A Guide to Forensic Accounting Investigation

Thomas W. Golden, CPA, CFE (Chicago, IL). Partner, PricewaterhouseCooper LLP specializes in providing consulting and expert witness testimony in both civil and criminal matters with special expertise in forensic accounting, fraud investigation, and financial statement accounting. He is a former Chairman of the Board of Regents for the Association of Certified Fraud Examiners and the current President of the Better Government Association, a citizen watchdog group in Chicago, IL. Mr. Golden is an adjunct professor at DePaul University. Steven L. Skalak, CPA, (Chicago, IL) is the National Practice Leader for PwC Investigations & Forensic Services of PricewaterhouseCoopers LLP. He has participated in a variety of corporate investigations relating to allegations that the Securities and Exchange Acts were violated, and of accounting or auditing improprieties. Steve has represented Audit Committees, Directors, Officers, Auditors, and Companies in class action litigation with shareholders and SEC investigations. Mona M. Clayton, CPA, CFE, (Chicago, IL) Partner for Pwc specializes in international fraud investigations with particular emphasis in Latin America where she has conducted investigations.  She has designed investigative practice aids providing for consistent methodologies to be incorporated across common scheme investigations. Ms Clayton is an adjunct professor at DePaul University.

Preface xxi

Acknowledgments xxiii

Chapter 1 Fraud: An Introduction 1

Fraud: What is It? 2

Fraud: Prevalence, Impact, and Form 3

Fraud in Historical Perspective 4

Types of Fraud 5

Root Causes of Fraud 6

A Historical Account of the Auditor’s Role 7

Auditors Are Not Alone 14

Deterrence, Auditing, and Investigation 16

Conceptual Overview of the Fraud Deterrence Cycle 17

First Look Inside the Fraud Deterrence Cycle 19

Auditing and Investigation 22

Chapter 2 Psychology of the Fraudster 25

Calculating Criminals 26

Situation-Dependent Criminals 27

Power Brokers 28

Fraudsters Do Not Intend to Harm 28

Kinds of Rationalization 33

Auditors’ Need to Understand the Mind of the Fraudster 33

Conclusion 34

Chapter 3 The Roles of the Auditor and the Forensic Accounting Investigator 37

The Patrolman and the Detective 38

Complexity and Change 41

Auditor Roles in Perspective 42

Not All Good People 44

Each Company is Unique 45

Role of Company Culture 45

Estimates 46

Choices 49

What Auditors Do 50

Bedrock of an Effective Audit 55

SPADE 57

Auditing Standards Take a Risk-Based Approach to Fraud 58

Management Override 60

Regulatory Reaction to Fraud 60

Financial Benefits of Effective Fraud Management 61

Conclusion 61

Chapter 4 Auditor Responsibilities and the Law 63

Appendix: Summary of PCAOB Matters Involving Detection of Fraud 77

Chapter 5 When and Why to Call in Forensic Accounting Investigators 79

Today’s Auditors Are Not Forensic Accounting Investigators 80

Auditors Are Not Authenticators 80

Auditors Have Limited Exposure to Fraud 81

Auditors Are Not Guarantors 82

Historically, Audits May Have Been Predictable 83

Potential Trigger Points of Fraud 84

Reliance on Others 91

Conclusion 92

Chapter 6 Internal Audit: The Second Line of Defense 95

What Do Internal Auditors Do? 96

Internal Audit Scope of Services 98

The Handoff to Forensic Accounting Investigators and Legal Counsel 99

Perception Problem 101

Complex Corporate Fraud and the Internal Audit 102

WorldCom and the Thornburgh Report 102

Case Studies: The Internal Auditor Addresses Fraud 103

A Tragic Circumstance 105

Reporting Relationships: A Key to Empowering Fraud Detection 111

Tomorrow’s Internal Auditor, Tomorrow’s Management and Board 113

Chapter 7 Teaming with Forensic Accounting Investigators 115

Forensic Accounting Investigators’ Cooperation with Internal Auditors 117

Forensic Accounting Investigators’ Cooperation with External Auditors 120

Objectives of All Interested Parties 122

Forensic Accounting Investigators’ Objectives 122

Who Should Direct the Investigation and Why? 126

Ready When Needed 127

Where to Find Skilled Forensic Accounting Investigators 127

Chapter 8 Anonymous Communications 133

Typical Characteristics of Anonymous Tips 134

Federal Statutes Related to Anonymous Reporting and Whistle-Blower Protections 135

Receipt of an Anonymous Communication 139

Initial Understanding of Allegations 140

Determine Whether Any Allegation Requires Immediate Remedial Action 141

Development and Implementation of the Investigative Strategy 142

The Investigation Team 142

Disclosure Decisions 143

Prioritize the Allegations 144

Interviewing Employees 145

Follow-Up Tip 149

Conclusion 150

Chapter 9 Personal Privacy and Public Disclosure 151

Introduction 151

Data Privacy: Providing Context 152

Data Privacy in the United States 153

Data Privacy in the European Union 158

Navigating the Legal Differences Between the United States and the European Union 162

Elsewhere around the Globe 165

Public Disclosure 168

Conclusion 173

Chapter 10 Building a Case: Gathering and Documenting Evidence 175

Critical Steps in Gathering Evidence 176

Whose Evidence is It? 182

Evidence Created by the Forensic Accounting Investigator 183

What Evidence Should Be Gathered? 185

Important Considerations Regarding Documents and Working Papers 186

Conclusion 189

Chapter 11 Independence, Objectivity, Skepticism 191

Accountant’s Independence 192

SEC Final Rules for Strengthening Auditor Independence 192

SEC Regulation of Forensic Accounting Services 193

Consulting versus Attest Services 196

Integrity and Objectivity 198

Professional Skepticism 199

Trust but Verify: Exploring Further 203

Loose-Thread Theory of Auditing 207

Further Thoughts on the Loose-Thread Theory 210

Chapter 12 Potential Missteps: Considerations When Fraud is Suspected 213

Confronting Suspects 213

Dismissing the Target 216

Assumptions 217

The Small Stuff Could Be Important 221

Materiality: More on a Key Topic 223

Addressing Allegations 224

The Case of the Central American General Manager 225

Exercising Skepticism 228

Case Outcomes 229

Chapter 13 Potential Red Flags and Fraud Detection Techniques 231

Types of Fraud Revisited 232

Fraud Detection: Overview 233

Laying a Foundation for Detection 236

Interpreting Potential Red Flags 238

Importance of Professional Skepticism 240

Revisiting the Fraud Triangle 243

Identifying and Evaluating Risk Factors 248

Information Gathering 251

Analytic Procedures 254

Analytic Techniques 258

Assessing the Potential Impact of Fraud Risk Factors 260

Evaluating Controls 261

Unpredictable Audit Tests 263

Observation and Inspection 264

Financial Statement Fraud: Detection Techniques 266

Revenue Recognition 267

Corruption 268

Summary 269

Chapter 14 Investigative Techniques 271

Timing 271

Communication 272

Early Administrative Matters 272

Predication 273

What Should You Know before You Start? 275

A Word about Insurance 281

Exceptions and Other Considerations 282

Considerations on International Assignments 283

Accounting Issues 285

Data Analysis 286

Document Review 286

Conclusion 291

Chapter 15 Corporate Intelligence 293

Definition of Corporate Intelligence 293

Evolution of Corporate Intelligence 294

Today’s Business Need 297

Legal and Regulatory Drivers of Corporate Intelligence 297

Cost Drivers of Corporate Intelligence 301

Negotiation Drivers of Corporate Intelligence 303

Basic Deployment and Consumption of Corporate Intelligence 304

Customary Data Fields Necessary to Fulfill Corporate Intelligence Remits 306

Analysis and Reporting of Findings 307

Coordination and Selection of Management and External Advisors for Intelligence Gathering 307

Timing of Deployment 308

Limitations of and Inherent Barriers to Corporate Intelligence 308

Legal Parameters and Operating Constraints versus Enabling Ethical Debates Surrounding Corporate Intelligence 313

Summary 315

Chapter 16 The Art of the Interview 317

Difficulty and Value of Obtaining an Admission 318

Planning for the Interview 319

Types of Interviews 321

Others May Wish to Attend Interviews 325

Interview Process 326

Documenting the Interview 330

Use of Subterfuge 331

Summary 331

Chapter 17 Data Mining 333

Definition and Benefits of Data Mining 334

Structured versus Unstructured Data 335

Planning 335

Methods of Data Acquisition 340

Structured Data Analysis 341

Unstructured Data 352

Advanced Data Analysis Tools 358

Conclusion 360

Chapter 18 Report of Investigation 363

Types of Reports 364

Importance of Adequate Preparation 364

Standards of Reporting 365

Written Report of Expert Witness Opining for the Plaintiff on a Civil Fraud Claim 371

Affidavits 374

Informal Reports 374

Giving a Deposition 376

Mistakes to Avoid in Reporting 380

Working Papers 382

Relationship Review 384

Substantive Working Papers 384

Each Working Paper Should Stand on Its Own 384

Testimony Binder 386

Interview Memorandums 386

Chapter 19 Supporting a Criminal Prosecution 389

Key Considerations 390

Referral Considerations 393

Chapter 20 Working with Attorneys 399

In the Company of Lawyers 399

Confidentiality Requirements 400

Forming the Investigative Team 401

Documentation 407

Civil Litigation 408

Interviewing 408

External Audit Firm 409

Working for or Interacting with Law Enforcement or Government Agencies 412

Disagreements with Counsel 413

Conclusion 414

Chapter 21 Financial Reporting Fraud and the Capital Markets 417

Targets of Capital Market Fraud 418

Securities Investment Model 419

Some Observations on Financial Fraud 429

Summary 430

Chapter 22 Financial Statement Fraud: Revenue and Receivables 433

Improper Revenue Recognition 435

Revenue Recognition Detection Techniques 438

Analytical Procedures to Identify or Explore Potential Revenue Red Flags 440

Improper Allocation of Value in Multiple-Element Revenue Arrangements 450

Improper Accounting for Construction Contracts 452

Related-Party Transactions 453

Revenue and Receivable Misappropriation 455

Inflating the Value of Receivables 460

Extended Procedures 461

Round-Tripping 463

Improperly Holding Open the Books 464

Consignments and Demonstration Goods 465

Summary 466

Chapter 23 Financial Statement Fraud: Other Schemes and Misappropriations 467

Asset Misstatements 467

Understatement of Liabilities and Expenses 478

Backdating Share Options 479

Off-Balance-Sheet Transactions 480

Two Basic Accounting Models 481

Cookie Jar Reserves 482

Improper and Inadequate Disclosures 483

Materiality 484

Disbursement Schemes 485

Invoice Schemes 486

Check Tampering 489

Expense Reimbursement Schemes 490

Payroll Schemes 491

Fraud in an Economic Downturn 492

Unauthorized Trading 492

Mortgage Fraud 494

Chapter 24 Ponzi Schemes 495

Ponzi Scheme Origin and Development 495

Recent Spotlights 497

Insights into Ponzi Schemes: Passing Trend or Lasting Reality? 503

Accountant’s Challenges 507

Regulatory Bodies and Task Forces 508

Bankruptcy Implications 509

Summary 510

Chapter 25 Money Laundering 511

Relationship between Fraud and Money Laundering 511

Counter-Terrorist Financing 514

Varying Impact of Money Laundering on Companies 515

The Five-Point Program for AML-Regulated Businesses 516

Impact of Money Laundering on Financial Statements 520

AML and Forensic Accounting Investigation 521

Legal Arrangements Lending Themselves to Anonymity 523

Auditing and Money Laundering 524

Relationship between Fraud Investigation and AML 525

Chapter 26 Foreign Corrupt Practices Act 527

Background 527

Recent Enforcement Trends 530

U.K. Bribery Act 2010 536

The Role of the Forensic Accountant 537

Red Flags 542

Reporting 545

Conclusion 546

Chapter 27 Construction Projects 547

The Nature of the Construction Industry 547

Contract Pricing Strategy 550

Standard Form Contracts 554

Issues in Analysis 559

Change Orders 560

Financial Damages 561

Underbid 567

Inflation 567

Analysis of Claims 567

Summary 569

Chapter 28 Contract Compliance 571

Effective Integrated Internal and External Contract Compliance Program 572

The Role of the Forensic Accountant 576

Government Contracting 578

Risk and Compliance 578

Recovery 579

Crisis Management and Litigation Support 581

Chapter 29 Other Dimensions of Forensic Accounting 585

Environmental Issues 586

Intellectual Property 586

Insurance and Business Interruption 587

Marital Dissolution 588

Shareholder Litigation 588

Business Valuation 589

Business Combinations 589

Cybercrime 590

Chapter 30 Corporate Remediation 593

What is Remediation? 593

What is Driving Corporate Remediation? 594

Why is Remediation Necessary? 597

How to Remediate 599

Role of the Forensic Accountant 603

Recent Cases 605

Remediation Going Forward 607

Index 611