Forensic Accounting: An Introduction

Forensic Accounting:An Introduction

JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. • CONTACT: • 0322-3385752 • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

Overview • What is Forensic Accounting? • What is fraud? • Who commits fraud? • How do forensic accountants search for fraud? • What’s the demand for forensic accounting? • How can you prepare for opportunities in this area?

What is Forensic Accounting? Forensic accounting is the practice of utilizing accounting, auditing, and investigative skills to determine whether fraud has occurred. It encompasses two main areas: Litigation support Investigation

Litigation Support • Is the factual presentation of economic issues related to existing or pending litigation. • The forensic accountant quantifies damages sustained by parties involved in legal disputes and assists in resolving disputes, even before they reach the courtroom.

Litigation Support • Arbitration assistance • Business valuation for divorce, stockholder disputes • Computation of damages resulting from personal injuries, wrongful death, breach of contract, casualty, and fidelity losses • Determination of lost profits due to business interruption • Testifying as an expert witness • Financial review of contractual obligations • Investigative services related to fraud and other illegal acts

Investigation • Is the act of determining whether criminal matters such as employee theft, securities fraud (including falsification of financial statements), and insurance fraud have occurred. • Also includes searching for irregularities associated with civil matters, such as a search for hidden assets in divorce cases.

What is Fraud? Fraud is an intentional misrepresentation of a material point or issue on which a victim relies. This reliance usually results in one or more victims suffering damages.

Types of Fraud • Occupational • Financial statement schemes • Asset misappropriation (e.g., cash theft, fraudulent disbursements, inventory theft) • Bribery and corruption • Intellectual property

Types of Fraud • Other Frauds • Financial institution • Check and credit card fraud • Insurance fraud • Health care fraud • Bankruptcy fraud • Tax fraud • Securities fraud • Money laundering • Consumer fraud • Computer and Internet fraud • Governmental fraud

Examples of FraudFinancial Statement Schemes A publicly-traded company engaged in sham transactions for more than seven years by using several shell companies. The money transferred to the shell companies as payments for assets were returned as payments on accounts receivable. The company’s assets were inflated by as much as $80 million.

Examples of FraudEmployee Embezzlement A warehouse foreman and a parts ordering clerk colluded to purchase $300,000 of nonexistent supplies. The parts ordering clerk initiated the transactions by obtaining ordering approval. The orders were sent to a vender who prepared false invoices. The foreman then verified receipt.

Examples of FraudAsset Misappropriation A CEO conspired with a former employee to sell a building to a company owned by the CEO’s employer. The building was sold for $1.2 million more than it had been purchased by the former employee. All transactions occurred on the same day.

Examples of FraudHealth Care Fraud Dr. X billed a patient’s insurance for the following activities: • Knee arthroscopy with debridement $1,650 • Diagnostic knee arthroscopy 1,625 Total billed $3,275 The second procedure listed above is included in the first procedure. Therefore, the correct amount of the bill is $1,650.

Examples of FraudDivorce Fraud John Dewey is the majority owner of a large public relations firm. His wife, Mary, recently filed for divorce and is asking for half John’s assets. Prior to being served, John took some trips to the Cayman Islands and Switzerland. During the divorce proceedings, Mary was shocked to learn that the value of the firm is $50,000. Prior to the divorce, John had given her $200,000 a year to cover their personal expenses.

Examples of FraudFraudulent Disbursements An employee created over 1,000 false refunds, all under the review limit of $15.00. He was caught because be began processing refunds before store hours and another employee noticed this. Before the scheme was detected, he made off with over $11,000.

Examples of Fraud Governmental Services Association (GSA) purchased $200M of furniture from a New Jersey vendor. The furniture was defective. A GSA regional supervisor was suspected of taking bribes to ignore the defects. He bought 11 racehorses for $13K apiece during a four year period.

Examples of FraudVendor Fraud: Defective Delivery The low bidder was awarded a contract to pave a parking lot. Upon examination, several randomly-taken core samples revealed 2” of paving whereas the contract specified 4”. Also, the parking lot had not been sealed as required by the contract.

Examples of FraudVendor Fraud: Unbalanced Bid Bid was let to construct 3 buildings in the following order: A, B, C. Buildings BidderABCTotal Avalon $510K $250K $240K $1M St. James 375K 375K 375K 1.125M Corinna 400K 400K 400K 1.2M What’s the problem?

Examples of FraudKickbacks: Unilateral Mary, the employee responsible for purchasing at JLH, was the recipient of lavish gifts from a large supplier that she did not disclose to her employer (accepting these gifts was against company policy). Who is most responsible here?

Examples of FraudKickbacks: Bi-Lateral Assume the cost of janitorial services ranges from $1.50 to $2.50 per square foot (psf). BBK Company has 1,000,000 sq. ft. to be serviced. If JanServ charges 20 ¢ more psf than does an honest service, JanServ will make an extra $200K that can be used to pay a kickback to the employee who helps JanServ obtain the contract. .

Who Commits Fraud? • Frauds against organizations (M = median) 40% by employees (M = $78,000) 41% by management (M = $218,000) 19% by owners (M = $1,000,000) • Males (61%, M = $250,000) Females (39%, M = 102,000) • High school (33%, M = $100,000) College (55%, M = $200,000) Postgraduate (12%, M = 425,000)

Who Commits Fraud? • Median loss per age group < 26 years $ 25,000 26 – 30 50,000 31 – 35 134,000 36 – 40 135,000 41 – 50 250,000 51 – 60 350,000 > 60 713,000

Who Commits Fraud? • Perpetrator’s Criminal Histories Charged but not convicted 4% Had prior convictions 8% Never charged or convicted 88%

Why is Fraud Committed? The Fraud Triangle perceived pressure, perceived opportunities, and rationalizationSource: SAS No. 99, Consideration of fraud in a financial statement audit

Perceived Pressure Employees, managers, and owners can feel pressure to commit fraud as a result of • Greed or preoccupation with being successful • Living beyond means • High personal debts • Unexpected financial needs • Expensive vices • Family-imposed pressures

Perceived Opportunities Opportunities to commit fraud exist when levels of trust in an organization are reached or when controls are weak. • Inappropriate segregation of duties • Ineffective supervision • Transaction authorization not required • Lack of physical controls • Lack of adequate audit trail

Rationalization Individuals usually don’t commit fraud unless they can justify their actions in relation to their own code of ethics. • Feeling underpaid or overworked • Desire to seek revenge • Belief that taking the assets is a loan • Belief they are helping others (family, employees)

How do Forensic AccountantsSearch for Fraud? • Proactive fraud detection • Reactive fraud detection

Proactive Fraud Detection Inductive approaches Use of Data-mining software Digital analysis of company data Deductive approach Determine what kinds of frauds can occur. Search for symptoms of these frauds.

Data-mining Software • Excel • ACL • IDEA • Microsoft Access

Digital Analysis of Company DataBenford’s Law (first digit frequency)

Deductive Approachto Detecting Fraud Involves a 5-step process: • Understanding the business environment • Understanding the kinds of fraud that can occur in this environment • Determining the most likely symptoms • Using databases and systems to search for the fraud symptoms • Following up on discoveries to determine likelihood fraud exists

Reactive Fraud Detection Fraud accountants are often engaged after someone in the entity suspects that fraud has been committed. Usually the area in which fraud has been committed is known. Often, the entire area is examined.

Evidence Categories

Testimonial Evidence • Interviewing • Interrogatories (written questions that identify information needed from opposing party) • Honesty tests (e.g., graphology, polygraph)

Documentary Evidence • Document examination • Public records searches • Audits • Computer searches • Net worth calculations • Financial statement analysis

Physical Evidence • Fingerprints • Tire marks • Weapons • Stolen property • Identification numbers or markings on stolen objects

Personal Observation • Invigilation • Surveillance • Covert operations

How can you prepare for the opportunities in this area? • Self study • On-the-job training • Formal education Obviously, a combination of at least two of these approaches will lead to optimal preparation.

Forensic Accounting: An Introduction