.” Modern Version “Let’s face it, we in the forensic profession labor in an obscure corner of the vineyard. We are the carefully selected, trusted, highly trained guardians of one of the last great secrets remaining on the face of the earth - - the $600 billion [now $652], more or less annual problem nobody knows about.” Joseph W. Koletar, Fraud Exposed, John Wiley & Sons, Inc 2003, p. 228. 45

    46. Be like 46

    47. Panel on Audit Effectiveness In 1998, the Public Oversight Board appointed the Panel on AuditEffectiveness 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]. 47

    48. Required Forensic Audits Coming? The accounting profession may be making a strategic shift as they see that SAS No. 99 and the other rules are not protecting them from being the insurer of last resort. The Big Four along with Grant Thornton and BDO International recently released a report entitled “Serving Global CapitalMarkets and the Global Economy.” In the report, one of the things they are suggesting is for companies to have a forensic audit. Companies would be required to have such an audit every fiveyears or face these audits on a random basis. “Auditing Firms Urge New Ways to Detect Fraud,” NYSSCPA.org News Staff. Posted on November 11, 2006. 48

    49. Fraud Strategies Differ Forensic Accountants Internal Auditors External Auditors Fraud Examiners Certified Fraud Deterrence Analysts (CFD) or CFFAs Forensic CPA Society (FCPA) 49

    50. Predication The ACFE group indicates that in the private sector, a fraud investigation should not be conducted without proper predication. Examples: Anonymous tips, complaints, audit inquires, conflict of interest. Thus, predication is the basis for undertaking a fraud investigation. Without predication, the target might be able to sue for real or imaginary damages. 50