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CHAPTER 7: CONDUCTING A FRAUD INVESTIGATION

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Learning Objectives

Evaluate the reasonableness of a suspicion of fraud
Create a preliminary fraud hypothesis
Test and refine the fraud hypothesis through financial statements analysis and journal entry testing
Test and refine the fraud hypothesis by conducting interviews
Identify specific schemes used to perpetrate the fraudulent activity

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Learning Objectives

Determine the economic loss resulting from the fraudulent activity
In response to a finding of fraud, identify potential recommendations for resolution

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Fraud Investigation: Introduction

Objective is to gather evidence of a suspected fraud
Forensic accountants might be engaged as:

Agent of law enforcement
Member of an audit team
Private accountant engaged by victim or victim’s counsel
Private accountant engaged by accused or accused’s counsel

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Cautions and Reminders

In conducting a fraud investigation, the following cautions and reminders are presented:

Every fraud investigation is unique
Has its own cast of characters, facts, and circumstances
Fraud investigations are initiated after the fact (that is, in response to an allegation or suspicion of fraud)
Once an allegation of fraud is received or a suspicion identified, the company (the victim) is faced with the decision of whether to pursue an investigation
Another necessary decision is who should conduct the investigation—in-house personnel, law enforcement, an external audit team, or a private outside firm

The purpose of this chapter is to employ the many concepts, tools, and techniques to the challenge of conducting a fraud investigation.
In preparation for this challenge, the following cautions and reminders are presented:

Every fraud investigation is unique and has its own cast of characters, facts, and circumstances.
Fraud investigations are initiated after the fact—that is, in response to an allegation or suspicion of fraud. In other words, once an allegation of fraud is received or a suspicion identified, the company (that is, the victim) is faced with the decision of whether to pursue an investigation. Another necessary decision is who should conduct the investigation—in-house personnel, law enforcement, an external audit team, or a private outside firm.
Although the initial suspicion of fraud might help frame your case and develop your working hypothesis, it is imperative to remain objective. Forensic accountants should operate in a state of disbelief or suspended belief, where information and representations are evaluated in a rational, curious, objective, and systematic manner.
The scientific process is the most effective and efficient approach to conducting a fraud investigation. Remember, a hypothesis is not a statement of fact; it is simply a tentative explanation based on preliminary observations or suspicions that must be tested. Without a working hypothesis, a fraud investigation is only random data collection.
Evidence is something that tends to prove or disprove the existence of an alleged fact. Forensic accountants gather and analyze both documentary evidence, such as financial data and other business records, and interactive evidence, such as interviews and observations.

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Cautions and Reminders

Forensic accountants should operate in a state of disbelief or suspended belief, where information and representations are evaluated in a rational, curious, and objective
The scientific process is most effective and efficient approach to conducting a fraud investigation
Remember, a hypothesis is not a statement of fact; it is simply a tentative (uncertain ) explanation based on preliminary observations or suspicions that must be tested

The purpose of this chapter is to employ the many concepts, tools, and techniques to the challenge of conducting a fraud investigation.
In preparation for this challenge, the following cautions and reminders are presented:

Every fraud investigation is unique and has its own cast of characters, facts, and circumstances.
Fraud investigations are initiated after the fact—that is, in response to an allegation or suspicion of fraud. In other words, once an allegation of fraud is received or a suspicion identified, the company (that is, the victim) is faced with the decision of whether to pursue an investigation. Another necessary decision is who should conduct the investigation—in-house personnel, law enforcement, an external audit team, or a private outside firm.
Although the initial suspicion of fraud might help frame your case and develop your working hypothesis, it is imperative to remain objective. Forensic accountants should operate in a state of disbelief or suspended belief, where information and representations are evaluated in a rational, curious, objective, and systematic manner.
The scientific process is the most effective and efficient approach to conducting a fraud investigation. Remember, a hypothesis is not a statement of fact; it is simply a tentative explanation based on preliminary observations or suspicions that must be tested. Without a working hypothesis, a fraud investigation is only random data collection.
Evidence is something that tends to prove or disprove the existence of an alleged fact. Forensic accountants gather and analyze both documentary evidence, such as financial data and other business records, and interactive evidence, such as interviews and observations.

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Cautions and Reminders

Evidence is something that tends to prove or disprove the existence of an alleged fact
Forensic accountants gather and analyze both documentary evidence, such as financial data and other business records, and interactive evidence, such as interviews and observations.

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Cautions and Reminders

One of the most valuable evidence-gathering techniques forensic accountants use is financial statements analysis
Interview: Another widely used investigation tool, which has two primary advantages:
It is a direct means of obtaining evidence
It provides immediate results.
Fraud is a crime of intent, absent an admission
circumstantial evidence is used to establish or infer fraudulent intent

One of the most valuable evidence-gathering techniques forensic accountants use is financial statements analysis. Financial statements rarely reflect economic reality and often conceal more than they reveal.
Another widely used investigation tool is the interview, which has two primary advantages: It is a direct means of obtaining evidence, and it provides immediate results. Interviewing is much more than just asking questions. It is a systematic process that requires planning, staging, execution, and active listening.
Fraud is a crime of intent. Absent an admission, circumstantial evidence is used to establish or infer fraudulent intent. The reliability of circumstantial evidence for the purpose of establishing intent depends on two key factors: alternative explanations and degree of impact. Because the results of your investigation cannot provide certainty, you should avoid conclusions of guilt or innocence.
Cressey’s fraud triangle suggests that fraud results from the convergence of three conditions: need (pressure), opportunity, and rationalization. Research has identified many red flags, or indicators of fraud, that support Cressey’s framework. Identifying red flags helps to evaluate the reasonableness of suspicions and allegations of fraud.
Fraud is not an accounting problem—it is a social phenomenon. Forensic accounting is rooted in law and economics, not psychology or criminology. Thus, our interest in “why” people commit fraud, especially when conducting a fraud investigation, is explanatory (cause and effect), not predictive. Applying traditional economic theory, we propose that people commit fraud when the perceived reward ($) is greater than the probable loss—the calculus of fraud. Because fraud investigators are called in after a suspicion of fraud has been identified, the focus is who, when, how, and how much—not why.

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Cautions and Reminders

Cressey’s fraud triangle suggests that fraud results from convergence of three conditions:

Need (pressure)
Opportunity
Rationalization

Fraud is not an accounting problem—it is a social phenomenon
Fraud investigators are called in after a suspicion of fraud has been identified, the focus is who, when, how, and how much—not why

Another widely used investigation tool is the interview, which has two primary advantages: It is a direct means of obtaining evidence, and it provides immediate results. Interviewing is much more than just asking questions. It is a systematic process that requires planning, staging, execution, and active listening.
Fraud is a crime of intent. Absent an admission, circumstantial evidence is used to establish or infer fraudulent intent. The reliability of circumstantial evidence for the purpose of establishing intent depends on two key factors: alternative explanations and degree of impact. Because the results of your investigation cannot provide certainty, you should avoid conclusions of guilt or innocence.
Cressey’s fraud triangle suggests that fraud results from the convergence of three conditions: need (pressure), opportunity, and rationalization. Research has identified many red flags, or indicators of fraud, that support Cressey’s framework. Identifying red flags helps to evaluate the reasonableness of suspicions and allegations of fraud.
Fraud is not an accounting problem—it is a social phenomenon. Forensic accounting is rooted in law and economics, not psychology or criminology. Thus, our interest in “why” people commit fraud, especially when conducting a fraud investigation, is explanatory (cause and effect), not predictive. Applying traditional economic theory, we propose that people commit fraud when the perceived reward ($) is greater than the probable loss—the calculus of fraud. Because fraud investigators are called in after a suspicion of fraud has been identified, the focus is who, when, how, and how much—not why.

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Mountain State Sporting Goods: A Case of Fraud

On March 18, 2009, Mountain State Sporting Goods, Inc., held its annual meeting of directors and shareholders
The company’s general manager Thomas Workman and CPA Charles Hess presented the company’s financial report and responded to questions regarding the company’s failure to meet projections and its current financial instability
Other issues for discussion included a request by the general manager to increase the company’s line of credit and enhance employee benefits

On March 18, 2009, Mountain State Sporting Goods, Inc., held its annual meeting of directors and shareholders.
The company’s general manager Thomas Workman and CPA Charles Hess presented the company’s financial report and responded to questions regarding the company’s failure to meet projections and its current financial instability.
Other issues for discussion included a request by the general manager to increase the company’s line of credit and enhance employee benefits.
Immediately following the annual meeting, the company’s two shareholders, brothers Robert and Nathaniel Smith, contacted attorney Dwane Peoples, a former federal prosecutor, to discuss their suspicions of fraudulent activity within the company.
The shareholders’ suspicions were sparked by observations of the general manager’s lavish lifestyle.

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Mountain State Sporting Goods: A Case of Fraud

Immediately following the annual meeting, the company’s two shareholders, brothers Robert and Nathaniel Smith, contacted attorney Dwane Peoples, a former federal prosecutor, to discuss their suspicions of fraudulent activity within the company
The shareholders’ suspicions were sparked by observations of the general manager’s lavish lifestyle

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Organization and Ownership

Background information

Mountain State Sporting Goods is a Kentucky corporation organized by J.D. Smith in 1993
Following J.D.’s death on December 15, 2006, day-to-day management was assigned (via an employment contract, effective January 1, 2007) to Thomas A. Workman, a long-term employee and assistant manager under J.D

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Organization and Ownership

Ownership of the company’s stock was inherited equally (50/50) by J.D.’s two children—Robert and Nathaniel, both full-time college students (ages 18 and 19, respectively)
Pursuant to the terms of his employment contract with the company, Workman is required to facilitate the preparation of annual (audited) financial reports with supporting schedules and footnotes.

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Table 7-1—Gross Revenues: Projected Versus Actual

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Table 7-2—Product Categories

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Table 7-3—Pawn Items

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Management

The company was co-managed by Sue Bryant and Workman following J.D.’s death (December 15, 2006) until her retirement on January 6, 2007. Since that time, the company has been managed by Workman pursuant to the terms of his employment contract
Robert and Nathaniel do not actively participate in management but attend annual BOD meetings to review financial reports, which are prepared and presented by the company’s auditor, Charles Hess, CPA

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Compensation

Officers’ Compensation

Workman’s compensation determined by his employment contract

Base salary of $50,000 plus 1% of all sales exceeding projections
To date, company has failed to meet projections

Key Employees, Compensation, and Benefits

Average of eight employees

Including Workman’s spouse, Anita, and his 17-year-old daughter, Mia
Anita and Mia share in-house accounting duties and responsibilities
Before J.D.’s death, these duties were performed by Sue Bryant, who retired shortly thereafter

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Significant Accounting Policies

Accrual method of accounting
Following J.D.’s death, in December 2006,the company abandoned perpetual system and converted to periodic inventory method
Current practice was to conduct physical inventory at the end of each year, adjusting cost of goods sold and ending inventory accordingly
Moreover, company's auditor did not object and, in fact, encouraged the change

Significant Accounting Policies followed by Mountain State Sporting Goods

Method of accounting

The company employs the accrual method of accounting. Under the accrual method, income is accounted for (recognized) when earned. It is not the actual receipt, but rather the right to receive, that governs. Expenses are recognized as incurred—that is, when all events have occurred that fix the amount of the item and determine the liability to pay.
As explained by Hess, the IRS requires taxpayers that maintain inventories to employ the accrual method of accounting.

Inventory accounting

Inventory is usually the largest current asset of a business, and its proper measurement is necessary to ensure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched. When ending inventory is incorrect, the following balances on the balance sheet are also incorrect as a result: inventory, total assets, and owners’ equity. When ending inventory is incorrect, the cost of merchandise sold and net income on the income statement are also incorrect.
The two most common inventory systems are the periodic and perpetual systems.
Following J.D.’s death in December 2006, the company abandoned its perpetual system and converted to a periodic inventory method. Under this method, a purchases account is used, and the beginning inventory is unchanged during the period (month, quarter, or year).
At the end of an accounting period, the inventory account is adjusted by closing out the beginning inventory and recording the ending inventory, as determined by a physical inventory.
The company’s current practice is to conduct a physical inventory at the end of each year, adjusting cost of goods sold (COGS) and ending inventory accordingly.
As presented by Workman, the perpetual system maintained by J.D. before his death was too complex, too time-consuming, and simply not cost justified. Moreover, the company’s auditor did not object and, in fact, encouraged the change.

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Significant Accounting Policies

Company employed FIFO cost flow assumption to value ending inventory

Physical inventory: All items on premises (or in transit) for which it has legal title
Lower of cost or market method
Accounting Functions
Effective January 1, 2007, all accounting functions and day-to-day accounting activities have been processed by the company’s in-house personnel, Anita and Mia, and supervised by Workman, as the company’s manager
Annual financial reports and related income tax returns are prepared by Hess

Method of Valuing Ending Inventory

The valuation of inventory can be a complex process that requires the determination of:

(a) the physical goods to be included;
(b) the costs to be included;
(c) the cost flow assumption to be adopted (that is, cost or lower of cost or market); and
(d) the accounting cost flow assumption to be adopted (specific identification, LIFO, FIFO, or moving-average).

The company employs the FIFO cost flow assumption.
The company includes in its physical inventory all items on premises (or in transit) for which it has legal title, with the exception of forfeited pawn items.
The company employs the lower of cost or market method in valuing its ending inventory, and items identified as unsellable due to obsolescence or condition are valued at bona fide selling prices, as determined by Workman.

Accounting Functions

Effective January 1, 2007, all accounting functions and day-to-day accounting activities have been processed by the company’s in-house personnel, Anita and Mia, and supervised by Workman, as the company’s manager.
Annual financial reports and related income tax returns are prepared by Hess.

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Phase I of Investigation

Phase I(a): Confirm the reasonableness of the suspicions of fraud

Review case profile presented previously
Identify ten conditions (red flags) that either confirm or fail to confirm the reasonableness of Smith’s suspicions
Employ the fraud triangle

Phase I(b): Create a fraud hypothesis

Hypothesis: An educated guess about how something works or an explanation for an event
Exercise critical thinking and reasoning skills

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The Fraud Triangle

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Phase II(a) of Investigation

Phase II(a): Test hypothesis via financial statements analysis

Examination of financial statements for the purpose of acquiring additional information
This analysis may reveal unexpected relationships or the absence of expected relationships
Use various analytical techniques
Consider the implications of your findings

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Phases II(b) of Investigation

Phase II(b): Test hypothesis via journal entry testing

Can potentially undermine the validity of financial statements and the financial reporting process
Objective is to identify and assess any inappropriate or unusual activity
Important when there is ineffective system of internal controls and management has ability to override the journal entry process
Consider characteristics of fraudulent journal entries

PhaseII(b): Test Your Hypothesis via Journal Entry Testing

Journal entries (JEs) can potentially undermine the validity of financial statements and the financial reporting process.
Thus, the importance of JE testing cannot be overstated.
The objective of this testing is to identify and assess any inappropriate or unusual activity.
This is especially important when, as in this case, there is an ineffective system of internal controls and management has the ability to override the JE process.
As outlined in SAS No. 99, fraudulent JEs have several common characteristics:

JEs made to unrelated, unusual, or seldom-used accounts
JEs recorded at the end of the period or as post-closing entries with little or no explanation
JEs containing round numbers or a consistent ending number
JEs applied to intercompany or related parties

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Phase III of Investigation

Phase III: Refine and confirm hypothesis via interviews

At this stage, you should have:

Developed a working knowledge of the business
Developed a working knowledge of company’s accounting system
Identified any questionable financial statement reporting issues
Identified the key players to be interviewed and the information sought

Follow the interview sequence

Phase III: Refine and Confirm Your Hypothesis via Interviews

An interview is a primary tool used by forensic accountants to gather information and make assessments.
At this phase of your investigation, you should have:

1. Developed a working knowledge of the business (including the pawn shop operation).
2. Developed a working knowledge of the company’s accounting system, especially the internal controls (or lack thereof).
3. Identified any questionable financial statement (tax return) reporting issues (for example, no pawn receivables, no interest expense, and questionable JEs).
4. Identified the key players to be interviewed and the information sought.

Who should be interviewed? In what order? Should the interviews be formal or informal? To assist you in this phase, we propose the following interview sequence:

1. Neutral third parties (Sue Bryant)
2. Corroborative witnesses and possible co-conspirators (Anita Workman)
3. Suspected co-conspirators (Charles Hess)
4. Target (Thomas Workman)

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Phase IV of Investigation

Phase IV: Draw conclusions and communicate results

Determination of the amount misappropriated
Related discussion of specific schemes employed
Loss components

Specific transactions
Unreported loan interest
Unreported pay with sales

Phase IV: Draw Your Conclusions and Communicate Results

This phase of the engagement requires a determination of the amount “misappropriated” and a related discussion of the specific schemes employed.
To assist you in this phase, we have identified four different loss components:

Specific transactions
Unreported pawn loan interest
Unreported forfeited pawn sales
Statutory interest at 7.5%

A scheme is “an artful plot or plan, usually to deceive others.”
Specific Transactions

Specific transactions can be been identified in the JEs and confirmed in the interviews.

Unreported Pawn Loan Interest and Unreported Forfeited Pawn Sales

Given that J.D. died on December 15, 2006, your challenge is to compute unreported pawn loan interest and forfeited pawn sales for years 2007 and 2008 only.

Calculation of Statutory Interest

Statutory interest is a rate of interest, prescribed by the applicable state (or federal) statute, that is applied to a determined amount of economic loss. For the purpose of your loss calculation, the statutory interest (7.5%) is determined at the end of each year using simple interest.

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Common Fraud Schemes

Skimming : Stealing cash revenue “off the top,” before it is recorded in the accounting system
Cash larceny: Stealing cash revenue after it has been recorded in the accounting system
Register disbursement: Making false entries in a cash register to conceal the fraudulent removal of cash
Less cash scheme: Deducting cash from check deposits
False credits / discounts: Using false credits or discounts to disguise theft of revenue

A scheme is “an artful plot or plan, usually to deceive others.” Examples of fraud schemes experienced in small organizations (such as Mountain State Sporting Goods) are identified as below.

Skimming: Stealing cash revenue “off the top,” before it is recorded in the accounting system
Cash larceny: Stealing cash revenue after it has been recorded in the accounting system
Register disbursement: Making false entries in a cash register to conceal the fraudulent removal of cash
Less cash scheme: Deducting cash from check deposits
False credits / discounts: Using false credits or discounts to disguise theft of revenue
Diversion of loan proceeds: Diverting proceeds of business loans for personal use
False entries: Falsification of financial information, including false accounting entries and fictitious transactions designed to overstate revenues or understate losses
Unauthorized disbursements: Disbursement of company funds through some trick or device for an unauthorized purpose
Billing scheme: Type of unauthorized disbursement scheme in which a perpetrator submits invoices for fictitious goods and services, inflated invoices, or invoices for personal expenses
Check tampering: Type of unauthorized disbursement scheme in which a perpetrator forges, steals, or alters a company check

Other common fraud schemes includes:

Payroll fraud: Type of unauthorized disbursement scheme that involves falsification of payroll records; examples include altering employee time cards and making payments to fictitious (or “ghost”) employees

Expense reimbursements: A claim by an employee for reimbursement of fictitious or inflated business expenses

Kickback: Payment back by a seller of a portion of the purchase price to a buyer to induce purchase or influence future purchases

Swap transaction: A scheme in which two conspiring companies exchange payments and services for the sole purpose of inflating revenues

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Common Fraud Schemes

Diversion of loan proceeds: Diverting proceeds of business loans for personal use
False entries: Falsification of financial information, including false accounting entries and fictitious transactions designed to overstate revenues or understate losses
Unauthorized disbursements: Disbursement of company funds through some trick or device for an unauthorized purpose

A scheme is “an artful plot or plan, usually to deceive others.” Examples of fraud schemes experienced in small organizations (such as Mountain State Sporting Goods) are identified as below.

Skimming: Stealing cash revenue “off the top,” before it is recorded in the accounting system
Cash larceny: Stealing cash revenue after it has been recorded in the accounting system
Register disbursement: Making false entries in a cash register to conceal the fraudulent removal of cash
Less cash scheme: Deducting cash from check deposits
False credits / discounts: Using false credits or discounts to disguise theft of revenue
Diversion of loan proceeds: Diverting proceeds of business loans for personal use
False entries: Falsification of financial information, including false accounting entries and fictitious transactions designed to overstate revenues or understate losses
Unauthorized disbursements: Disbursement of company funds through some trick or device for an unauthorized purpose
Billing scheme: Type of unauthorized disbursement scheme in which a perpetrator submits invoices for fictitious goods and services, inflated invoices, or invoices for personal expenses
Check tampering: Type of unauthorized disbursement scheme in which a perpetrator forges, steals, or alters a company check

Other common fraud schemes includes:

Payroll fraud: Type of unauthorized disbursement scheme that involves falsification of payroll records; examples include altering employee time cards and making payments to fictitious (or “ghost”) employees

Expense reimbursements: A claim by an employee for reimbursement of fictitious or inflated business expenses

Kickback: Payment back by a seller of a portion of the purchase price to a buyer to induce purchase or influence future purchases

Swap transaction: A scheme in which two conspiring companies exchange payments and services for the sole purpose of inflating revenues

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Common Fraud Schemes

Billing scheme: Type of unauthorized disbursement scheme in which a perpetrator submits invoices for fictitious goods and services, inflated invoices, or invoices for personal expenses
Check tampering: Type of unauthorized disbursement scheme in which a perpetrator forges, steals, or alters a company check
Others: Payment back by a seller of a portion of the purchase price to a buyer to induce purchase or influence future purchases

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Phase V of Investigation

Phase V: Present a discussion of Mr. Hess’s roles, duties, and responsibilities

Evidences indicate that Mr. Hess may be a co-conspirator and may have violated the AICPA’s ethical and professional standards in his service
Consider the following questions as a starting point:

Was Mr. Hess independent with respect to the 2009 meeting with the BOD?
Did Mr. Hess meet the following requirements:

Professional competence
Due professional care
Planning and supervision

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Phase VI of Investigation

Phase VI: Present recommendations for resolution and remediation

Present your recommendations for resolution and remediation
Consider the following
Time (it takes hours or days versus years)
Cost (hundreds of dollars versus thousands of dollars
Flexibility (complete versus limited)
Privacy (total versus public)
Formality (low versus high)
Enforceability (high versus cannot be appealed)

Phase VI: Present Recommendations for Resolution and Remediation

Assuming that fraudulent activity has been identified, present your recommendations for resolution and remediation. Your discussion should consider the following:

How strong is the evidence?
Have any alternative explanations been identified?
Should a criminal complaint be filed? If so, against whom?
Should a civil complaint be filed? If so, against whom?
Should alternative dispute resolution (ADR) be considered?

Alternative dispute resolution (ADR) is an alternative to litigation for resolving disputes.

ADR strategies generally include mediation, arbitration, or some combination of the two.

Mediation is a confidential and nonbinding structured process. It is generally facilitated by an independent third party (for example, a retired judge), who facilitates the exchange of positions and encourages the identification of common ground.

A successful mediation results in a mutually satisfactory resolution.
Compared to litigation and arbitration, mediation is generally less expensive and time-consuming.

Arbitration is a binding process, where both sides present evidence and argue their respective positions to an arbitration panel, which usually includes at least one lawyer.

This forum is considerably less formal than a trial and is generally focused on fact finding.

The advantages of ADR versus litigation can be summarized as follows:

Time (it takes hours or days versus years)
Cost (hundreds of dollars versus thousands of dollars)
Flexibility (complete versus limited)
Privacy (total versus public)
Formality (low versus high)
Enforceability (high versus cannot be appealed)

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