What is forensic accounting pdf

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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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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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INTRODUCTION On April 23, 1930, the Chicago Crime Commission issued its first Public Enemies List. At the top of the list was Alphonse Capone (also known as “Big Al,” “Scarface,” and “Big Shot”), one of the most notorious gangsters in U.S. history. Unable to convict Capone of murder,* the U.S. Attorney’s Office aggres- sively pursued criminal prosecution against him in an effort to “restore respect for federal laws” that had been eroded by the gangster class.1 On March 13, 1931, a secret federal grand jury issued an indictment against Capone charging him with tax evasion for year 1924. Similar indictments for years 1925 through 1928 followed shortly thereafter. The Internal Revenue Service (IRS)† estimated Capone’s annual gross earnings (from gambling, prostitution, and bootlegging) at more than $100 million.2 The government’s challenge, however, was proving it.

Capone maintained no bank accounts, kept no activity records, bought no prop- erty in his own name, conducted all his financial transactions in cash, and never filed a tax return. Moreover, Capone’s reputation for violence created a strong disincentive for any potential informants. In the eyes of most, Capone was bigger than the government . . . and certainly more deadly.

Development of the case against Al Capone was assigned to IRS Special Agent Frank J. Wilson. Wilson’s assignment was to find evidence that would persuade a jury beyond a reasonable doubt (the standard of proof for conviction in a criminal case) of Capone’s guilt. The investigation included hundreds of witness

1 Introduction to the World of Forensic Accounting Learning Objectives After completing this chapter, you should be able to:

LO1. Explain what forensic accounting is.

LO2. Identify common types of forensic accounting engagements.

LO3. Compare and contrast the role of the forensic accountant with the roles of transactional accountants and auditors.

LO4. Identify the necessary skills of forensic accountants.

LO5. Recognize major providers of forensic accounting certification and continuing education.

LO6. Identify potential careers in forensic accounting.

1

* The St. Valentine’s Day Massacre of February 14, 1929, was ascribed to Capone, although Capone himself was in Florida on that date. Capone was also suspected of murdering Assistant State’s At- torney W.H. McSwiggin on April 26, 1926.

† Then called the Bureau of Internal Revenue.

Al Capone

Source: www.fbi.gov

www.fbi.gov
2 Forensic Accounting

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interviews, wiretaps, and search raids, which failed to produce sufficient evidence. Near a point of hopelessness, Wilson took a second look at the evidence and discovered his first key witness—Leslie A. Shuway. Shu- way, one of Capone’s former gaming parlor cashiers, was a waterfall of information. He identified Capone as the principal owner of a gambling syndicate and confirmed amounts paid to Capone. He also identified other individuals (leads) who could provide additional evidence against Capone.

The testimonial evidence gathered by Wilson was compelling, but not convincing beyond a reasonable doubt. The government’s challenge was to explain to the jury the complexities of accounting and tax in a manner that was not only persuasive, but could also withstand the test of cross- examination. Meeting this challenge head on, Wilson developed and presented to the jury a calculation of Capone’s unreported taxable income using what he called the “net worth method.”‡ The underlying theory of this method is quite simple—you can’t spend what you don’t have. Wilson’s analysis is summarized in Table 1-1.

IRS Special Agent Frank Wilson

Source: www.life.com

‡ Also known as the net worth plus expenditures method.

Table 1-1 | Net Worth Calculation Step Action Example Calculation*

1 Determine ending net worth. $2.250m

2 Determine beginning net worth. $1.125m

3 Calculate the change in net worth during the period. $1.125m

4 Determine expenditures (consumption) during the period. $ .500m

5 Calculate the sum of funds used for asset acquisitions and consumption. $1.625m

6 Calculate the sum of reported income and other legitimate sources of funds. (Remember, Capone never filed tax returns.)

-0-

7 Calculate the difference between legitimate sources and uses of funds, which indicates unreported income.

$1.625m

* Numbers are for illustration purposes only.

Special Note

The net worth method, which is fully explained in Chapter 12, is an application of deductive reasoning. As discussed later in this chapter, deductive reasoning reaches a conclusion (unreported income) through underlying propositions (cash spent versus cash available). The advantages of deductive reasoning (and the net worth method) are its intuitive appeal—it “makes good sense”—and its ease of application in certain situations.

On October 18, 1931, Al Capone was convicted of tax evasion for years 1925 through 1927 and failure to file income tax returns for years 1928 and 1929. Shortly thereafter, he was sentenced to 11 years in federal prison, fined $50,000, and charged $7,692 for court costs, in addition to a tax loss of $215,000 plus interest. On November 16, 1939, Capone was released after serving seven years, six months, and fifteen days. Capone lived the balance of his life in seclusion, never returning to gangland politics. He died on January 25, 1947.

www.life.com
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Chapter 1 | Introduction to the World of Forensic Accounting 3

Frank J. Wilson, who was rightfully credited3 with bringing down Al Capone, is commonly recognized as the first forensic accountant. His net worth method was the first indirect method†† to receive judicial approval,4 and it continues to be used by IRS and FBI agents, as well as forensic accountants. Like Wilson, modern-day forensic accountants are often called upon to reconstruct missing or destroyed information, develop leads, interview witnesses, assist counsel in advancing (or challenging) the theory of a case, and communicate complex concepts to a jury. In addition to financial analysis, these diverse tasks require intellectual tools such as logic, reasoning, and intuition.

WHAT IS FORENSIC ACCOUNTING? The term forensic is defined in Black’s Law Dictionary as “used in or suitable to courts of law or public debate.”5 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.

Other common definitions include the following:

business problems, conducted in a legal setting.6

both occupational fraud and financial statement fraud; and (2) the rendering of other litigation-support services.7

8

As will be explored throughout this text, 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. Nonetheless, the unique skills of forensic accounting are valuable competencies that can easily be transferred to activities outside the courtroom.

The term forensic accountant was first used by Maurice Peloubet in 1946 in the Journal of Accountancy9 to recognize and celebrate IRS Special Agent Frank J. Wilson as the man who brought down Capone. Peloubet identified Wilson’s “mindset” as the difference between accountants and forensic accountants. What is a mindset? More importantly, what is the mindset of a forensic accountant?

The Mindset of the Forensic Accountant Broadly speaking, a person’s mindset is his or her mental state, which evolves from educa- tion, experience, prejudices, and so on.10 Specifically, your mindset incorporates mental processes that dictate how you respond to situations or challenges. Activating one mind- set instead of another may change your observations—what you see and how you see it,

§ Can be accessed at http://www.irs.gov/foia/article/0,,id=179352,00.html ** Can be accessed at http://www.fbi.gov/foia/ †† Indirect methods are necessary when, for whatever reason, books and records are inadequate to determine taxable

income. As with Al Capone, indirect methods are often used against suspected recipients of illegal income. Other indirect methods include the bank deposits method, the expenditures method, and the reverse net worth method.

Dig Deeper

In February 2008, the IRS released for public view records related to Al Capone’s crim- inal investigation. Such a release is highly unusual because all federal tax records are confidential by law. The records were released due to their historical significance and interest to the public. Students are encouraged to the visit the IRS web site§ to review copies of reports and letters that summarize the events and activities of the three-year investigation of Al Capone. Another information source is the FBI’s Reading Room,** which provides historical documents related to famous cases such as Capone’s.

http://www.irs.gov/foia/article/0,,id=179352,00.html
http://www.fbi.gov/foia/
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questions you ask, judgments you form, and decisions you make.11 For example, auditors are prone to have a “same as last year” (or SALY) mindset, wherein they expect and accept findings consistent with prior years. A different mindset might start with the premise that something has changed, which requires a new assessment of risk and management.

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 preexisting judgments and conclusions.

In addition to a curious mindset, 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 skepticism. This reflects a proactive, questioning mindset, where nothing is as it seems and “trust, but verify” is the general rule.

FORENSIC ACCOUNTING SERVICES Forensic accountants are in major part defined by the nature of their work. Although most people equate forensic accounting with fraud, the scope of forensic accounting work is actually much broader. According to Accounting Today’s survey of the top 100 CPA firms, the most common forensic services are business valuations, fraud investigations, and liti- gation support.12 For the past sixteen years, these service categories have been offered by a majority of the respondent firms. 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.13

A distinctive feature of this text is its comprehensive view of the forensic accounting profession, providing a more accurate picture of what forensic accountants actually do. The largest practice components, as identified in Figure 1-1 (fraud, business valuations, and economic damages) are discussed in detail in Chapters 6, 7, 11, and 12.

Other 1%

Computer forensic analysis 4%

Bankruptcy 4%

Insolvency and reorganization

4%

Business valuation–other

12%

Fraud detection, deterrence, and

response 12%

Calculation of economic damages

15%

Financial statement misrepresentation

17%

Family law–including business

valuations 31%

4% In re

Calcula ent on

g

Figure 1-1 Forensic Accounting Practice Components

Source: AICPA 2011 Forensic and Valuation Services Trend Survey

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Chapter 1 | Introduction to the World of Forensic Accounting 5

As illustrated in Figure 1-2, forensic accounting services are commonly divided into two major components: investigative services and litigation services.

As will be emphasized throughout this text, forensic accounting services are engagement- specific. Even so, all forensic accounting engagements share four common phases:

1. Defining the engagement—the “why” 2. Discovery—gathering evidence 3. Analysis—interpreting evidence 4. Communication—presenting evidence (opinions) orally or in writing

The remaining chapters of this text guide you through each of these phases within the context of investigative services and litigation services.

Investigative Services 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 ac- tual 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.15 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 inter- nal or external threats (for example, employee fraud, misappropriation of assets, financial statement fraud, or corruption). Specific types of forensic accounting investigations include fraud detection, fraud examination, and fraud deterrence.

Fraud Detection 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,

Forensic Accounting Services

Litigation

Fraud Examination

Fraud Deterrence

Fraud Detection

Other Expert Consultant

Investigation

Business Valuations

Shareholder Disputes

Financial Crimes

Economic Damages

Estate Valuations

Bankruptcy Computer Forensics

Other

Figure 1-2 Categories of Forensic Accounting Services

Special Note

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 (ET §101.05).14 Although qualified in the Code as being limited in use (p. 1728, footnote 25), these categories have been embraced in practice.

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financial statements analysis, and anonymous reporting channels (such as hotlines). Im- portantly, detective procedures are designed to identify an error or irregularity after it has occurred, whereas preventive procedures (discussed in a later section) are designed to dis- courage such occurrences before they happen. But how are frauds actually detected?

Fraud studies consistently identify tips as the most common source of fraud detection, thus highlighting the need for reporting channels. For example, a 2012 study by the Association of Certified Fraud Examiners (ACFE) reports that 43.3% of occupational frauds are detected by tips.16 According to this same study, more than half of all tips (50.9%) come from employees, followed by customers (22.1%), anonymous sources (12.4%), and vendors (9%). A distant second source of fraud detection is management review (14.6%), followed by internal auditors (14.4%), and detection by accident (7%). Interestingly, the ACFE study reports that only 3.3% of occupational frauds are detected by external auditors. Thus, although auditors play an important role in fraud deterrence (discussed in the “Fraud Deterrence” section), they cannot be relied on to detect fraud.

Fraud Examination 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 fo- cus of a fraud examination is to determine the following elements of the fraud: who commit- ted 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 why (need or motive), although important to our overall understanding of fraud, is not the immediate challenge.

The forensic accountant employs a systematic and scientific approach in the discovery, analy- sis, and determination of alleged fraudulent activity. As highlighted throughout this text, a fraud examination is an evolutionary process that adjusts as new evidence is gathered and evaluated.

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.

Fraud Deterrence 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 deter- rence 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 au- dits), and organizational culture. Aside from a policy of not hiring criminals, we contend that the most effective means of fraud deterrence is promoting the expectation (perception) among employees that wrongdoers will be caught and that punishment will be swift and appropriate for the offense.

Special Note

An operative first step in a fraud investigation is to confirm the existence of an inves- tigation policy and, if one exists, secure a copy to ensure compliance. An investigation policy identifies the process and interested parties and establishes investigative and reporting protocols. Such policies are designed to ensure that investigations are carried out promptly and in a fair and equitable manner to the individuals involved, allowing them an opportunity to respond to the matter under investigation. Moreover, investiga- tion policies establish thresholds for identifying significant issues worth pursuing.

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Chapter 1 | Introduction to the World of Forensic Accounting 7

Other Investigations In addition to the fraud-related investigations previously discussed, forensic accountants are commonly engaged to conduct investigations unrelated to fraud. Examples of such investi- gations 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.18 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).

Litigation Services As defined by the Code (ET §101.05, pp. 1728–29), 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.

Expert Witness 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.”19 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 firsthand knowledge about a fact in issue or person involved in the litigation. An expert witness, on the other hand, is an individual with scientific, techni- cal, 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 wit- nesses differ from fact witnesses in that they can express opinions. As will be discussed in Chapter 2, an expert’s opinion must be based on sufficient facts or data, be the product of reliable methodology, and be case-specific.

As emphasized throughout this text, forensic accountants providing expert witness services have a duty to the court, the public, and the profession to offer objective and independent opinions that will assist the trier of fact. This is no small task, given the adversary–advocacy nature of the field. These challenges and the forensic accountant’s professional responsibili- ties are discussed in detail in Chapter 10.

Consulting Services 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

Working Analogy

A simple analogy for explaining the distinction between detection, investigation, and deterrence is unhealthy weight gain.17

= identification of the specific health concern (that is, unhealthy weight gain)

∘ In its early stages, weight gain can be detected by scales; as the problem progresses, it becomes more visibly noticeable.

= identification of the factors that caused the weight gain ∘ Potential explanations include changes in diet, alcohol consumption,

sleeping patterns, stress, work, family, or exercise. = addressing the causal factors

∘ Mitigating strategies include improved diet (both food selection and con- sumption) and increased physical activity.

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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.

FORENSIC ACCOUNTANTS VS. TRANSACTIONAL ACCOUNTANTS AND AUDITORS Forensic accountants differ in many respects from transactional accountants and auditors. These differences flow primarily from their respective objectives. To enhance your under- standing of forensic accounting, let’s compare these roles.

Transactional Accountant Accountants working for an organization employ generally accepted accounting prin- ciples (GAAP) to process information useful in decision making. The accounting process has three basic steps: recording, classifying, and summarizing. To facilitate this process, transactional accountants require core accounting skills. Most have undergraduate degrees in accounting, and many have one or more professional certifications, such as Certified Public Accountant (CPA), Certified Management Accountant (CMA), or Certified Internal Auditor (CIA).

Internal Auditor Aside from management, the first line of defense against accounting failures within an organization is the internal auditor, whose responsibilities extend beyond the process- ing functions of a transactional accountant. The internal auditor’s function is to report on the adequacy of internal controls, the accuracy and propriety of transactions, the extent to which assets are accounted for and safeguarded, and the level of compliance with a com- pany’s internal policies as well as external laws and regulations. This function exists to support the other three representatives of an organization: the board of directors (BOD), executive management, and the external auditor. In addition to core accounting skills, inter- nal auditors must possess critical thinking, problem-solving, and communi cation skills.

External Auditor External auditors, who work for CPA firms, are hired by organizations to evaluate their internal control systems and test their transactions and accounts to ensure that all economic events are recorded and reported in the proper accounting period. The purpose of the ex- ternal auditor is to form and express an opinion as to whether the organization’s financial statements, taken as a whole, reflect its financial position on a given date and the results of its operations for a given period. An unqualified (clean) opinion from the external auditor adds credibility to the organization and its financial statements. Skills required by external auditors are similar to those for internal auditors.

As summarized in Table 1-2, the objectives and processes of forensic accountants vary significantly from those of transactional accountants, internal auditors, and external auditors.

FORENSIC ACCOUNTING SKILLS In 2009, Davis, Farrell, and Ogilby surveyed a mix of attorneys, CPAs, and academ- ics to gain a better understanding of the dominant skills and characteristics of effective forensic accountants.20 The diversity of the survey respondents is significant because it provides information from different points of view: attorneys (consumers of forensic accounting services), CPAs (providers of forensic accounting services), and academics (initial educators of forensic accountants). Three essential characteristics or skills identi- fied in the study (and consistent with our experience) are critical thinking, reasoning, and communication.

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

Transactional Accountant

Internal Auditor

External Auditor

Forensic Accountant

Timing Day-to-day and month-to-month

Conducted according to a plan or because a defi- ciency has been identified

Conducted on a recurring basis

Conducted on an as-needed (nonrecurring) basis

Scope Manage the organization’s accounting and internal control system

Validate effectiveness of controls in various processes or areas of the organization

Examination of the financial data

Defined by the specific engagement

Objective Capture and record all economic transactions of the organization

Ensure compliance with policy and procedures; offer recommendations for improvement of internal controls

Form an opinion on the overall financial statements taken as a whole

Address a specific question/issue

Purpose Prepare financial statements for decision makers

Required by the BOD based on overall corpo- rate risk assessment

Usually required by third- party users of financial statements

Defined by the spe- cific engagement

Value Information useful for decision-making purposes

Provides assurance that management is adequately identifying and mitigating risks

Adds credibility to reported financial information

Completion of stated engagement objective

Source of Evidence / Methodology

Original transactions for the acquisition and em- ployment of assets, liabili- ties, equity, revenue, and expense in the conduct of business

Inquiry, observation, examination, and testing of processes

Inquiry, observation, exami- nation, and reconstruction of accounting transactions to support financial state- ment representations

Review detailed financial and nonfi- nancial data, search public records, con- duct interviews, and make observations

Sufficiency of Evidence

Reasonable assurance Reasonable assurance Reasonable assurance Establish facts to support the conclusion/opinion

Audience Management at all levels and the BOD

Executive management and the BOD

Serves the public interest, specifically investors and other stakeholders

Engaging party

Critical Thinking As previously discussed, forensic accountants provide services in a variety of engagements. Most (if not all) involve critical thinking. Commonly identified attributes of critical think- ers include:21

and methodologies

common sense

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decisions

What Is Critical Thinking? John Dewey (1933), who is widely recognized as the father of modern critical thinking, defined it as “active, persistent, and careful consideration of a belief or supposed form of knowledge in the light of the grounds which support it and the further conclusions to which it tends.”22 Several other definitions are presented in the following list, in chronological order, to illustrate key (recurring) themes and demonstrate the development of the concept over time.

activity with reflective skepticism.”23

- search assumptions that challenge their thoughts and actions.24 Brookfield identified five activities and processes that take place when individuals are thinking critically:

∘ Critical thinking is a productive and positive activity that requires active engagement with life.

∘ Critical thinkers continuously question assumptions; therefore, critical thinking is a process and not an outcome.

∘ The thinking processes of critical thinkers vary enormously according to the contexts in which it occurs.

∘ Critical thinking results from individuals experiencing positive and nega- tive events that can initiate the process of questioning previously trusted assumptions.

∘ Critical thinkers find emotions central to the critical thinking process, allowing them to be emotive and rational with their assumptions.

- sible thinking that facilitates good judgment because it: (a) relies upon criteria, (b) is self-correcting, and (c) is sensitive to context.”25

reasonable decisions about what to believe and what to do.”26

and insight together from various disciplines to provide information for decision making.”27

- mation gathered from multiple sources to make judgments that lead to the develop- ment of a thought or action.28

A common theme among these definitions is the idea of questioning assumptions, particu- larly with respect to cause–effect relationships. A critical thinker exercises judgment, us- ing criteria developed from past observations and experiences. This process is flexible and highly sensitive to the context in which it occurs. Finally, critical thinking should ultimately influence decision making and thus lead to action.

The Value of Critical Thinking Critical thinking is a necessary skill for any type of investigation, research, or scientific inquiry. As will be emphasized throughout this text, the analytical processes employed by forensic accountants are based on a scientific approach. This involves (1) identifying a question, (2) gathering sufficient relevant data, (3) analyzing the data, (4) drawing conclu- sions, and (5) communicating results. In this context, critical thinking serves as a guiding frame to preserve the integrity of the scientific process. Various threats to the integrity of this process are manifested in the concept of “blind spots.” Blind spots are caused by mis- takes in reasoning, human irrationality, biases, distortions, and self-interest. As humans,

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Chapter 1 | Introduction to the World of Forensic Accounting 11

we all have blind spots. However, by exercising critical thinking, we can more easily detect our own blinds spots as well as those of others.

Reasoning Reasoning is a problem-solving skill that involves drawing inferences or conclusions from known or assumed facts.29 Reasoning is closely associated with critical thinking in that it is a rational process of attempting to understand an event or behavior. Just like the iconic Sherlock Holmes, forensic accountants use both deductive and inductive reasoning to iden- tify clues and patterns of behavior, gather and evaluate evidence, question arguments, and develop conclusions.

Deductive Reasoning 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.”30 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 state- ments of certainty that imply 100% confidence.