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Unformatted text preview: Forensic and Investigative Accounting Forensic Chapter 4 Detecting Fraud in Financial Reporting © 2009 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com Court-Appointed Trustee Forensic accountants are being used by the court – appointed trustees (Irving Picard Forensic and Securities Investor Protection Corporation) to reconstruct the books of Bernard L. Madoff Investment Securities (BLMIS). According to Picard, there were paper records, microfilm, and microfiche. But there was nothing that was electronic. microfilm, Every customer statement was fiction, so the first task is to reconstruct the books and records of BLMIS. One of the early projects was to digitize the records so they are easier to compare, including customer statements, incoming letters, faxes, and bank records. The forensic accountant will use records from third parties and customers. Every customer account must be reconstructed from the ground up. Every Stephen Harbeck, President of Securities Investor Protection Corporation, stated that the forensic accountants “are working as quickly as possible to catalog all the farthe reaching aspects of the Madoff scheme and to recover money for investors to the extent reaching possible by law.” The cost of the Ponzi scheme may be as high as $65 billion. possible Source: WebCPA staff, Forensic Accountants Reconstruct Madoff Books, May 15, 2009. http://www.webcpa.com/news/Forensic-Accountants-Reconstruct-Madoff-Books-50484-1.html Chapter 4 Forensic and Investigative Accounting 2 PCAOB Guidance: Smaller Public Companies 1. 2. 3. 4. 5. 6. 7. 8. Scaling the Audit for Smaller, Less Complex Companies. Evaluating Entity-Level Controls. Assessing the Risk of Management Override and Assessing Evaluating Mitigating Actions. Evaluating Evaluating Segregation of Duties and Alternative Evaluating Controls. Controls. Auditing Information Technology Controls in a Less Auditing Complex IT Environment. Complex Considering Financial Reporting Competencies and Their Considering Effect on Internal Control. Effect Obtaining Sufficient Competent Evidence When the Obtaining Company has Less Formal Documentation. Company Auditing Smaller, Less Complex Companies with Auditing Pervasive Control Deficiencies. Pervasive Forensic and Investigative Accounting 3 Chapter 4 Entity-Level Controls Controls related to the control environment. Controls Controls over management override; the company's risk Controls assessment process. assessment Centralized processing and controls, including shared service Centralized environments. environments. Controls to monitor results of operations. Controls to monitor other controls, including activities of the audit Controls committee and self-assessment programs. committee Controls over the period-end financial reporting process. Policies that address significant business control and risk Policies management practices. management Source: PCAOB, October 17, 2007, pp. 12. Chapter 4 Forensic and Investigative Accounting 4 Definition of Fraud Four major legal elements of fraud would be: A false representation or willful omission false regarding a material fact. regarding The fraudster knew the representation was The false. false. The target relied on this misappropriation. The victim suffered damages or incurred a The loss. loss. Chapter 4 Forensic and Investigative Accounting 5 Audit Procedures Audit evidence is gathered in two fieldwork Audit stages: stages: 1. Internal control testing phase. 2. Account balance testing phase. Chapter 4 Forensic and Investigative Accounting 6 Definitions Materiality is the measure of whether something is significant enough to change an investor’s investment decision. investor’s Control risk is risk that a material error in the balance or transaction class will not be prevented or detected. prevented Chapter 4 Forensic and Investigative Accounting 7 Definitions Inherent risk is risk that an account or transactions contain material misstatements before the effects of the controls. before Detection risk is risk that audit procedures will not turn up material error when it exists. exists. Chapter 4 Forensic and Investigative Accounting 8 External Auditors and Fraud Detection Although auditors have previously had the Although responsibility to detect material misstatement caused by fraud, SAS No. 82 details more precisely what is required to fulfill those responsibilities. (continued on next slide) (continued Chapter 4 Forensic and Investigative Accounting 9 External Auditors and Fraud Detection Now, auditors must specifically assess and Now, respond to the risk of material misstatement due to fraud and must assess that risk from the perspective of the broad categories in the SAS. External auditors have to satisfy new documentation and communication requirements. SAS No. 82 superseded by SAS No. 99. No. Chapter 4 Forensic and Investigative Accounting 10 Fraudulent financial reporting may occur by the Fraudulent following: following: Manipulation, falsification, or alteration of Manipulation, accounting records, or supporting documents from which financial statements are prepared. which Misrepresentation in or intentional omission from the Misrepresentation financial statements of events, transactions, or other significant information. significant Intentional misapplication of accounting principles Intentional relating to amounts, classification, manner of presentation, or disclosure. presentation, Source: SAS No. 99, “Consideration of Fraud in a Financial Statement Audit,” New York: Source: AICPA AICPA Chapter 4 Forensic and Investigative Accounting 11 SAS No. 99 Ways to Overcome the Risk of SAS Management Override of Controls Management Examining journal entries and other adjustments. adjustments. Reviewing accounting estimates for bias, including a retrospective review of significant management estimates. management Evaluating the business rationale for significant unusual transactions. unusual Chapter 4 Forensic and Investigative Accounting 12 How Management Overrides Controls How (SAS No. 99) (SAS Recording fictitious journal entries Recording fictitious (especially near end of quarter or year). (especially Intentionally biasing assumptions and Intentionally biasing judgments used to estimate accounts (e.g., pension plan assumptions or bad debt allowances). allowances). Altering records and terms related to important and unusual transactions. important Forensic and Investigative Accounting 13 Chapter 4 Think Like A Crook Know your enemy as you know yourself, and you can fight a Know hundred battles with no danger of defeat.” Chinese Proverb. hundred Military leaders study past battles. Football and basketball teams study game films of their Football opponents. opponents. Chess players try to anticipate the moves of their opponent. Examples: If contracts above $40,000 are normally audited each Examples: $40,000 year, check the contracts between $30,000-$40,000. $30,000-$40,000 FAs must learn the tricks of the trade as well as the trade. FAs Chapter 4 Forensic and Investigative Accounting 14 SAS No. 99 Recommendations Brainstorming Increased emphasis on professional Increased skepticism. skepticism. Discussions with management. Unpredictable audit tests. Responding to management override of Responding controls. controls. Chapter 4 Forensic and Investigative Accounting 15 SAS No. 99: Skepticism An auditor is instructed to conduct an audit An “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.” management’s FA’s motto should be “Trust no one; FA’s question everything; verify.” question Chapter 4 Forensic and Investigative Accounting 16 Public Company Accounting Public Oversight Board (PCAOB) Oversight The Sarbanes-Oxley Act of 2002 created a The new, five-member oversight group called the PCAOB. PCAOB. The PCAOB is empowered to set accounting The standards that establish auditing, quality control, and ethical standards for accountants. (continued on next slide) (continued Chapter 4 Forensic and Investigative Accounting 17 Public Company Accounting Public Oversight Board (PCAOB) Oversight The PCAOB is also empowered to adopt or The amend standards issued or recommended by private accounting industry groups or to adopt its own standards independent of such private industry standards or recommendations. recommendations. Chapter 4 Forensic and Investigative Accounting 18 Walkthroughs According to the PCAOB, in a walkthrough, an According auditor traces “company transactions and events auditor – 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.” the Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003. Chapter 4 Forensic and Investigative Accounting 19 Internal Auditors and Fraud Detection The Institute of Internal Auditors’ Due The 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. internal (continued on next slide) Chapter 4 Forensic and Investigative Accounting 20 Internal Auditors and Fraud Detection However, Section 280 says that management However, 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. management Chapter 4 Forensic and Investigative Accounting 21 When Fraud Is Discovered 1. 2. Notify management or the board when the Notify incidence of significant fraud has been established to a reasonable certainty. established If the results of a fraud investigation indicate If 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. directors (continued on next slide) Chapter 4 Forensic and Investigative Accounting 22 When Fraud Is Discovered 1. 2. A written report should include all findings, written conclusions, recommendations, and corrective actions taken. corrective A draft of the written report should be draft submitted to legal counsel for review, especially where the internal auditor chooses to invoke client privilege. to Chapter 4 Forensic and Investigative Accounting 23 Audit Committee The audit committee is the subcommittee of The an organization’s board of directors 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. process. Chapter 4 Forensic and Investigative Accounting 24 Management’s Role The Sarbanes-Oxley Act of 2002 mandates The that CEOs and CFOs certify in periodic reports containing financial statements filed with the SEC the appropriateness of financial statements and disclosures. statements Chapter 4 Forensic and Investigative Accounting 25 Board of Directors’ Role Oversee the integrity, quality, transparency, Oversee and reliability of the financial reporting process. process. Oversee the adequacy and effectiveness of Oversee the internal control structure in preventing, detecting, and correcting material misstatements in the financial statements. misstatements Oversee the effectiveness, efficacy, and Oversee objectivity of audit functions. objectivity Chapter 4 Forensic and Investigative Accounting 26 Enter the Forensic Accountant Forensic accountants may be brought in to: – Investigate the minute any irregularities Investigate surface. surface. – Measure risk factors and create policy that Measure brings the forensic accountant in when certain scores are attained. certain – Check in randomly as a matter of routine. Chapter 4 Forensic and Investigative Accounting 27 Audit Tests The Panel on Audit Effectiveness recommended The that surprise or unpredictable elements should be incorporated into audit tests, including: incorporated – Recounts of inventory and unannounced visits Recounts to locations. to – Interviews of financial and nonfinancial client Interviews personnel in different locations. personnel (continued on next slide) Chapter 4 Forensic and Investigative Accounting 28 Auditing Hints SAS No. 99 does not require auditors to make inquiries of SAS not “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. may Use independent sources for evaluating management (e.g., Use financial analysts). Surf the internet. Surf Auditors need to follow the performance history of managers and Auditors directors. directors. If a company has an anonymous reporting system, obtain If information about the incidents reported and consider them information when assessing fraud risk. when (continued on next slide) Chapter 4 Forensic and Investigative Accounting 29 Auditing Hints Be sure to perform analytical procedures, and the work should be Be reviewed by senior members of the audit team. reviewed Auditors should select sample items below their normal testing scope (e.g., HealthSouth). Fraud procedures should be more than checklists. Audits should focus on finding and detecting fraud. Ask for and review all “top drawer” entries. Ask for and review all side agreements. Look for hockey stick pattern. Chapter 4 Forensic and Investigative Accounting 30 Audit Tests – Requests for written confirmations from Requests client employees regarding matters about which they have made representations to the auditors. auditors. – Tests of accounts not normally performed Tests annually. annually. – Tests of accounts traditionally or frequently Tests deemed “low risk.” deemed Chapter 4 Forensic and Investigative Accounting 31 Financial Statement Fraud Financial Categories and Red Flags Categories Overstated revenues. Management estimates. Pro formas can mislead. Earnings problems: masking reduced cash flow. Earnings before interest, tax, depreciation, and Earnings amortization (EBITDA). amortization Excessive debt. Inventory problems. Forensic and Investigative Accounting 32 Chapter 4 Cooking-the-Books Often Collaborative Effort • For restatements between January 1, 1997 to June 30, 2002, 45% For 45% were accused of securities fraud and subject to shareholder suits. were Average of 7 individuals were implicated, including Average CEOs CFOs COOs General counsel Directors Internal/external auditors • Source: Robert Tillman and Michael Indergaard, Control Overrides in Financial Statement Source: Fraud. Fraud. Chapter 4 Forensic and Investigative Accounting 33 WorldCom Fraud Massive At least 40 people knew about the fraud. At 40 They were afraid to talk. Scott Sullivan handed out $10,000 checks to 7 involved Scott $10,000 individuals. individuals. Altered key documents and denied Andersen access to the database where most of the sensitive numbers were stored. stored. Andersen did not complain about denied access. Andersen not Company officials decided what tax rates they wanted and Company then used the reserves to arrive at the tax rates. then Source: Rebecca Blumenstein and Susan Pullian, “WorldCom Fraud Source: Was Widespread,” Wall Street J., June 10, 2003, p. 3. Wall Chapter 4 Forensic and Investigative Accounting 34 Financial Statement Fraud Financial Categories and Red Flags Categories CPA problems. Sales and expenses problems. Big bath. Balance sheet account problems. Pension plan problems. Reserve estimates (cookie jar accounting). Personal piggy bank. Barter deals. Chapter 4 Forensic and Investigative Accounting 35 HealthSouth From 1999 to 2001, HealthSouth’s net income From increased nearly 500 percent, but revenue grew only five percent. only On March 19, 2003, the SEC said that On HealthSouth faked at least $1.4 billion in profit since 1999. since Professional fees associated with the Professional reconstruction of HealthSouth’s financial records and restatement of 2001 and 2002 consolidated financial statements totaled over $270 million. financial Forensic and Investigative Accounting 36 Chapter 4 Financial Fraud Detection Tools Interviewing the executives. Analytics. Percentage analysis: – Horizontal analysis. – Vertical analysis. – Ratio analysis. Chapter 4 Forensic and Investigative Accounting 37 Financial Fraud Detection Tools Using checklists to help detect fraud: – SAS checklist. – Attitudes/Rationalizations checklist. – Audit test activities checklist. – Miscellaneous fraud indicator checklist. Chapter 4 Forensic and Investigative Accounting 38 Behavioral Approaches Some fraud schemes cannot be effectively Some detected using data-driven approaches. Instead, behavioral considerations may help an auditor find fraud. Employee attitudes, feelings, values, norms, interaction with peers, and general satisfaction should all be considered when looking for fraud. considered Chapter 4 Forensic and Investigative Accounting 39 Federal Sentencing Guidelines Federal Sentencing Guidelines were adopted in 1984 to emphasize fairness, Federal consistency, punishment, incapacitation, and deterrence in sentencing. This mandatory sentencing regime was in place until the Supreme Court in 20041 and mandatory 20052 converted the guidelines to advisory status, stating that these guidelines 2005 violated the Sixth Amendment. District court judges are now required only to consider guideline ranges. consider Under the sentencing guidelines the base offense level is determined for a specific offense.3 For example, the basic offense level for larceny, embezzlement, and offense. other forms of theft is 6 where the loss is $5,000 or less. However, if the loss is more than $2.5 million, add 18 to the 6. Other adjustments are made for victim, role, obstruction of justice, multiple counts, and defendant’s criminal history. Negative adjustments can be made for accepting responsibility.4 Negative (continued on next slide) Chapter 4 Forensic and Investigative Accounting 40 Federal Sentencing Guidelines If an individual has an offense level of 16 and falls into the first criminal history category, the guideline sentence is 21 to 27 months. If, however, the criminal history category is 5, the guideline prison sentence is 41-51 months. criminal A Department of Justice Fact Sheet date March 15, 2006 said that as a result of the Booker decision, the fairness, consistency, predictability, and accountability Booker that were the hallmarks of the mandatory guidelines are in serious jeopardy as a result of a decline in compliance with the guidelines. Within one year the number of sentences imposed within the guidelines has dropped 62.2 percent.5 number 1 U.S. U.S. v. Blakely, 542 U.S. 296 (2004). 2 U.S. v. Booker, 543 U.S. 220 (2005). U.S. 3 U.S. Sentencing Commission, Guideline Manual, §3E1.1 (November 2008), p.16. Guideline 4 Ibid., p. 395. Ibid. 5 Department of Justice, Fact Sheet: The Impact of United States v. Booker on Federal Sentencing, United March 15, 2006. March Chapter 4 Forensic and Investigative Accounting 41 Accounts Payable Fraud Red Flags 1. Duplicate payments (2% of total purchases) Duplicate $80 million times 2% = $1.6 million loss. $80 – – – Extract only the numerical digits of an invoice number and match on only the Extract numbers portion of the invoice. numbers Try identifying the dates that are similar such as dates that are less than 14 days. Try matching on the absolute value of the amount. 1. 2. 3. 4. 1. Rounded-amount invoices. Invoices just below approval amounts. Abnormal invoice volume activity (two invoices one month and 60 the next). Vendors with sequential invoice numbers. Vendors LC 0002, LC 0003, LC 0004 LC Above average payments per vendor. C. Warner and B. G. Dubinsky, “Uncovering Accounts Payable Fraud,” Fraud Magazine, C. Fraud July/ August 2006, pp. 29-51. July/ Chapter 4 Forensic and Investigative Accounting 42 ...
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