[IMGCAP(1)]Forensic accounting has become a “hot” topic in recent years due to the increase in high-profile cases of companies and individuals charged with corruption and fraud.
The accounting scandals at Enron, WorldCom and other companies shocked the world and exposed the great potential for deceit that can accompany blind corporate greed. More recently, the financial crisis has exposed a vast number of fraud schemes, most notably Bernie Madoff’s multi-billion dollar Ponzi scheme.
Forensic accountants are tasked, among other things, with piecing together the financial puzzle after the fallout of such scandals. They rebuild entire financial systems, uncover financial statement fraud, trace funds, discover hidden assets, and more. These scandals, and the subsequent investigations and trials that have followed, have given the general public a glimpse into just one of many areas of forensic accounting.
This article will offer a brief survey of the full spectrum of forensic accounting, and explain what forensic accountants do and how they do it.
Forensic accounting is the integration of accounting and auditing skills with investigative techniques and professional skepticism. Alan Zysman, a noted forensic accountant since 1987, states, “Forensic accounting provides an accounting analysis that is suitable to the court which will form the basis for discussion, debate and ultimately dispute resolution.”
Typically the work prepared by a forensic accountant, or fraud examiner, is done in anticipation of litigation and therefore must be of such a quality that it can withstand scrutiny by attorneys, judges and juries. A fraud examiner often serves as an expert witness and will testify as to his or her findings with respect to an investigation.
[IMGCAP(2)]To many people the differences between a forensic accounting investigation and an audit may be unclear. The Statements on Auditing Standards No.1, guidelines for audits, states: “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by error or fraud, that are not material to the financial statements are detected.”
Because the role of auditors focuses on reasonable assurance that financial statements are free of material misstatements, they test financial transactions on a sample basis. An auditor reviews the books and records for reasonableness. A detail review of the nature of every transaction is not the goal of an audit.
However, in a forensic accounting investigation materiality is not a factor and does not affect the scope; sample testing is generally not done. A review of all records for a time period is typically performed to determine trends and identify patterns. Transactions of all sizes can be reviewed. In fact, even the smallest transactions can lead a fraud examiner to a potential fraudulent scheme.
A fraud examiner can make recommendations and propose corrective actions if a fraud scheme is identified, or if there is a high inherent risk for fraud. Also, in an audit the financial statements are the responsibility of management, and therefore management is relied upon to provide data and answers for the auditors.
Forensic accountants possess a strong sense of professional skepticism and require original documentation to substantiate facts and circumstantial evidence to form opinions.
The need for forensic accountants oftentimes is reactionary, in that they are sought by companies and individuals when there is the potential for financial loss or the risk of loss. This perception of loss could originate from a whistleblower letter, observed suspicious activity or the risk of potential litigation.
The fraud examiner conducts an investigation documenting the who, what, when, where, and how of financial transactions. During the investigation, source documents of all kinds may be reviewed, including bank statements, checks, tax returns, payroll records, general ledgers, and documents produced by third parties. Fraud examiners will also interview people to get a better understanding of the possible impropriety being investigated.
History of Forensic Accounting
The field of forensic accounting is not a new concept, though it has grown in popularity in recent years. The basis of this field is founded upon understanding the mind of the fraudster in order to understand why frauds are committed. Donald Cressey, a sociologist and criminologist in the 1940s, became a leader in understanding fraudsters and why they do what they do. Cressey wrote, “Theft of the Nation,” a treatise on la Cosa Nostra, and he was widely known for his studies in organized crime. Cressey first gained notoriety in this field while completing his PhD dissertation on embezzlers, while at Indiana University. Cressey interviewed nearly 200 incarcerated individuals charged with embezzlement. From his research, Cressey developed “The Fraud Triangle.”
The Fraud Triangle states that there are three factors that must be present for fraud to occur: pressure, opportunity and rationalization. Employees faced with immediate financial needs may feel pressure to relieve the financial burdens facing them. This financial need is often secret and employees feel anxiety to solve their problems quickly and quietly.
Once in this perceived dire situation, employees may then identify an opportunity to commit a fraud without the fear of being caught at their place of employment. Employees may rationalize that the motivation for committing a fraud is that their needs outweigh the cost to the employer or they are entitled to take assets due to a perceived unjust treatment. Frauds often spiral out of control as the need to conceal the crime grows.
Skills Needed and Industries Served by Forensic Accountants
Forensic accountants, or fraud examiners, have a unique skill set that enables them to do the type of work they do. These individuals oftentimes have credentials, such as CPA, Certified Fraud Examiner or Certified in Financial Forensics, that help them obtain and hone the skills they need to do this type of work.
Professional skepticism is one of these traits. Fraud examiners must be able to identify the financial issues in question. If cash is disappearing, the examiner must be able to identify potential fraud schemes that may be occurring within the organization to determine the proper investigative techniques to be used. An examiner must have knowledge of investigation techniques and methods of discovery.
In an investigation, many types of documents are needed and an examiner must be able to identify what should be requested and from whom. Also, during investigations, it is helpful to interview those who have knowledge of the issues at hand. An examiner must be skilled in interview techniques to gain the trust of interviewees and to learn as much information as possible.
In most circumstances, a forensic accountant’s work will be used in court, so a forensic accountant must have an understanding of the rules of evidence. When evidence is received, it is important to maintain a proper chain of custody, and to obtain the evidence from the proper channels in order to maintain confidentiality.
A fraud examiner must also be able to interpret the financial information they receive. Documents from general ledgers, invoices and even third parties must be analyzed to determine their relevance and significance. Once an investigation has been completed, the work is not useful to the client if the forensic accountant cannot clearly present his or her findings. Reports must be written describing to the client the documents reviewed, steps taken during the investigation, and what the findings were. These reports are often submitted to judges, opposing counsel, and opposing experts, and must clearly and persuasively present the facts. The culmination of a forensic accountant’s role in an investigation is serving as an expert witness and providing testimony at trial. The forensic accountant must state the facts of the investigation in an understandable way to the judge, jury and opposing counsel.
The work of forensic accountants is widely varied, as is their client base. Forensic accountants are engaged to trace assets such as cash or real estate, or they may be engaged in the identification of undisclosed assets. They may work on receivership cases or bankruptcies. Oftentimes forensic accountants are brought in to calculate damages for lawsuits or to value a business under dispute in a divorce proceeding. They may investigate suspected fraudulent activity, or participate in implementing fraud prevention methods at a business.
Forensic accountants are often hired by litigators, but they are also hired by companies and individuals. During investigations, forensic accountants have the opportunity to work with people in a range of fields, including tax accountants, auditors and economists.
In some investigations, forensic accountants may work side-by-side with law enforcement and government agencies to achieve an end goal, whether that is to complete an investigation or to gather information to present to a grand jury.
Examples of Investigations
The following are examples of some cases investigated that demonstrate the skills needed and the types of industries with which forensic accountants work.
A large nongovernmental organization received a whistleblower letter regarding its CEO’s involvement in potential fraudulent activity. Because allegations against the CEO could have disastrous effects on donations received by the NGO, it decided to hire a forensic accountant to verify the merit of the accusations. As the forensic accountants, we interviewed members of the audit committee, the CFO, and individuals who worked closely with the CEO. We gathered and analyzed documents from the company as well as publicly available information.
Upon review of corporate credit card statements, we observed potential abuse of the corporate account by the CEO, including personal vacations, meals and entertainment. We noted there were no controls over the spending of the CEO and no one reviewed the CEO’s credit card statements. Upon further research it was discovered that unbeknownst to the audit committee, the CEO was receiving a salary from an associated NGO for unnamed services.
Our investigation into spending of the NGO, as approved by the CEO, also reflected a series of contracts entered into with friends and associates who provided services to the NGO for inflated prices. Our analysis brought to light these serious issues and allowed the audit committee to assess and handle the situation. Our analysis also demonstrated how the lack of internal controls had enabled the CEO to take advantage of the NGO.
In another case, in the spring of 2005, an entrepreneur in the business of buying and flipping foreclosure properties filed for Chapter 11 bankruptcy protection. By order of the Bankruptcy Court, in the late summer of 2005, the case was converted to a Chapter 7 bankruptcy and a trustee was appointed to administer the estate. We were hired to assist the trustee in locating the assets of the estate, as insignificant assets were declared in the debtor’s bankruptcy filings.
During our investigation, we prepared subpoenas for numerous companies, including banks, substitute trustees, auction houses, title companies and mortgage companies. Through our research we uncovered a scheme in which the debtor engaged in purchasing and flipping properties that he bought at foreclosure auctions in an attempt to hide the true nature of the transactions. We identified over 250 fictitious entities used to purchase properties and ultimately obfuscate assets from the trustee. Profits from the sale of the properties were concealed under the guise of substitute purchasers and also through hundreds of fictitious bank, brokerage and other accounts. We continue to assist the trustee in documenting to the Bankruptcy Court those sham entities in which properties were purchased nominally in alter egos intended to conceal the true ownership of the property. To date, we have assisted the trustee in recovering in excess of over $10 million in property and cash.
Marion Hecht, CPA, CFE, CIRA, CFF, MBA, is managing director, and MaryEllen Redmond, CPA, CFE, is a manager, with Goodman & Company and operate out of the firm’s Washington, D.C., office in its Goodman Solutions, LLC-Forensic, Litigation & Valuation division. They and the forensic team are frequently asked to investigate, document and testify regarding allegations of employee and financial statement fraud, misappropriation of assets, piercing the corporate veil, professional negligence and assisting attorneys with commercial litigation, divorce, and bankruptcy matters. For more information on Goodman & Company or Goodman Solutions, visit www.goodmanco.com.
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