Case study on forensic audit

Forensic Accounting: Case Study

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Forensic Accounting

Robert J. Rufus Rufus & Rufus Accounting Corporation, Huntington, WV

University of Charleston, WV

Laura Savory Miller Rufus & Rufus Accounting Corporation, Huntington, WV

University of Charleston, WV

William Hahn Southeastern University, Lakeland, FL

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ISBN 13: 978-0-13-305047-9 ISBN 10: 0-13-305047-5

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About the Authors Dr. Robert J. Rufus is the Managing Principal of Rufus & Rufus Accounting Corporation located in Huntington, West Virginia, a boutique CPA firm with a concentrated practice in foren- sic accounting, tax, and litigation support. Dr. Rufus has more than thirty years of field experi- ence as a forensic expert and investigative accountant in both civil and criminal matters. He started his professional career with the Treasury Department, where he worked as an IRS agent for five years. Dr. Rufus is currently the Program Director for the Master of Forensic Accounting program at the University of Charleston, West Virginia. He has also held instructor positions at Ohio University and Marshall University. Dr. Rufus has contributed to the science of forensic accounting through numerous journal publications and conference presentations. He received his B.S. from Concord College, his M.B.A. from Marshall University, and his D.B.A. from Nova Southeastern University, all with concentrations in Accounting. Dr. Rufus is a Certified Public Accountant, a Certified Valuation Analyst, Certified in Financial Forensics, and a licensed private investigator.

Laura Savory Miller is a forensic analyst at Rufus & Rufus Accounting Corporation in Huntington, West Virginia. Her areas of specialization include business valuations, quantita- tive methods, and calculations of economic damages. In her ten years with the firm, Ms. Miller has authored or coauthored hundreds of expert reports and has testified in several jurisdictions. Ms. Miller is also a lead instructor in the University of Charleston’s Master of Forensic Accounting program and provides investment advisory services through Advanced Investment Strategies, Inc. Ms. Miller is a doctoral candidate (D.B.A. in Finance) at Nova Southeastern University in Fort Lauderdale, Florida, with an anticipated graduation date of May 2014. She received her B.S. in Finance from Marshall University and her M.A. in Economics from Ohio University. Her professional designations include Chartered Financial Analyst and Certified Valuation Analyst.

Dr. William Hahn is a professor of accounting at Southeastern University in Lakeland, Florida. Dr. Hahn has published frequently in refereed and banking journals and has presented at both academic conferences and CPA continuing education programs. Before entering the education profession, Dr. Hahn spent twenty years in the banking industry as both a CFO and COO for NASDAQ-traded companies. In his banking career, he managed accounting, investments, loan and deposit operations, computer operations, legal, facilities, and human resources. Prior to his banking career, he spent four years as an auditor with what is now Ernst & Young, CPAs. Dr. Hahn received his B.S. in Accounting from Ball State University, his M.B.A. in Finance from the University of Toledo, and his D.B.A. in Management and Accounting from Nova Southeastern University. He is a Certified Public Accountant licensed in Ohio.

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Brief Contents Preface xi

Chapter 1 Introduction to the World of Forensic Accounting 1

Chapter 2 The Legal Environment of Forensic Accounting 21

Chapter 3 Screening and Staging Engagements 47

Chapter 4 Gathering Evidence—Interviews and Observations 69

Chapter 5 Financial Statements Analysis—Reading Between the Lines 95

Chapter 6 Fraud and White-Collar Crime 141

Chapter 7 Conducting a Fraud Investigation 175

Chapter 8 Transforming Data into Evidence (Part 1) 227

Chapter 9 Transforming Data into Evidence (Part 2) 259

Chapter 10 Professional Responsibilities 291

Chapter 11 Fundamentals of Business Valuation 313

Chapter 12 Special Topics 349

Glindex (combined Glossary and Index) 401 Credits 418

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Contents Preface xi

Chapter 1 Introduction to the World of Forensic Accounting 1

Introduction 1

What Is Forensic Accounting 3

Forensic Accounting Services 4

Forensic Accountants vs. Transactional Accountants and Auditors 8

Forensic Accounting Skills 8

Forensic Accounting Certifications and Supporting Organizations 13

Careers in Forensic Accounting 14

Summary 15

Chapter 2 The Legal Environment of Forensic Accounting 21

Introduction 21

United States v. Bonnie J. Bain 21

Understanding the Legal Environment 23

Procedure: The Anatomy of a Trial 26

Evidence and the Expert 30

Privileged Communication 34

Working with Attorneys 35

Epilogue: U.S. v. Bonnie Bain 36

Appendix 2-A 37

Appendix 2-B 38

Appendix 2-C 39

Chapter 3 Screening and Staging Engagements 47

Introduction 47

Screening Engagements 49

Staging an Engagement 53

Epilogue: Mattco Forge, Inc. v. Arthur Young & Company 60

Appendix 3-A 62

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Chapter 4 Gathering Evidence—Interviews and Observations 69

Introduction 69

The Interview: A Primary Evidence-Gathering Tool 71

Conducting Interviews 75

The Value of Observations 80

Epilogue: U.S. v. Ronda Nixon 82

Appendix 4-A 84

Chapter 5 Financial Statements Analysis—Reading Between the Lines 95

Case Study: ZZZZ Best Carpet Cleaning Service 95

Introduction 97

Context of Financial Reporting 97

Foundations of Financial Statements Analysis 105

Methods of Financial Statements Analysis 107

Cash Flow Analysis 112

Journal Entry Testing 114

Content Analysis 115

Personal Financial Statements 116

Summary 118

Appendix 5-A 118

Appendix 5-B 124

Appendix 5-C 126

Chapter 6 Fraud and White-Collar Crime 141

Introduction 141

Fraud and White-Collar Crime 144

Fraud Theory 148

Why Do People Commit Fraud? 151

Who Commits Fraud? 156

Victims of White-Collar Crime 156

The Government Is Not Always Right 157

Why You Need to Know 157

Appendix 6-A 157

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Chapter 7 Conducting a Fraud Investigation 175

Introduction 175

Suspicions of Fraud 176

Background Information 177

Significant Accounting Policies 179

The Engagement 180

The Investigation 181

Epilogue 225

Chapter 8 Transforming Data into Evidence (Part 1) 227

Introduction 227

The Role of Data Analysis 227

Framing the Data Analysis Task 230

Data Sources 231

Planning for Data Analysis 233

Data Collection 236

Data Preparation 237

Data Analysis Tools 239

Interview Transcription 244

Case Application 245

Summary 245

Appendix 8-A 246

Chapter 9 Transforming Data into Evidence (Part 2) 259

Introduction 259

Descriptive Statistics 261

Methods for Displaying Data 267

Data Mining 270

Data Analysis Software 274

Digital Analysis—Benford’s Law 276

Summary 280

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Chapter 10 Professional Responsibilities 291

Introduction 291

Professional Responsibility 292

AICPA Code of Professional Conduct 297

Statement on Standards for Consulting Services No. 1 300

ACFE Code of Professional Standards 301

NACVA Professional Standards 302

Six Essential Qualities 303

Revisiting the Rules of Evidence and Discovery 303

Other Standards and Regulatory Agencies 304

Professional Responsibilities and the Expert 304

Reconciling Conflicts 305

The Adversary-Advocacy Nature of Forensic Accounting 305

Making Good Decisions 306

Common Professional Responsibility Failures 308

Epilogue: Dock’s Creek Land Company, LLC v. T. R. Robertson, CPA 308

Chapter 11 Fundamentals of Business Valuation 313

Introduction 313

How Much Is the Business Worth? 314

Valuation Theory (The Time Value of Money) 320

Business Valuation Process 325

Other Valuation Issues 332

Professional Standards 333

Concluding Truths 334

Chapter 12 Special Topics 349 12.1 Methods of Proof (Direct vs. Indirect) 349

Introduction 349

Direct Method of Proof 349

Indirect Method of Proof 351

Method of Proof Selection 356

Indirect Methods and the Courts 357 12.2 Economic Damages 357

Introduction 357

What Are Economic Damages? 358

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Types of Compensatory Damages 360

Calculating Economic Damages 362

Concluding Comments 367 12.3 Computer Forensics 367

Introduction 367

Computer Forensics in Context 371

The Process of a Computer Forensics Investigation 372

Trends in Computer Forensics 375

A Final Caution 376 12.4 Reporting Results 376

Introduction 376

Judicial Mandate—Rule 26 377

Professional Guidelines 378

Tips for Effective Reports 381

Appendix 12-A 381

Glindex (combined Glossary and Index) 401 Credits 418

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Preface This text is the first to provide a comprehensive view of what forensic accountants actually do and how they do it. With experience as both practitioners and educators, we offer a unique perspec- tive that bridges the gap between theory and practice. Our objective is to introduce students to the knowledge and skills required in the practice of forensic accounting. As emphasized throughout the text, the scope of forensic accounting services extends far beyond the realm of fraud inves- tigation, which is commonly emphasized in academic settings. Despite the engagement-specific nature of the work, forensic accounting engagements share common elements such as gather- ing and analyzing evidence, interpreting and communicating findings, and applying specialized knowledge. The building-block structure of this text is designed to guide students through each component, in the context of real-world situations.

Although intended primarily for use in upper-level undergraduate or graduate courses, this text is also a valuable resource for new practitioners or even seasoned practitioners seeking a review of critical concepts.

FORENSIC ACCOUNTING KNOWLEDGE AND SKILLS Consistent with the AICPA curriculum for the Certified in Financial Forensics (CFF) credential, this text highlights a three-layer skill set for forensic accountants:

1. core skills, 2. fundamental forensic knowledge, and 3. specialized forensic knowledge.

As illustrated, the center of the CFF Wheel is core skills. These skills, which are consid- ered prerequisites for this text, include functional competencies in accounting, economics, and finance. Armed with core skills, students can use this text as a springboard for developing both fundamental and specialized forensic knowledge.

Focus of the CFF

Bankruptcy, Insolvency, and Reorganization

Computer Forensic Analysis

Family Law

Valuation

Fraud Prevention,

Detection, & Response

Financial Statement

Misrepresentation

Economic Damages

Calculations

Fundamental Forensic Knowledge

essional responsibilities and practice management

ws, courts, and dispute resolution

ormation gathering and preservation (documents, interviews/interrogations, electronic data)

very

ting, experts, and testimony (Durkin and Ueltzen, 2009)

Specialized Forensic Knowledge

CPA Core Skills

CFF Holder

Source: From the International Glossary of Business Valuation Terms. Reprinted by permission of the American Institute of CPA’s.

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Areas of fundamental forensic knowledge include the legal environment, engagement plan- ning, methods of analysis, report writing, and professional responsibilities. Specialized knowl- edge, in contrast, pertains to specific practice niches such as fraud, business valuation, family law, economic damages, bankruptcy, and computer forensics.

Fundamental Forensic Knowledge Students begin the development of fundamental forensic knowledge in Chapter 2, with a com- prehensive discussion of the legal environment of forensic accounting. This discussion includes a description of the anatomy of a trial, along with explanations of the key concepts of discovery, evidence, expert methodology, expert opinions, and attorney-client privilege.

Chapter 3 highlights the importance of screening and staging engagements, primary fac- tors to consider before accepting an engagement, necessary elements of engagement letters, and considerations involved in framing a case. This chapter also explores a scientific approach to forensic accounting engagements and demonstrates the value of different forms of research.

Chapter 4 introduces students to interactive evidence, specifically evidence gathered through interviews and observations. Key learning objectives include an understanding of the communication process, the ability to implement the concept of active listening, and an apprecia- tion of the significance of body language. Students also learn the different types of interviews, interview questions, and stages of an interview.

Chapter 5 discusses financial statements analysis in a forensic accounting context. This chapter is designed to challenge the assumed reliability of the financial reporting process. Part of this challenge involves looking beyond the numbers to the context of financial statements. In addition to basic analytical techniques, students learn the value of nonfinancial measures and the footnotes to financial statements.

In Chapters 8 and 9, the text transitions from gathering evidence to analyzing evidence. Analysis, along with interpretation, is necessary for the development of meaningful conclusions. Chapter 8 explains how to frame the data analysis task and introduces various tools and tech- niques commonly used by forensic accountants. In Chapter 9, students learn analytic methods appropriate for large volumes of quantitative data. The operative focus, which extends to all areas of forensic accounting, is sufficient relevant data.

Although highlighted throughout the text, Chapter 10 provides a focused discussion of the forensic accountant’s specific professional responsibilities—to the client, the court, the profes- sion, and the public.

Development of fundamental forensic knowledge concludes with Chapter 12. Section 12.1 introduces the concept of method of proof, highlighting the differences between direct and indi- rect methods of proof. Students learn about specific indirect methods of proof used by forensic accountants, circumstances in which they are used, and the respective strengths and weaknesses of each method. Section 12.4 addresses the report writing task, which is arguably the most criti- cal element of the engagement process, representing the culmination of all preceding efforts. Although the form and content of any report is determined by the nature, scope, purpose, and terms of the specific engagement, students learn that forensic accountants must adhere to appli- cable judicial mandates and professional guidelines.

Specialized Forensic Knowledge This text presents discussions of four areas of specialized knowledge: fraud (Chapters 6 and 7), business valuation (Chapter 11), economic damages (Chapter 12), and computer forensics (Chapter 12). Although limited in scope, these discussions equip students with a working knowl- edge of key issues in each specific area. According to recent AICPA surveys, and consistent with our professional experience, these areas comprise the vast majority of actual forensic accounting engagements.

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UNIQUE FEATURES A Case-Based Instructional Design A unique feature of this text is its case-based instructional design, in which each chapter is accom- panied by a case that highlights key issues addressed in the chapter. The cases are sometimes pre- sented in their entirety at the beginning of the chapter and sometimes split into a prologue and epilogue. We make the cases an integral part of the text by including references throughout the body of each chapter and revisiting the cases in the end-of-chapter exercises. Also included in some of the end-of-chapter exercises are smaller cases that highlight specific applications.

Case-based instruction provides situational context that increases student understanding and facilitates the integration and application of diverse concepts. Moreover, the use of cases promotes critical thinking and active learning, providing students with the opportunity to rec- ognize problems, make assessments, and define solutions. Such an approach is essential in the instruction of forensic accounting, given its context-specific nature. Unlike other sciences, foren- sic accounting does not address abstract problems. Rather, each engagement involves a unique purpose, situation, and cast of characters.

Because most of the cases used in this text are products of our professional experiences, they represent authentic scenarios that students can expect to encounter in their careers. Unlike hypothetical cases found in many texts, we present real narratives involving real people and consequences. The cases are comprehensive, providing the levels of breadth and depth necessary to facilitate meaningful analysis and discussion. Several of the case narratives include detailed accounts of trial proceedings, offering students an up-close perspective of forensic accounting in action. Moreover, records of some cases are available in the public domain, allowing students to exercise their research skills in gathering additional information.

The Scientific Approach Another unique feature of this text is its emphasis on the scientific approach. The text advocates the scientific process as the most effective and efficient approach for gathering, synthesizing, and summarizing evidence—the basic functions of a forensic accounting engagement. Our experience as practitioners confirms the value of the scientific approach in bringing order and reasoning to forensic accounting engagements. Moreover, the approach enhances the credibility of a forensic accountant’s analysis and conclusions, which is critical for expert witness testimony.

Using scientific methods introduced in Chapter 3 and advocated throughout the text, stu- dents employ the scientific approach step by step in Chapter 7 to complete their first forensic accounting assignment—a fraud investigation involving Mountain State Sporting Goods.

Special Elements We incorporate a variety of special elements throughout the text, including:

Special notes that provide greater detail or clarification Working examples that facilitate application and discussion

dig deeper through independent exploration think about it

Cautions that every forensic practitioner should consider Practitioner’s perspectives through which the authors share insights gained through their experiences

Also included as exhibits and appendices to various chapters are examples of documents that forensic accountants commonly encounter in practice, such as a legal complaint, an engagement letter, interview transcripts, and financial statements. As with the cases, these are drawn from our professional experiences in actual cases.

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End-of-Chapter Exercises The end-of-chapter exercises provide several different types of learning opportunities for stu- dents. Short-answer Chapter Questions and Multiple-Choice Questions focus attention on key chapter concepts and terminology. Workplace Application projects are more abstract in nature, challenging students to apply key concepts and exercise critical thinking. Consistent with the sci- entific approach, Chapter Problems require students to independently explore the chapter content in more depth, thereby practicing a required skill of forensic accountants. Finally, each chapter includes (in the chapter interior or the end-of-chapter exercises) one or more Cases that require stu- dents to integrate several chapter learning objectives to analyze a problem and arrive at a solution. The Workplace Applications, Chapter Problems, and Cases also provide opportunities for stu- dents to enhance their skills in business writing, online research, and use of spreadsheet software.

SUPPLEMENTS FOR INSTRUCTORS AND STUDENTS Instructor’s Solutions Manual Comprehensive solutions, prepared by the authors, are provided for all end-of-chapter material. The manual includes a chapter-by-chapter listing of problems correlated to each learning objective.

Test Item File This is a ready-to-use bank of testing material that contains, for each chapter, a variety of types of questions. For ease of use, each question is linked to chapter objectives and also provides a sug- gested difficulty level.

TestGen This testing software is designed to aid in creating custom tests in minutes. Features include ques- tion randomization, a point-and-drag interface, and extensive customizable settings.

PowerPoint Presentation Complete PowerPoint presentations are provided for each chapter. Instructors may down- load and use each presentation as is or customize the slides. Each chapter’s set of PowerPoints allows instructors to offer an interactive presentation using colorful graphics, outlines of chap- ter material, and graphical explanations of difficult topics. This supplement is available online at www.pearsonhighered.com/rufus.

Course Companion Web Site This web site, www.pearsonhighered.com/rufus, provides additional resources for students and faculty, including links to articles cited in the text.

ACKNOWLEDGMENTS We wish to thank the following reviewers whose feedback was helpful in developing this edition:

Richard G. Brody, University of New Mexico Brent S. Daulton, West Virginia University William Green, CFE Jacquelyne L. Lewis, North Carolina Wesleyan College Mike Seda, Pfeiffer University Robert L. Taylor, Lees-McRae College Tim Weiss, University of Northwestern Ohio

Dr. Robert J. Rufus Laura Savory Miller

Dr. William Hahn

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