Forensics Exam #1 (Ch. 1-5)

What are the three M's of financial reporting fraud?

1. Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared. 2. Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information. 3. Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.

In the Kessler international Survey, what was the major motivation for employee fraud?

Greed (49%)

What are the three ways managers override internal controls? How can a forensic accountant overcome managers overriding internal controls?

Managers override internal controls: 1. recording fictitious journal entries 2. intentionally biasing assumptions and judgements used to estimate accounts 3. altering records and terms related to important and unusual transactions Forensic accountant overcome managers overriding internal control: 1. examining journal entries and other adjustments 2. reviewing accounting estimates for bias evaluating the business rationale for significant unusual transactions

Define misappropriation of asset. What are other terms for this concept?

It involves the theft of an entity's assets by stealing, misuse of company assets, and causing a company to pay for goods or services that have not been received. Also called theft or defalcation.

Other forensic accounting engagements

Loss profits Business income loss lost earnings (wrongful termination, PI, death) Divorce, spousal support Bankruptcy Criminal Net worth analysis Subrogation

What huge bankruptcy in 2001-2002 caused forensic accounts to become rising stars within the accounting profession?

The Enron bankruptcy.

Are the GAAS audit standards designed to catch fraud other than financial statement fraud? What is the expectation gap? Did SAS No. 99 close it?

The GAAS are not designed to catch fraud other than financial statement fraud. There is a gap and typically an audit client will be unwilling to pay for an audit that would catch most fraud, so the gap will never go away. SAS No. 9 tries to make the gap smaller, however they ignored many of the forensic techniques offered by the Panel on Audit Effectiveness.

What impact did the IRS have on forensic accounting in the United States?

The IRS developed a number of indirect techniques to catch taxpayers not paying their taxes (e.g., net worth method, cash T, bank deposit method). An instructor may wish to discuss the Al Capone indictment.

Channel stuffing

booking income before receiving payments (sunbeam and Qwest)

Types of litigation services

damages antitrust analyses accounting valuation general consulting analyses

The modern role of forensic accounting has been defined by Wayne Bremser to include 4 elements. Which of the following is NOT one of the four:

e. Decisions on the case

EBIT

earnings before interest and taxes

EBITDA

earnings before interest, taxes, depreciation, and amortization

Skimming

technique to remove cash before a company records the receipts

Bottom line

the net profit of a company

Bid rigging

when a vendor is given an unfair advantage in an open competition for a certain contract.

Big bath

where a business manipulates its income statement in one year to show a larger loss in order to enhance the future years' earnings

What did Sherron Watkins say about rationalization and Jeff Skilling and Andy Fastow?

"But there is not a defining point where they became corrupt. It was one small step after another, with more and more rationalizations. There was a slow erosion of values over time."

Define forensic accounting.

The science that deals with the relation and application of accounting facts to legal problems

What is meant by alter ego?

"Second self." Under the doctrine of alter ego, the owners of the corporation are held responsible for corporate acts, disregarding the corporate entity.

Multiplier, Inc. has 25% gross profit margin during a year when there is a skimming scheme which reduces the bottom-line by $1,200,000. What increase in revenue is needed to replace this bottom-line loss?

$1,200,000/25%= $4.8 million

What are pro formas?

(cash earnings or operating earnings) are often issued with many expenses excluded, resulting in "hide and seek" earnings. Accountants must focus on the earnings figures that are prepared according to GAAP

What is vertical analysis?

(often referred to as common-size statements) presents every item in a statement as a percentage of the largest item in the statement. When vertical analysis is used to compare F/S from several periods, changes in the relationship between items can be easily determined.

Give Professor Robertson's typical white-collar criminal characteristics.

* Likely to be married * Member of a church * Education beyond high school * No arrest record * Age range from teens to older than 60 * Socially conforming * Employment tenure from 1 to 20 years * Acts alone 70% of the time

What are the number one and two conditions conducive for fraud according to KPMG's surveys?

Inadequate internal controls and Collusion between employees and third parties

Motive to commit fraud usually will include all of the following except:

Inadequate separation of duties

In the 1920s, what senior partner began giving speeches encouraging financial and industrial investigations?

The senior partner was Arthur Anderson.

In the Kessler International Survey, what percentage of employees said they lied on their job application?

92%

What percentage of forensic experts hired are CPAs?

94%

Fraud Auditor

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

White collar crimes

Antitrust Bankruptcy fraud Corporate/securities fraud Health care fraud Money laundering Mortgage fraud

What situations did Wayne Bremser suggest are active areas for forensic accountants

Antitrust, commercial contracts, patent infringement, trademark, and copyright infringement, product liability, mergers and acquisitions, insurance claims, shareholder units, reorganization and bankruptcy, taxation, malpractice, and corporate fraud

Sherron Watkins quote on rationalization

At what point did they turn crooked? "But there is not a defining point where they became corrupt. It was one small step after another, with more and more rationalizations. There was a slow erosion of values over time."

What change in auditing may have caused Enron, WorldCom, Xerox, and the other fraudulent situations?

Auditing started to use computers for their record keeping rather than having staff review the millions of transactions that happened in each company. By cutting costs this way, auditors relied more heavily on internal controls and paid less attention to the account balances and entries. Because top executives are able to interfere with internal controls, they were able to manipulate records. This led to scandals such as Enron, WorldCom, Xerox, and other fraudulent situations.

As an expert witness, the forensic accountant should have an understanding of:

Business valuations commercial litigation bankruptcy courtroom terminology

How may misappropriations be accomplished?

By false or misleading records/documents

Give some examples of external fraud.

Check forgery, false insurance claims, credit card fraud, false invoices, product substitution, bribes/secret commission, bid rigging/price fixing, false representation of funds

Give the percentages when CEOs and CFOs are involved in fraudulent financial fraud cases.

CEO: 72%, CFO: 43%, CEO/CFO: 83%

External Fraud

Check forgery False insurance claims Credit card fraud False invoices Product substitution Bribes/secret commission Bid rigging/price fixing False representation of funds

What is the definition of earnings management?

Earnings management: the purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain.

Profile of a fraudster

Egotistical Risk taker Hard worker Greedy Disgruntled or a complainer Overwhelming desire for personal gain Pressured to perform Inquisitive Rule breaker Under stress Financially needy Big spender Close relationship with vendors/suppliers

Which would not fall under corruption?

Extortion

True or false: Large amounts of cash on hand may create pressure on an employee to misappropriate assets

False

Break financial statement fraud schemes into 10 types.

Fictitious revenues, misapplication, timing differences, misrepresentation, concealed liabilities and expenses, improper disclosures, improper asset valuations, manipulations.

How does forensic audit differ from a regular audit?

Financial Audit - standard audit plan, sampling, test of controls, scope limited based on materiality Forensic Audit - no standard audit plan, looking at every transaction, scope not just on materiality, looks for errors, no assumption of integrity management, more time consuming and expensive

Should a forensic accountant have a CPA certificate? What other certificates are appropriate?

Forensic accountants do not need a CPA. Other certificates that are appropriate are CMA, CFFE, CVA, or CBA

What is fraudulent earnings management?

Fraudulent earnings management: an intentional and material misrepresentation of results.

According to 2010 Wells Report, the most costly form of fraud was

Fraudulent financial statements

What are some audit steps to catch skimming and money-laundering schemes?

Gross profit analysis, compare receipts to deposits, surprise cash count, and investigate customer complaints

Waystopreventemployeefraud

Have a fraud hotline. Institute a mandatory vacation policy. Rotate assignments of employees who handle cash, payables, and receivables. Have a written and signed ethics policy. Have internal auditors do different procedures each time they audit a unit. Observe and listen to employees; look for lifestyle changes.Really understand the business unit and what functions employees actually perform. Do not allow employees or executives to get away with anything. In a small business, the owner should receive the monthly bank statements unopened. Bank statements should always be reconciled. Supervisors should try to think like criminals. Do not assume employees behave honestly. Check employee references and résumés. Think outside the box. Bond employees. Use a positive pay system. Use a locked box system. Count the cash twice in one day. Count the cash at irregular intervals. Unannounced inventory counts. Have a fraud risk assessment. Beware of related parties. Avoid check-signing machines and signature stamps. Be careful allowing employees to make side agreements.

Who was Frank Wilson?

He was a man who was assigned from the Special Intelligence Unit from Baltimore's office to work on Al Capone's case. He was said to be afraid of "nothing that walks" and would "pore over a set of books, eighteen hours a day, seven days a week, forever. Wilson was the one who found the "smoking gun" that showed a ledger with net profits that had Al Capone's name on it.

What is forensic accounting 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 from projecting future financial data to settle legal disputes

What procedures may be used in a forensic audit?

Interviews document inspection Public records search Rules of evidence

What are G.E. Moutlton's fraud indentifiers?

Large ego, substance abuse problems or gambling addiction, living beyond apparent means, self-absorption, hardworking/taking a few vacations, under financial pressure (heavy borrowing), and sudden mood changes.

Explain how a shell company could be used to engage in pass-through billing scheme.

It may be used to steal assets through accounts payable. An employee may create a shell company with the secretary of state, open a bank account, and send false invoices to their employer. The shell company puts itself between a real vendor and a company. EX: sends $16,000ninvoice to intermediary company and then sends a new inflated invoice to the victim's business for $20,000 to make an unauthorized payment of $4,000.

If there is a substantial increase in bad debts, what might this mean?

It might mean that fictitious accounts receivable are established to cover a phony sale. Write-offs to bad debt can conceal inventory thefts and kickback schemes

What is horizontal analysis?

It starts with a base year, and each successive year is compared with the base year. The significant changes in account balances from period to period should be investigated to determine the reason for the change. They could signify financial improvement or decline in the specific company or its industry.

Internal - Management Fraud

Lapping Expense accounts False financial statement Misappropriation of cash/assets Unnecessary purchases Check forgery Kickbacks Ghost vendors Diversion of sales

Give some examples of internal fraud.

Lapping, expense accounts, false financial statements, misappropriation of cash/assets, unnecessary purchase, check forgery, kickbacks, ghost vendors, diversion of sales.

In the Kessler International survey, what percentage of employees steal from their employers?

None of the above (39%)

Who commits fraud

Middle class employees Respectable citizens More women than men No one gets hurt Not really a crime Entitled because feels underpaid Greedy Desperate

Fraud triangle

Motive Opportunity Rationalization

What are the three factors of the fraud pyramid?

Motive, rationalization, opportunity.

What was WorldCom's main fraud strategy?

Moving expenses into asset accounts

Forensic Audit

No standard audit plan Scope not limited based on Materiality Looks for what is wrong v. checking if right Not assuming management has integrity More time consuming & expensive

Should a forensic accountant express an opinion in a report regarding the guilt or innocence of any person or party?

No, they are not supposed to express an opinion in a report regarding the guilt or innocence of any person or party.

May a forensic accountant have a monetary interest in the outcome of a court decision?

No, they are not supposed to have a momentary interest in the outcome of a court decision.

Forensic Accounting Engagements

Quantification of damages in litigation Investigative auditing Commercial property insurance claims Business Valuations Expert Witness Testimony

What do behavioral psychologists call rationalization?

Reframing - where someone who is about to cheat will adjust the definition of cheating to exclude his or her actions

Which would not be an indicator of alter ego?

Risk assessment

Do not-for-profit organizations face incentives and pressures to cook their books? Discuss

SAS No. 99 suggests that they do feel incentives and pressures. Fraud may be more prevalent in nonpublic entities since they are dealing with other people's money

Financial Audit

Standard audit plan Sampling v. looking at every transactions Test of controls Scope limited based on Materiality Confirming amounts are correct

Internal - Employee Fraud

Stock theft Misappropriation of cash assets Lapping Check forgery Expenses accounts Petty cash Kickbacks Loans/investments Ghost employees

How did Sunbeam create revenues?

Sunbeam created revenues through contingent sales, bill and hold strategy, and accelerating sales.

What is the most common response to the discovery of fraud by an organization? How often does an organization report a fraud to a law enforcement agency?

The most common response (at 94%) and they report it 62% of the time

What subtle shift in external auditing occurred in the early 1980s?

The subtle shift in the early 1980s was in the way external auditors reviewed clients' records. Using computers to perform record keeping made for intense competition and in turn made auditing fees fall by as much as 50%. This made them have to cut costs by reducing labor-intensive processes of reviewing hundreds of corporate accounts. They began to rely more on internal controls and worked less with account balances and entries. Because top executives could circumvent internal controls, they could manipulate records and in turn we get the results of Enron, WorldCom, Xerox, etc.

How can one spot a kiting scheme?

To spot it, look for frequent deposits and checks in the same amount, large deposits on Fridays, short time lag between deposits and withdrawals, and a bank reconciliation.

Forensic accounting always involves which one of the following?

Using accounting techniques and financial expertise in a legal environment

Which would not be considered a source document?

Weekend entry

Which statement is false?

WorldCom's external auditors missed about $21 billion of improperly booked items

What does forensic mean?

a discipline that deals with the relation and application of financial facts to legal problems or any investigation of a financial nature that has a legal consequence.

Off-balance-sheet financing

financing sources other than debt and equity, such as partnerships, joint ventures, and operating leases

Cookie jar accounting

practice of setting up reserves in one year and then releasing the reserves in future years to smooth earnings

Kiting

involves building up balances in two or more bank accounts based upon floating checks drawn against the other accounts

Lapping

involves recording of payment on a customer's account some time after the receipt of the payment

Cooking the books

knowingly providing incorrect information in a company's financial statements

What are some ways to steal cash?

larceny, skimming, theft of incoming checks, kiting, or by the person who takes the deposits to the bank

Reactive fraud investigations

occur after there is a reason to suspect fraud or after there is a significant loss

Proactive investigations

occur as a part of normal operations even when there is no reason to suspect fraud

Kickbacks

often involve a vendor/supplier and an employee who work in cahoots to underreport inventory or payment of an inflated price

A forensic accountant may

perform audits provide litigation support investigate an embezzlement trace missing funds

Earnings management

purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain

What can help to prevent cash and check thefts?

segregation of duties, mandatory vacations, and rotation of duties