Forensic and Investigative Accounting

Chapter 1 Introduction to Forensic and Investigative Accounting

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Forensic Accounting vs. Fraud Auditing

Fraud Auditor: An accountant especially skilled in auditing who is generally engaged in auditing with a view toward fraud discovery, documentation, and prevention.

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Forensic Accounting vs. Fraud Auditing

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

Time: Forensic accounting focuses on the past, although it may do so in order to look forward. Purpose: Forensic accounting is performed for a specific legal forum or in anticipation of presentation before a legal forum. Peremptory: Forensic accountants may be employed in a wide variety of risk management engagements within business enterprise as a matter of right, without the necessity of allegations (e.g., proactive).
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Forensic Accounting Defined

Forensic accounting is the action of identifying, recording, settling, extracting, sorting, reporting, and verifying past financial data or other accounting activities for settling current or prospective legal disputes or using such past financial data for projecting future financial data to settle legal disputes.

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Historical Roots of Accounting

10,000 years agoTemple priests took inventory of village livestock. 3,000 B.C.Scribes recorded rulers wealth. 1887American Association of Public Accountants (later becoming the AICPA) was formed. 1896New York State legislated the first CPA law. 1900School of Commerce, Accounts, and Finance at New York University opens.
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Historical Roots of Accounting

1902Congress calls for audit reports for large corporations. 1913Federal Reserve Board created. 1913Federal income tax law was passed. 1914Federal Trade Commission created. By 1921All states had passed laws requiring exam for CPA certificate.

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History of Financial Reports and Legal Challenges

Financial reports were created by accountants long before independent audits were mandated. Current system of accounting checks and balances is relatively recent.

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History of Financial Reports and Legal Challenges

Before financials were audited by outside experts, the courts often handled challenges and brought in experts to give testimony. Practice of forensic accounting was common even before independent accountants were asked to certify financial statements in auditing engagements.

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Threads of Forensic Accounting

1817Canadian court decision of Meyer v. Sefton. 1824James McClelland started his business in Glasgow, Scotland. 1856In England, the audit of corporations became required.

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Forensic Accounting in Print

Articles on arbitration, fraud, investigation, and expert witnesses began appearing in the late 1800s. After a comment in 1925 by the Chairman of the U.S. Board of Tax Appeal, The Journal of Accountancy proposed that educational institutions should start including in their curricula the study of the law of evidence.

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Phrase Forensic Accounting Is Born

Maurice E. Peloubet coined the phrase in print in 1946. Max Lourie wrote an article and also claimed to coin the phrase, seven years after Peloubet. Louries article voiced three important positions: An accountant should not have to attend law school to learn the art of expert testimony. Colleges and universities should deliver forensic accounting training. Forensic accounting reference books and textbooks should be developed for students.

The first forensic accounting book appeared in 1982.

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FBI and Forensics

During WWII, the FBI employed approximately 500 agents who were accountants. In 1960, about 700 FBI agents were Special Agent Accountants. Today, there are more than 600 FBI agents with accounting backgrounds. The FBI has a Financial Crimes Section that investigates money laundering, Internet crimes, financial institutions fraud, and any other economic crime.

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AICPA Practice Aid

In 1986, the AICPA broke forensic accounting into two broad areas: investigative accounting and litigation support. The types of litigation services were further broken down in Practice Aid 7, listing: damages antitrust analyses accounting valuation general consulting analyses
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Panel on Audit Effectiveness

In 1998, the Public Oversight Board appointed the Panel on Audit Effectiveness to review and evaluate how independent audits of the financial statements of public companies are performed and to assess whether recent trends in audit practices serve the public interest.

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Panel on Audit Effectiveness

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.

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AICPA Fraud Task Force Report

In 2003, the AICPAs 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.
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Accountants Role in Fraud Detection

In the early 1980s, companies began to use computers to perform their record keeping. Intense competition caused auditing fees to fall as much as 50% from the mid-1980s to the mid1990s. Auditors cut costs by reducing the process of reviewing hundreds of corporate accounts. They grew more reliant on internal controls. The Journal of Forensic Accounting was created.
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Accountants Role in Fraud Detection

Top executives were able to circumvent internal controls and manipulate the records. This lead to situations such as Enron, WorldCom, Xerox, Adelphia Communication, and the fall of Arthur Andersen in the early 2000s. Due to the financial disaster of companies such as Enron and WorldCom, there has been an increased use of forensic techniques in audits and an increase in fees.
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Accountants Role in Fraud Detection

Some accounting experts believe that every audit engagement should include much more skepticism and detailed review of transactions. Other accounting experts suggest that only special engagements specifically targeting fraud can adequately and effectively root out the problem. The Big Four and the next two accounting firms believe that every public corporation should have a forensic audit every three years.
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Recent Events
Economic recessions often increase fraud, since executives may engage in more cooking the books techniques to improve financial results, and financially strapped employees will steal business funds or commit other types of fraud and abuse. In April 2009, Audit Analytics predicted that 3,589 companies (nearly 25%) will report that their auditors doubt they will continue as going concerns. In 2001, the percentage was only 19.2 percent.1 The Federal Governments $787 billion economic stimulus and bailout programs will be breeding grounds for fraud, waste, and abuse. Dan Weil estimates that up to $50 billion of the total (or 5 to 10 percent) will be susceptible to fraud. FBI Director Robert Mueller warns of fraud stemming from the stimulus packages.2 There should be much work for forensic accountants.
Sarah Johnson, Auditors: Nearly 25% of Companies May Not Be Going Concerns, CFO, April 22, 2009, www.cfo.com/article.cfm/13525910/c_2984368/?f=archives 2 Dan Weil, Expert: Stimulus Fraud May Hit $50 Billion, Newsmax.com, June 16, 2009, http://mmoneynews.newsmax.com/printTemplate.html
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Big-Six's Position

A forensic audit is akin to a police investigation. All public companies should have a forensic audit on a regular basis. Companies would be required to have such an audit every three or five years or face these audits on a random basis. Forensic auditors scrutinize any 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 auditors to complete a forensic audit with the aid of independent attorneys (not those who have represented the audit client in the other engagements).

Source: Serving Global Markets and the Global Economy: A View from the CEOs of the International Audit Networks, November 2006, p. 13.

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More Differences
Two practitioners have suggested these additional procedures may be used in a forensic audit: Extensive use of interviews and leveraging techniques designed to elicit sufficient information to prove or disprove a hypothesis. Document inspection that may extend to authentication procedures and handwriting analysis. Significant public records search to uncover, for example, unexpected title or ownership, other known addresses, and prior records of individuals. Legal knowledge regarding rules of evidence including chain of custody and preservation of evidence integrity.
Source: Annett Stalker and M.G. Ueltzen, An Audit Versus A Fraud Examination, CPA Expert, Winter 2009, p. 4.
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Inexperienced Forensic Auditors

Find out who did it. Do not worry about all the endless details. Be creative, think like the fraudster, and do not be predictable. Lower the auditing threshold without notice. Take into consideration that fraud often involves conspiracy. Internal control lapses often occur during vacations, sick outages, days off, and rest breaks, especially when temporary personnel replace normal employees.

H. R. Davia, Fraud 101, New York: John Wiley & Sons, 2000, pp. 42-45.

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Contrasting Auditing, Forensic Accounting, and Fraud Examination

Characteristic Time perspective: Primary focus: Investigation scope: Main work product is: Main responsibility to: Guidelines are: Purpose of report: Professional stance: Audit Historical Periodic Narrow Audit opinion Company and public Rules-based Ensure GAAP is followed Nonadversarial Fraud Examination Historical Reactive Narrow Fraud case report Defrauded party Forensic Accounting Future and historical Proactive and ongoing Broad ranging Forensic audit report Concerned principal or third party

Principles-based; under audit Principles-based rules, it is rule-based Identify perpetrator of fraud Adversarial Fraud risk assessment and strategic services Adversarial and nonadversarial
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Some White Collar Crimes

Antitrust. Bankruptcy fraud. Corporate/securities fraud. Health care fraud. Insurance fraud. Mass marketing fraud. Money laundering. Mortgage fraud.
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SarbanesOxley Legislation
1. 2. Title 1 establishes the Public Company Accounting Oversight Board (PCAOB) under the SEC to regulate auditing and to discipline auditors. Title 2 contains a series of rules to ensure that auditors are independent from their clients. For example, neither the primary nor reviewing partner may audit the same client for more than five consecutive years, and the auditor must report all material written communication to the audit committee. Title 3 requires publicly traded companies to have an audit committee, the CEO and CFO must certify their companys financial statements, and provides rules for the conduct of officers and their attorneys. Title 4 prohibits personal loans and requires certain financial disclosures. Title 5 mandates rules for financial security analysts (i.e., research analysts) to avoid conflicts of interest. Titles 6, among other provisions, allows federal courts the power to bar individuals who violate security laws from participating in penny stocks.

3. 4. 5.

6.

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SarbanesOxley Legislation
7.

8.

9. 10. 11.

Title 7 requires reports and studies on consolidation of accounting firms, credit rating agencies, enforcement actions, and investment banks. Title 8 provides protection for whistleblowers and mandates penalties and fines for certain acts not dischargeable by bankruptcy. For example, failure of an auditor to keep working papers for 5 years is subject to fines and 10 years in prison, and fine or imprisonment of up to 25 years for anyone knowingly defrauding shareholders of publicly traded companies. A person can receive 20 years in prison and fines for altering, destroying, mutilating, concealing, covering up, falsifying or making a false entry in any record, document, or tangible object. Title 9 increases maximum prison sentences for mail and wire fraud from 5 to 20 years. Willfully and knowingly certifying financial reports not in compliance with the Act is now a criminal offense. Title 10 says that it is the Sense of the Senate to require the CEO to sign the corporate tax return. Title 11 provides a possible 20-year prison sentence for anyone altering, destroying, mutilating, or concealing a record, document, or other object (or otherwise impeding) for an official proceeding.
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