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ACCT 201
Gordon Whitman

Lecture Notes on Forensic Accounting Investigations ▯ Jagdish S. Gangolly Department of Accounting & Law State University of New York at Albany 1 Introduction Fraud is a legal and not an accounting concept. For this reason, the accountants have traditionally chosen to treat it as a concept alien to them. 1.1 What is fraud? There are four elements to any fraud: ▯ A false representation of a material nature (either misstatement or omission of a material fact) ▯ Scienter: Knowledge that the representation is false, or reckless disregard for truth ▯ Reliance: The person receiving the representation has reasonably and justi▯ably relied on it ▯ Damages: Such receiving party has sustained ▯nancial damages from all of the above It is important to note that the under the securities laws, some of these conditions are relaxed. 1.2 Types of Fraud ▯ Misappropriation of assets (Retail Fraud) ▯ Financial Statement Fraud (Wholesale Fraud) ▯These notes are based on the book A Guide to Forensic Accounting Investigations by Thomas W. Golden, Steven L. Skalak, and Mona M. Clayton. They are meant for ghe exclusive use of the students in the course Acc 551 at SUNY Albany 1 1.3 Gatekeepers ▯ Macro level { Standard setters { Market Regulators { Emerging Technologies ▯ Micro level { Board of directors { External Auditors { Analysts { Legal Profession 1.4 Fraud Deterrence Cycle ▯ Corporate Governance ▯ Transaction level control of processes (System of internal control) ▯ Audit of corporate governance and internal control ▯ Investigation/remediation of suspected alleged problems 1.5 Auditing History Timeline ▯ Pre-1929: GAAP determined primarily by common law ▯ 1929 stock market crash ▯ Securities Act 1933, Securities & Exchange Act 1934, and the establishment of the SEC ▯ Establishment of the Committee on Accounting Procudure (AICPA) 1939 ▯ Accounting Principles Board (AICPA) 1959 ▯ Trueblood Commission and subsequent erstablishment of the Financial Accounting Standards Board 1973 ▯ Foreign Corrupt Practices Act 1977 ▯ Sarbanes-Oxley Act 2002, Public Companies Accounting Oversight Board (PCAOB) 2 2 Auditor and the Forensic Accounting Investigator The auditors’ concerns include: ▯ Provide reasonable assurance that ▯ material misstatements do not exist and ▯ if they do exist, they are detected Auditors generally concern themselves with deterrence only to the extent that lack of such deterrence can entail possibility of fraud. Auditors also are generally not concerned with investigations except in case of special engagements. The Forensic Accounting Investigators’ concerns, on the other hand, include: ▯ relatively narrow boundaries ▯ detailed development of factual information (from documentary as well as testimonial evidence) ▯ assessments of loss or damages based on the examination of the evidence ▯ recommendations to provide deterrence in the future Forensic Accounting Investigator’s ▯ndings and recommendations can be used in litigations as well as testimony before federal/state government and judicial agencies. Both auditors and the forensic accounting investigators need to have: ▯ knowledge of the industry, the company and its business practices ▯ knowledge of GAAP in the jurisdiction ▯ skills in the interpretation of business documents and records ▯ independence and objectivity Some observations: ▯ Generally, however, auditor/client relationships are not adversarial, but the relation- ship between the forensic accounting investigator and the client are adversarial ▯ Auditor is like a patrolman; a forensic accounting investigator is like a detective. Patrolman is always on patrol, a detective, however, is called on only when there is suspicion of fraud or fraud has already been detected 3 2.1 SPADE VFramework ▯ Skepticism ▯ Probing communication ▯ Analytics ▯ Documentation ▯ Evaluation 3 Psychology of the Fraudster ▯ An individual’s propensity to commit crime is not related to personality. What ids important are the situations and social bonds within organisations (Edwin Suther- land, 1939) ▯ Criminality is not con▯ned to any speci▯c class in society (Edwin Sutherland, 1939) ▯ Culture of competition promotes and justi▯es the pursuit of material self-interest, often at the expense of others and even in violation of law (James Coleman, 1987) ▯ Calculating (Predatory) criminals, Situation-dependent criminals, Power brok 3.1 Calculating Criminals ▯ want to compete and assert themselves ▯ repeat o▯enders ▯ higher than average intelligence ▯ well educated ▯ begin life in crime at a later age than other criminals ▯ inclined to taking risks ▯ lack of feelings of anxiety or empathy ▯ "external locus of control" { lack of inner direction, self-con▯dence and self esteem ▯ motivated by their desire ▯t in and to be accepted ▯ they de▯ne success by others’ standards 4 3.2 Situation=dependent Criminals ▯ Ordinary people with no intent to harm others 3.3 Fraud Triangle ▯ Incentive/Pressure ▯ Opportunity ▯ Rationalisation 4 Financial Reporting and Capital Markets 4.1 Fraudulent Schemes ▯ attacked from within (rogue employee) ▯ attack from outside to obtain funds under false pretenses ▯ used an an unwitting participant to facilitate a fraudulent scheme perpetrated on others or for the bene▯t of others 4.2 Some Schemes ▯ Ponzi Scheme ▯ Bank frauds ▯ Pyramid Schemes ▯ "8-ball" model 5 Auditor Responsibilities and the Law 5.1 Common Law ▯ Contract: Negligence su▯cient; privity needed. Malpractice. ▯ Torts: Gross negligence or Fraud. Third parties. Ultramares ruling establishes three things (Brady, Accounting Review, 1938): { Negligence is not su▯cient for third parties to bring actions against accountants { Untrue certi▯cate of fact is a su▯cient basis for determining liability; express intent to deceive need not be shown (Gross negligence) 5 { Incorrect certi▯cate of opinion is not a su▯cient basis for determining liability unless the grounds for the certi▯cate are so imsy to suggest lack of good faith su▯cient to raise inference of fraud For the rest of this chapter see the handout on "Auditor Liability" 6 Independence, Objectivity, Skepticism ▯ Independence { Independence in fact { Independence in appearance ▯ Book-keeping services ▯ Financial systems design and implementation ▯ Appraisal and valuation services ▯ Actuarial services ▯ Internal audit outsourcing services ▯ Management functions ▯ Human resource services ▯ Broker/dealer, investment advisory, investment banking services ▯ Legal services and expert services unrelated to audit ▯ Any other services deemed impermissible by PCAOB ▯ Regulation of Forensic Accounting Services { Legal services and expert services unrelated to audit( Rule 2-01(c)(4)(x) of Reg- SX of SEC: No advocacy rule { Forensic services can be used to ▯ extend audit procedures ▯ "shadow" audit client’s independent legal counsel and retained outside foren- sic accoujnting investigatots ▯ perform combinations of the above two { Can investigate suspected illegal acts at the request of the audit committee in situations not involving litigation or regulatory proceedings { Forensic accounting investigative services to aid management or audit committee carrying out its corporate governance responsibilities { Forensic services already under way when government investigation commences so long as the auditor controls the work 6 { No services to client’s legal representative in connection with investigation by SEC’s Division of Enforcement,in litigation proceesings, or other government investigations { Forensic accountants can not take direction from client’s counsel or aid such counsel in any way ▯ Integrity and Objectivity ▯ Professional skepticism 7 Forensic Investigations vs. Financial Audits ▯ Auditors examine the ▯nancial statements in accordance with GAAP and GAAS, while the Forensic Accounting Investigators deal with fraudulent ▯nancial reporting and misappropriation of assets ▯ The audit opinion is on the ▯nancial statements taken as a whole. The work of Forensic accountants, on the other hand, usually relates to heightened awareness of speci▯c irregularities ▯ Auditors’ work serves public interest. Forensic accountants’ work, on the other hand, serves ther interest of the parties that hire them. ▯ Auditor’s work stands on its own, but a Forensic accountant’s work supports the work of the legal counsel or the board. ▯ Auditors express an opinion, but forensic accountants also recommend changes ▯ Auditors are concerned with errors and irregularities; forensic accountants are con- cerned with distinction between errors of judgement & deliberate misrepresentations ▯ The relationship between the auditor and the client is one of openness and full candor; the relationship between the forensic accountant and the party investigated is usually adversarial ▯ Audit work usually does not disrupt work environment of the client; in case of forensic accounting investigations, the work can be disruptive ▯ Clients always have a full understanding of the scope and objectives of the audit. However, in case of forensic accounting investigations, the party investigated may not have such understanding of the work ▯ Audit work is usually coherent, coordinated, and e▯cient. Forensic accountant’s work can be messy with many blind alleys 7 ▯ Auditors meet regularly on schedule with the audit committee and on an as-needed basis with the executive management; the forensic accountants have continual ac- cess to executive management and frequent but irregular contacts with the audit committee ▯ major di▯erences in sta▯ng between audits and forensic accounting investigations ▯ Auditors often use attribute sampling for tests of control and variable sampling for substantive tests (of transactions). Forensic accountants are more likely to use dis- covery sampling and dollar-unit sampling ▯ Audit work is not protected under attorney-client privilege. Most forensic accounting work is structured to be done in a privileged environment ▯ Auditors must work without indemni▯cation protections. Forensic accounting work usually has both indemni▯cation and hold-harmless protections ▯ Auditor determines the nature, scope, and extent of the audit. In case of forensic accounting investigations, they are determined by the client. It is because of this that the forensic accountant gets indemni▯cation and liability protection from the client ▯ The auditor presumes the validity of the documents and information, but the forensic accountant does not ▯ At the end of the audit there is an opinion; at the end of a forensic accounting investigation there are ▯ndings and recommendations 8 Red Flags and Fraud Detection ▯ Points to keep in mind in forensic accounting investigations { Professional skepticism { Bear in mind the possibility of falsi▯ed documents { Be alert to potential red ags, outliers, indicators of irregularities { Request more documentation if necessary: Trust but verify ▯ SAS 99 steps to early identi▯cation, evaluation, and response to the risks of material misstatements due to fraud: { Discussions among audit team regarding fraud risk { Obtaining information relevant to identi▯cation of fraud risk { Identi▯cation of risk of material misstatements due to fraud 8 { Assessment of identi▯ed risks taking into account internal controls { Responding to the results of the assessment { Evaluating audit evidence ▯ Fraud Risk Factors: { Management characteristics { Industry characteristics { Operating characteristics and ▯nancial stability { Susceptibility of assets to misappropriation { Adequacy of controls ▯ Fraud Risk Factors and Professional Skepticism { "Thoroughly probe the issues, acquire additional evidence as necessary, and con- sult with other team members and, if appropriate, experts in the ▯rm, rather than rationalise or dismiss information or other conditions that indicate a ma- terial misstatement due to farus may have occured" SAS 99 { Keeping an open mind, developing a heightened awareness, making a critical assessment of evidence, and seeking corroboration ▯ Analytic Procedures { Types of Analytic Procedures: Preliminary Analytic Procedures To determine the nature, timing, and extent of audit procedures Substantive Analytic Procedures To analyse the evidence obtained during the substantive testing of account balances Final Analytic Procedures Analysis of all evidence to support the audit con- clusions { Analytic Techniques ▯ Horizontal analysis (current period vs. prior periods) ▯ Vertical analysis (common size analysis) ▯ Comparison of details of totals with similar detail for prior years ▯ Ratio analysis and other ▯nancial relationships including comparisons with similar ▯rms 9 8.1 Some Frauds { Revenue Fraud: Fictitious sales revenue Sale of non-existent goods, sales to non-existernt customers In ated sales Shipping of goods not ordered, treating consignments as sales, ignoring shipping terms that deal with ownership transfer Over-billing customers Billing customers above agreed upon price Deceptive sales practices Defective parts Sale of defective parts that will be returned subsequently Reimbursement for services not provided or not covered under government programs Underwriting fraud schemes Usually, rigging the research reports on com- npanies to gain advantage in underwriting, eg., bullish reports by Smith Barney on AT&T to bene▯t in the underwriting of AT&T spino▯ of its wireless subsidiary Billing, collection, or recording of vendor allowances and support Earnings management by setting unrealistic sales targets, reporting underachieve- ment to vendors, marking down prices, and claiming allowances from ven- dors to shore up revenues, eg., Saks case Deceptive sales practices, including slamming Slamming is the practice of switching the long distance telephone service from one carrier to another without the customer’s consent Skimming abstracting cash by delaying the recording of transactions, or not recording it at all Product diversion Diversion of products to markets/uses not intended; usu- ally in export sales, promotional o▯ers, excess merchandise destruction, charitable donations ( In ated claims Often by Pharmacy Bene▯t Managers (PBM) Round-trip Trading An action that attempts to in ate transaction volumes through the continuous and frequent purchase and sale of a particular secu- rity, commodity or asset. ( triptrades.asp) Ricochet trading, sometimes known as Megawatt laundering Arbitrage trading involving buying at a low price from one market and selling the same product in another market at a much higher price. Enron indulged in it by buying power in California below their ceiling prices to sell it at almost ▯ve times the price elsewhere ( article.htm) Inter-positioning Specialist in a stock inter-positioning himself by trading separately with the buy order and the sell order rather than executing the 10 orders, thereby obtaining higher pro▯ts. Recently in July 2008, the US Court of Appeals (Second Circuit) set aside a gulity verdict under securities law, holding "that absent proof that the defendant actually conveyed a misleading impression to customers, ▯nding securities fraud liability would invite litigation beyond the immediate sphere of securities litigation. United States v. Finnerty, 2008 U.S. App. LEXIS 15296 (2d Cir. July 18, 2008) Trading ahead A specialist trading for his own account before trading for the public accounts. Recently in July 2008, the US Court of Appeals (Second Circuit) set aside a gulity verdict under securities law, holding "that absent proof that the defendant actually conveyed a misleading impression to cus- tomers, ▯nding securities fraud liability would invite litigation beyond the immediate sphere of securities litigation. United States v. Finnerty, 2008 U.S. App. LEXIS 15296 (2d Cir. July 18, 2008) Sim card cloning Selling of Cloned SIM cards of mobile phones { Asset Fraud: Theft of competitor secrets Theft of 3rd party intellectual property Manufacturing & Materials Fraud Fraud involving revenue-sharing arrangements, reinsurance arrangements or transactions { Violations of law: Anti-trust violations/market rigging/price ▯xing Violation of environmental laws and regulations Violations of occupational health and safety (OSHA) laws Late Trading and Market Timing Violations facilitating unlawful late trad- ing and deceptive market timing of mutual funds by its customers and cus- tomers of its introducing brokers. ( 38.htm) 9 Internal Audit: Second Line of Defense 9.1 COSO Internal Control Framework Components ▯ Control Environment ▯ Risk Assessment ▯ Control Activities ▯ Information and Communication 11 ▯ Monitoring 9.2 The Internal Audit Migration Model Value Funct Focus Skill Sets Assurance Value protec Transactions Fin/Compliance Auditing Int Control Assurance Internal Control Processes Operational Auditing] Business Process Improvement Product & Process Knowledge Value Enhance Risk Mgt Enterprise-wide Risk Mgt Risk Mgt Assurance 9.3 Hando▯ to Forensic Accounting Investigators & Legal Counsel ▯ When to hando▯ { On any sign of fraud { On suspicion of fraud { After gathering preliminary evidence ▯ Ractors determining when to hando▯ { Management policy { Skillset and experience of the internal audit team { Legal counsel’s policy { the emerging set of best practices ▯ Reasons for recent failures to detect fraud { Deference to senior management on complex ▯nancial transactions { Limitations on the information and scope provided for internal auditors ▯ Thornburgh Report Recommendations: { Maintain increased skepticism { Be wary of scope limitations on internal auditors { Support of the senior management, board and audit committee for the internal audit function { Evaluate ▯nancial statement fraud risk, specially in situations involving complex ▯nances and organisation { Strive for adequate internal audit planning { Strive for real and active contact with the audit committee 12 ▯ Recommendations of the Special Investigative Committee of WorldCom Board of Directors (Beresford Committee): { Strive for open communications between employees and the internal auditors { Focus on substantive interactions between the internal audit personnel and the external auditors 10 Financial Statement Fraud Overstatement of revenue is the predominant form of ▯nancial statement fraud. 10.1 Revenue ▯ Accelerating shipments towards the end of the accounting period ▯ Keeping books open beyond the end of accounting period ▯ Treating consignments as sales ▯ Bill-and-hold transactions (auditors should question business purpose) ▯ Goods shipped ion evaluation basis ▯ Sales where right of return exists ▯ Round-trip trades and swaps ▯ Related party transactions ▯ Overstating percentage of completion in long term contracts ▯ Understatement of returns, allowances, discounts, markdowns ▯ Fictitious sales ▯ alteration, falsi▯cation or backdating of sales/shipping documents ▯ channel Stu▯ng ▯ Partial shipments where the entire sale is recognised ▯ Early delivery of products ▯ Shipment of goods not ordered ▯ Recognition of revenue where contract calls for multiple deliverables (set up, instal- lation, testing, etc. 13 ▯ Misallocation of value in multiple-element revenue arrangements (sale + service ion software) ▯ up-front fees (subscriptions, maintenance contracts) 10.2 Criteria for recognition of revenue ▯ Persuasive evidence of an arrangement ▯ Delivery occured or services rendered, title transferred, risk of ownership transferred ▯ Price to buyer is ▯xed or determinable ▯ Reasonable assurance that gthe receivable is collectible 10.3 Detection Techniques ▯ Audit of transactions close to the end of the accounting period (cuto▯ tests) ▯ Audit of large transactions ▯ Audit of transactions with new customers and related parties ▯ Audit of unprocessed returns ▯ Audit of returns at gthe beginning of the subsequent accounting period ▯ reveivables con▯rmation (sometimes called circularisation) ▯ Manual sales entries in the books ▯ Audit of long term contracts (percentage of completion) ▯ Analytical tests of sales data 10.4 Inventory Misstatements ▯ In ation of inventory on hand ▯ In ation of inventory value by postponing writedowns ▯ Capitalisation of inventory 14 10.5 Investments Misstatements ▯ Fictitious investments ▯ Misclassi▯cation of equity investments (trading or available for sale) ▯ Misclassi▯cation of debt securities held as investments (trading, held to maturity, or available for sale); trading and available for sale investments in debt securities are stated at fair market value; unrealised gains/losses on trading securities are shown as part of income for the period, such gains/losses on those held as available for sale are shown as other comprehensive income. Held to maturity investments in debt securities are shown at amortised value. ▯ Failure to write down declines in the value of investments that are not expected to recover 10.6 Miscellaneous ▯ Fictitious assets ▯ Treatment of a part of the purchase price in mergers as in-process research & devel- opment so that they can be expensed by the acquiring company ▯ Capitalisation of start up costs ▯ Improper capitalisation of interest costs ▯ understatement of liabilities and expenses ▯ O▯-balance sheet transactions ▯ Cookie-jar reserves and earnings management ▯ Improper and inadequate disclosures ▯ Check tampering ▯ Expense reimbursement padding ▯ Payroll schemes (phantom employees and falsi▯cation of time cards) 11 Financial Statement Fraud: Other Schemes & Misappro- priations See Section 10. 15 12 When and Why to call in Forensic Accounting Investiga- tors Auditors’ skill sets: Prevention, Deterrence, Detection Forensic Accounting Investigators’ skill sets: Investigation, Resolution, Litigation Auditors ▯ are NOT Foernsic Accounting Investigators ▯ are NOT Authenticators ▯ have limited exposure to fraud ▯ are not guarantors (watchdogs, not bloodhounds) ▯ Audits are opredi
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