Chapter 1: INTRODUCTION to the world of forensic accounting

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American Board of Forensic Accounting September 2017 Newsletter

Change will happen in the accounting industry. It is just a matter of when and how. As a result, forensic accounting is important for your career.

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What Is Forensic Accounting?

Forensic: Used in or suitable to courts of law or public debate

Use of accounting theories, principles, or analyses in a legal action, often through expert witness testimony

Involves the application of accounting, finance, economics, statistics, law, research, and investigative methods in the collection, analyses, and communication of findings

Term first used in 1946 in Al Capone IRS case

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The term forensic is defined in Black’s Law Dictionary as “used in or suitable to courts of law or public debate.”

Extending this concept, we can define forensic accounting as the use of accounting theories, principles, or analyses in a legal action, often through expert witness testimony.

Forensic accounting involves the application of accounting, finance, economics, statistics, law, research, and investigative methods in the collection, analyses, and communication of findings. Given the adversarial nature of litigation, the role of a testifying forensic accountant is not suitable for everyone.

The term forensic accountant was first used by Maurice Peloubet in 1946 in the Journal of Accountancy to recognize and celebrate IRS Special Agent Frank J. Wilson as the man who brought down Capone.

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First Forensic Application

I am just a businessman giving the people what they want.

Capitalism is the legitimate racket of the ruling class.

Public service is my motto.

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Well known mobster- gambling, prostitution, bootlegging.

US Attorney Office unable to convict him of murder but pursued him in effort to restore respect for federal laws

Annual income estimated at $100mill

Went after him for tax evasion- not paying taxes on his income of $100mill

What would auditor do to investigate tax evasion?

start with tax returns- None

look at business records- None

look at bank records- None all cash

Frank Wilson IRS- Net Worth Method

start with what witnesses observed about his expenses and work backward

Net worth method- you cannot spend what you don’t have

Net worth method still used today

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Mind-set of the Forensic Accountant

Both researcher and problem solver

Intellectually curious

Instinct to explore challenging problems

Willing to question their own pre- existing judgments and conclusions

Embrace systemic thinking

Should not rush to judgment

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Forensic accountants are both researchers and problem solvers. As such, they need to be intellectually curious. An intellectually curious individual possesses a restless mind—one that is never satisfied with his or her understanding of an issue, regardless of experience and expertise.

Moreover, forensic accountants must have the instinct to explore problems that challenge conventional wisdom.

Perhaps most importantly, they must be willing to question their own pre-existing judgments and conclusions.

In addition to a curious mind-set, forensic accountants must also embrace systemic thinking. For example, forensic accountants recognize that problems are not always attributable to negligence or misconduct. Instead, these problems may be indicators of broader systemic failures within an organization.

Forensic accountants do not rush to judgment; they take a second look—and they look beyond the numbers! Finally, forensic accountants must exercise a healthy dose of professional scepticism. This reflects a proactive, questioning mind-set, where nothing is as it seems and “trust, but verify” is the general rule.

Similar to auditor mindset ?- yes

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Figure 1-1—Forensic Accounting Practice Components

Business valuations have been most significant practice component

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The results of a 2011 American Institute of Certified Public Accountants survey, illustrated in Figure 1-1, indicate that business valuations are by far the most significant practice component.

Business valuation

Discuss 5 hour energy – business valuation for estate purposes- investors, family tax planning, divorce

Brief discussion of valuation methods- to be discussed more fully later in course

Discuss Unicorns

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Figure 1-2—Categories of Forensic Accounting Services

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As illustrated in Figure 1-2, forensic accounting services are commonly divided into two major components: investigative services and litigation services. The framework depicted in Figure 1-2 is advocated by the AICPA’s Code of Professional Conduct (hereinafter the “Code”). In the context of the Code, this framework is intended to address independence in the performance of nonattest services. Although qualified in the Code as being limited in use these categories have been embraced in practice.

Examples

Investigative services:

Enron

Tyco

FIFA

DeFlategate

Russian 2016 Election meddling

Litigation Services: Expert testimony

Enron and Tyco – experts in accounting

FIFA- experts in money laundering and bribery

DeFlategate- consultants in “ gas theory”

Independence is extremely important for all forensic services

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Common Phases in Engagements

Engagements share four common phases

Defining the engagement—the “why”

Discovery—gathering evidence

Analysis—interpreting evidence

Communication—presenting evidence (opinions) orally or in writing

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The four phases of a forensic accounting engagement are: (1) defining the engagement, (i.e., why are we doing this?); (2) discovery, through the gathering of evidence; (3) analysis, which involves interpreting the evidence; and (4) communication, which involves presenting evidences or opinions, either orally or in writing.

We will be using this 4 phase approach when we look at case studies

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Investigative Services

A systematic inquiry, search, or research to obtain facts regarding a specific or general concern or concerns

Include all forensic accounting engagements that do not involve actual or threatened litigation

Generally related to corporate investigations

Initiated for the purpose of protecting the organization and its assets from internal or external threats

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As defined by the Code (ET §101.05, p. 1730), forensic accounting investigative services include all forensic accounting engagements that do not (at least at the outset) involve actual or threatened litigation.

An investigation is defined as a systematic inquiry, search, or research to obtain facts regarding a specific or general concern or concerns.

Investigative services provided by forensic accountants are generally related to corporate investigations, which are initiated for the purpose of protecting the organization and its assets from internal or external threats (for example, employee fraud, misappropriation of assets, financial statement fraud, or corruption).

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Investigative Services

Specific types include:

Fraud Detection

Actual discovery of fraud

Includes a variety of techniques

Auditors cannot be relied on to detect fraud

Fraud Examination

Conducted after a crime has been committed

Primary focus is to investigate the allegations

Fraud Deterrence

Proactive strategies to prevent fraud

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Specific types of forensic accounting investigations include fraud detection,fraud examination, and fraud deterrence.

As the name implies, fraud detection is simply the discovery of fraud. Fraud detection includes a variety of strategies, such as internal control procedures, statistical analysis, financial statements analysis, and anonymous reporting channels (such as hotlines). Importantly, detective procedures are designed to identify an error or irregularity after it has occurred, whereas preventive procedures are designed to discourage such occurrences before they happen. But how are frauds actually detected? Fraud studies identify tips as the most common source of fraud detect, so need for reporting channels.

A fraud examination is conducted after the fact, that is, in response to some indication of a crime. Its purpose is to investigate specific allegations or suspicions of fraud. The primary focus of a fraud examination is to determine the following elements of the fraud: who committed the fraud, how they committed it (the fraud scheme), when it was committed (time frame and duration), how much was taken, and who else was involved. The forensic accountant employs a systematic and scientific approach in the discovery, analysis, and determination of alleged fraudulent activity. A forensic accountant may conduct the entire investigation from start to finish or may be retained to investigate only a specific component. In either situation, the forensic accountant commonly works together with other interested parties, including legal counsel, corporate security, internal and external auditors, and management representatives.

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Fraud Deterrence

Describes proactive, rather than reactive, strategies

Includes both short-term and long-term initiatives

Short-term strategies: Evaluation of hiring practices, internal controls, and performance monitoring

Long-term strategies: Address issues such as organizational culture and the tone set by top management

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Fraud deterrence differs from fraud detection and fraud examination in that it describes proactive (rather than reactive) strategies. Such deterrence strategies include both short-term and long-term initiatives. Examples of short-term (or procedural) strategies include evaluation of hiring practices, internal controls, and performance monitoring. Because fraud requires individual actors (the offenders), a reasonable starting point for fraud deterrence is employee relations. Long-term strategies are more abstract in nature, addressing issues such as organizational culture and the tone set by top management (that is, “tone at the top”). Proactive employee strategies include preemployment screening, employee training, employee monitoring, perception of detection (through internal controls and external audits), and organizational culture.

Fraud deterrence- other examples; code of conduct signed annually- certification of info by officers- tone at top

Anti fraud controls- auditors look to these and test to see if they are properly designed and operating efficiently

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Other Investigations

Investigations unrelated to fraud

Whistleblower complaints and financial viability concerns

Whistleblower complaint is a disclosure by a person of wrongdoing within the organization

Financial viability investigations include short- or long-term assessments of financial and managerial sustainability

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In addition to the fraud-related investigations previously discussed, forensic accountants are commonly engaged to conduct investigations unrelated to fraud. Examples of such investigations include whistleblower complaints and financial viability concerns.

A whistleblower complaint is a disclosure by a person (usually an employee) of wrongdoing or misconduct within the organization.

Usually, a forensic accountant is utilized when the allegation is considered serious (for example, involving senior management) or when the appearance of independence is important. Financial viability investigations include short- or long-term assessments of financial and managerial sustainability (related to concerns of customers, vendors, or investors) or the reasonableness of insurance claims (such as lost profits or business interruption).

Fraud mostly found thru tips.

Whistleblower provisions part of SOX

We will look at a whistleblower case next week.

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Litigation Services

Provided in connection with actual, pending, or potential legal or regulatory proceedings—criminal or civil

Broad categories

Expert Witness Services

All evidence in a trial is presented by witnesses

Two types of witnesses: fact witnesses and expert witnesses

Consulting Services

Forensic accountant may also be engaged by an attorney as a consulting expert

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Forensic accounting litigation services are provided in connection with actual, pending, or potential legal or regulatory proceedings—criminal or civil. These services are segregated into expert witness (testifying) services and consulting (nontestifying) services.

All evidence in a trial is presented by witnesses. A witness, as defined by Black’s Law Dictionary, is “one who gives testimony in a cause before a court.” There are two types of witnesses: fact witnesses and expert witnesses. As the name implies, a fact witness testifies about the facts—his or her first-hand knowledge about a fact in issue or person involved in the litigation. An expert witness, on the other hand, is an individual with scientific, technical, or other specialized knowledge who is engaged to assist the “trier of fact” (a judge or jury) to understand the evidence or to determine a fact in issue. Importantly, expert witnesses differ from fact witnesses in that they can express opinions.

A forensic accountant may also be engaged by an attorney as a consulting expert. In this role, unlike the role of a testifying expert, the consultant assists an attorney in advocating for the client. Consulting experts perform many of the same tasks as testifying experts, with the exception of offering expert testimony. Depending on the circumstances of the specific engagement, a consulting expert may serve only a peripheral role or may participate in several aspects of the case, including the development of key arguments.

Explain my experience as fact witness and expert witness

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Table 1-2—Comparative Analysis: Accountant, Auditors, and Forensic Accountant

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Forensic accountants differ in many respects from transactional accountants and auditors. These differences flow primarily from their respective objectives.

This slide contrasts the roles of various accountants in an organization

Key differences between auditor procedures and forensic accountant procedures:

Auditors – start at source documents and follow thru processes to final FS- assumption is to confirm fair presentation

Forensic acct- start with hypothesis about issue and work backwards to source of issue- expect problems

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Table 1-2—Comparative Analysis: Accountant, Auditors, and Forensic Accountant

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Key differences between auditors procedures and forensic accountant procedures:

Auditors- start at source documents and follow thru process to final FS. Assumption is information is fairly stated and audit procedures will confirm this. What could go wrong?

Forensics- start with hypothesis about what went wrong and work backwards to discover relevant facts. Assumption is there are irregularities, problems, etc. What went wrong and why did it go wrong?

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Forensic Accounting Skills

Critical thinking

Rational

Skeptical

Reasonable

Well-informed

Open-minded

Self-aware

Persistent

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Three essential characteristics or skills identified in the study (and consistent with our experience) are critical thinking, reasoning, and communication.

Commonly identified attributes of critical thinkers include:

Rational—Considers all known evidence in an unbiased manner

Sceptical—Suspends judgment to allow proper consideration of evidence, context, and methodologies

Reasonable—Measures behaviours and conclusions with sound judgment and common sense

Well-informed—Possesses adequate and reliable information

Open-minded—Free of bias and receptive to new information and ideas from others

Self-aware—Cognizant of one’s own emotions and biases and how they impact decisions

Persistent—Resists jumping to conclusions

Similar to an external auditor:

Independent, not biased

Knowledgeable

Fair

Will get to the bottom of issues

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Forensic Accounting Skills

Reasoning

Problem-solving skill that involves drawing inferences or conclusions from known or assumed facts

Forensic accountants use:

Deductive reasoning—reasoning from the general to the specific, or from the premises to a logically valid conclusion

Inductive reasoning—draws conclusions from patterns

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Reasoning is a problem-solving skill that involves drawing inferences or conclusions from known or assumed facts.

Reasoning is closely associated with critical thinking in that it is a rational process of attempting to understand an event or behaviour.

Forensic accountants use both deductive and inductive reasoning to identify clues and patterns of behaviour, gather and evaluate evidence, question arguments, and develop conclusions.

Let’s first consider deductive reasoning, which is defined as “reasoning from the general to the specific, or from the premises to a logically valid conclusion. In other words, you first identify two or more general premises (either known or assumed to be true) and then apply these accepted truths to a specific situation. Importantly, deductive conclusions are statements of certainty that imply 100% confidence.

In contrast to deductive reasoning, inductive reasoning draws conclusions from patterns. The inductive reasoning process flows from a set of specific observations, facts, or data to a working hypothesis and then a general conclusion (that is, bottom up).

Deductive:

Premise- accounting clerk should have modest lifestyle spending

Premise- accounting clerk should not be able to afford a Mercedes

Hypothesis- If accounting clerk has a Mercedes, it is because of another source of cash which could be stealing from co.

Not 100% confidence

Inductive:

Observation- quarterly earnings are inconsistent over many quarters

Conclusion- next quarterly earnings may be inconsistent.

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Forensic Accounting Skills

Communication

Strong communication skills, both written and oral

Written reports must be clear, concise but comprehensive, and grammatically correct, with a professional tone

Must be able to relate findings in a simple, professional, and convincing manner

Failure is often caused by:

Body language, voice tone, words

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In forensic accounting, where there is often a wide knowledge gap between the expert and the audience, this may be the most challenging component of the process. Thus, forensic accountants are expected to have strong communication skills, both written and oral. Example- Enterasys trial re revenue recognition.

Forensic accountants expect their reports, and every word contained therein, to be closely examined and challenged. Thus, all written reports must be clear, concise but comprehensive, and grammatically correct, with a professional tone.

A forensic accountant must also be skilled in oral communication. Whether the communication is with an attorney, a client, a law enforcement officer, or a judge/jury, the ability to relate findings in a simple, professional, and convincing manner is a critical success factor.

Communication failure is often caused by a misunderstanding of the relative importance of the three components of oral communication: (1) body language, which accounts for roughly 55% of the message; (2) voice tone, which accounts for roughly 35% of the message; and (3) words, which account for only 10% of the message. Thus, nonverbal cues are critical: How you say it is more important than what you say.

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Figure 1-3—Pyramid of Forensic Accounting Skills

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Forensic accounting demands different skills from those employed by a traditional accountant. In addition to core accounting skills, forensic accountants must have a working knowledge of the judicial process (the legal environment) and the underlying concepts of evidence, discovery, and legally sufficient opinions. Moreover, successful forensic accountants must have specialized knowledge in a variety of practice areas, such as business valuation and fraud investigation.

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Quote by Wilber Wright in 1894

Business is merely a form of warfare in which each combatant strives to get the business away from his competitors and at the same time keep them from getting what he already has. No man has ever been successful in business who was not aggressive ,self-assertive and even a little bit selfish perhaps. There is nothing reprehensible in an aggressive disposition, so long as it is not carried to excess, for such men make the world and its affairs move.

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Wilber and Orville Wright considered to be business heros beyond reproach.

What does this mean for auditors? For forensic accountants?

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Financial Shenanigans

Aggressive disposition carried to excess………..

Enron -fabrication of revenue

WorldCom -fictitious profit and cash flow

Tyco -shameless heist by senior mgt

Symbol Tech -best use of many tricks

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Enron

Fabrication of revenue growth- $10bill to $100bill in 5yr

Unconsolidated partnerships $1.2bill loss

Complexity not understandable

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All about revenue growth

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WorldCom

Aggressive accounting for acquisitions

Capitalizing operating costs (line costs)

Manipulating earnings and cash flows

Loans to CEO

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Much of this was to cover up Bernie Ebbers spending and the fact that loans to him could not be repaid

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Tyco

Growth thru acquisitions 700 in 3 yrs

Acquisition acct for purchases of contracts

Purchase price inflated by connection fee

Use of cash included in investing not operations

Loans to senior management- forgiven

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Shear greed

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Symbol Technologies

Bogus adjustments each quarter for 32 quarters to meet analysts expectations

Many tricks:

Reserves (restructuring and other), channel stuffing, shipping unordered product, repurchase product at higher prices, defer expenses, reclassify accounts, capitalizing costs

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Enron, WorldCom, Tyco, Symbol

How long did the fraud go on?

Where were the independent auditors?

Were forensic accountants involved?

Were perpetrators of fraud brought to justice?

Could such massive frauds occur today?

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Weekly Current Events Assignment

Example : Special Counsel investigation of Russian meddling in 2016 US Presidential election – Trial of Paul Manafort, former Trump Campaign manager and Rick Gates, Chair of Trump Inaugural Committee

Tax and bank fraud

Money laundering

Lying to Federal authorities

Lying in a court deposition

Stealing money

Witness tampering

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Assignment for Next Week

Assignment for next week : Read article Outrageous pardon, hollow Congress and provide your thoughts on how this might relate to what we are studying. One page or less. Submit to Blackboard

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