Forensic Accounting and Fraud Investigation 3rd Edition Howard Silverstone Michael Sheetz Stephen Pedneault Frank Rudewicz CPE Edition Distributed by The CPE Store www.cpestore.com 1-800-910-2755 Forensic Accounting and Fraud Investigation CPE Edition Stephen Pedneault Frank Rudewicz Michael Sheetz Howard Silverstone Copyright © 2012 by John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher. CPE Edition published by The CPE Store, Inc., www.cpestore.com, 1-800-910-2755. Reprinted with permission from John Wiley & Sons, Inc. 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Printed in the United States of America Course Information Course Title: Forensic Accounting and Fraud Investigation Learning Objectives:  Recognize the definition of forensic accounting  Pinpoint the term that became commonplace after financial statement fraud schemes occurred in the early part of this century  Identify what bankruptcy fraud is  Determine what damages are a key component of  Recognize the definition of occupational fraud  Determine the number of accounting cycles which are common within any business  Recognize what white collar fraud involves  Pinpoint the accounting cycle where kickbacks to customers may take place  Ascertain when the Sarbanes-Oxley Act was passed  Determine when a forensic investigation may be undertaken  Identify the two primary bases of accounting  Discern which financial statement conveys the financial position of a business at one point in time  Identify the three main types of entities  Discern which type of entity is most easily started and administered  Recognize the term which refers to entities whose legal authority allows them to exist in a host country  Pinpoint the factor which is key to a financial crime scheme  Recognize the three main measures of financial analysis  Ascertain the standard measure of an entity’s financial health  Recognize what makes a good financial investigator  Discern how responsibilities are defined within a company  Pinpoint the most common targets of fraud  Recognize how businesses can be victims of fraud  Pinpoint the account that all accounting cycles pass through  Identify one of the fastest growing crimes  Recognize what the Tammany Society was  Identify the criminal organization that is responsible for nearly $500 million per year in crime  Recognize the process by which criminal enterprises convert dirty money into legitimate- appearing income  Identify the three stages of money laundering  Recognize the two general categories for investigation of financial crimes  Identify the basis for most fraud investigations  Pinpoint the characteristics that help predict how successful an investigation will be  Identify the two types of solvability factors  Recognize the parts of an investigative plan  Determine what term is used for a conversation with a purpose  Identify how interviews are traditionally categorized  Recognize one of the most promising advances in the interview area  Discern the two categories of evidence  Recognize the term which means that all evidence submitted to prove a claim must be the original  Identify the key to any document organization system  Pinpoint the item which is built in chains and must lead logically from point A to point B  Recognize the type of evidence that proves or disproves an issue in contention  Determine what a two-dimensional representation of a three-dimensional relationship among objects is known as  Identify the basic symbols of a link diagram  Recognize what edges in a diagram represent  Identify the concept which is used to assess the overall strength of a network  Recognize a type of graphic representations of an inferential relationships  Identify the term which is used to differentiate between heterogeneous and homogenous evidence  Pinpoint the term used for evidence that indirectly proves the facts in question  Discern which term is used for the list or database that contains a numerically indexed list of propositions and evidence  Recognize what a casebook is  Identify the different sections of a casebook  Pinpoint the two schools of thought regarding report writing  Recognize what the lawyer’s ultimate job is, from a litigation perspective  Discern the position from which a professional witness testifies  Identify the two roles that financial experts play in the litigation process Subject Area: Accounting Prerequisites: None Program Level: Overview Program Content: Forensic Accounting and Fraud Investigation provides an up-to-date resource for detecting, preventing, and successfully prosecuting financial fraud. It addresses all phases of forensic accounting, complete with actual examples demonstrating application in the real world. It provides non- experts with access to all the critical accounting principles and investigative techniques that help protect any organization from fraud, including insightful advice on where an organization is most susceptible to fraud and how to implement effective investigation processes when fraud is suspected. Advance Preparation: None Recommended CPE Credit: 20 hours Table of Contents Preface ................................................................................................................................................... v Chapter 1 – Forensic Accounting ......................................................................................................... 1 Learning Objectives ............................................................................................................................. 1 What Is Forensic Accounting................................................................................................................ 1 Why Has Forensic Accounting Become the Buzz? ............................................................................... 2 Introduction to a Profession ................................................................................................................. 3 Applications for Forensic Accounting.................................................................................................... 3 A Third Dimension: Contexts within Each Area of Specialization .......................................................... 6 Conclusion........................................................................................................................................... 8 Suggested Readings ........................................................................................................................... 9 Review Questions .............................................................................................................................. 10 Review Answers ................................................................................................................................ 11 Chapter 2 – Fraud in Society ............................................................................................................... 12 Learning Objectives ........................................................................................................................... 12 What Is Fraud? .................................................................................................................................. 12 Types of Fraud .................................................................................................................................. 15 Other Types of Financial Fraud .......................................................................................................... 17 Sarbanes-Oxley ................................................................................................................................. 18 What the Numbers Tell Us about Fraud ............................................................................................. 19 Categories of Occupational Fraud ...................................................................................................... 20 Drawing Conclusions ......................................................................................................................... 21 Society’s Perception of Fraud ............................................................................................................ 22 Who Commits Fraud?—Profile of the Typical Fraudster ..................................................................... 23 The Social Consequences of Economic Crime ................................................................................... 27 Conclusion......................................................................................................................................... 27 Suggested Readings ......................................................................................................................... 27 Review Questions .............................................................................................................................. 28 Review Answers ................................................................................................................................ 30 Chapter 3 – Understanding the Basics of Financial Accounting....................................................... 32 Learning Objectives ........................................................................................................................... 32 Where It All Begins ............................................................................................................................ 32 The Five Accounting Cycles ............................................................................................................... 34 Journals: Subsidiary and General ...................................................................................................... 39 Conclusion......................................................................................................................................... 40 Suggested Readings ......................................................................................................................... 40 Review Questions .............................................................................................................................. 41 Review Answers ................................................................................................................................ 42 Chapter 4 – Forms of Entities ............................................................................................................. 44 Learning Objectives ........................................................................................................................... 44 Basics of Business Structures ............................................................................................................ 44 Sole Proprietorships .......................................................................................................................... 44 Partnerships ...................................................................................................................................... 45 Corporations ...................................................................................................................................... 47 Business Enterprises in the Global Environment ................................................................................ 48 Conclusion......................................................................................................................................... 51 Suggested Readings ......................................................................................................................... 51 Review Questions .............................................................................................................................. 53 Review Answers ................................................................................................................................ 54 Table of Contents Chapter 5 – Fundamental Principles of Financial Analysis ............................................................... 55 Learning Objectives ........................................................................................................................... 55 Good Analysis = Due Diligence? ........................................................................................................ 55 Why Perform Financial Analysis? ....................................................................................................... 57 What and Whom Can You Trust?....................................................................................................... 57 Other Factors to Consider .................................................................................................................. 57 Financial Analysis for the Non-Expert ................................................................................................. 58 To the Future ..................................................................................................................................... 63 Conclusion......................................................................................................................................... 64 Suggested Readings ......................................................................................................................... 64 Review Questions .............................................................................................................................. 65 Review Answers ................................................................................................................................ 66 Chapter 6 – The Role of the Accounting Professional ....................................................................... 68 Learning Objectives ........................................................................................................................... 68 The Importance of Accounting Professionals in the Investigation ........................................................ 68 The Audit Process ............................................................................................................................. 71 Internal Controls ................................................................................................................................ 74 Conclusion......................................................................................................................................... 75 Review Questions .............................................................................................................................. 77 Review Answers ................................................................................................................................ 79 Chapter 7 – Business as a Victim ....................................................................................................... 81 Learning Objectives ........................................................................................................................... 81 Introduction........................................................................................................................................ 81 Employee Thefts ................................................................................................................................ 81 Fraudulent Billing Schemes ............................................................................................................... 86 Fraud Committed by Outsiders .......................................................................................................... 86 Management Thefts ........................................................................................................................... 87 Corporate Thefts ................................................................................................................................ 89 Identity Theft ...................................................................................................................................... 90 Conclusion......................................................................................................................................... 91 Suggested Readings ......................................................................................................................... 92 Review Questions .............................................................................................................................. 93 Review Answers ................................................................................................................................ 94 Chapter 8 – Business Villains ............................................................................................................. 96 Learning Objectives ........................................................................................................................... 96 Introduction........................................................................................................................................ 96 Organized Crime and Business .......................................................................................................... 96 Money Laundering ........................................................................................................................... 102 Conclusion....................................................................................................................................... 106 Suggested Readings ....................................................................................................................... 107 Review Questions ............................................................................................................................ 109 Review Answers .............................................................................................................................. 110 Chapter 9 – The Investigative Process ............................................................................................. 112 Learning Objectives ......................................................................................................................... 112 Introduction...................................................................................................................................... 112 Case Initiation .................................................................................................................................. 112 Case Evaluation .............................................................................................................................. 113 Solvability Factors............................................................................................................................ 114 Goal Setting and Planning ............................................................................................................... 115 ii Table of Contents Investigation .................................................................................................................................... 121 Background ..................................................................................................................................... 121 Conclusion....................................................................................................................................... 127 Suggested Readings ....................................................................................................................... 127 Review Questions ............................................................................................................................ 128 Review Answers .............................................................................................................................. 130 Chapter 10 – Interviewing Financially Sophisticated Witnesses ..................................................... 132 Learning Objectives ......................................................................................................................... 132 Introduction...................................................................................................................................... 132 The Interview ................................................................................................................................... 132 Interviewing Financially Sophisticated Witnesses ............................................................................. 143 Conclusion....................................................................................................................................... 145 Suggested Readings ....................................................................................................................... 146 Review Questions ............................................................................................................................ 147 Review Answers .............................................................................................................................. 148 Chapter 11 – Proving Cases through Documentary Evidence ........................................................ 150 Learning Objectives ......................................................................................................................... 150 Introduction...................................................................................................................................... 150 Document Collection ........................................................................................................................ 151 Document Organization ................................................................................................................... 160 The Process of Proof ....................................................................................................................... 163 The Logic of Argument ..................................................................................................................... 164 Proof through Inference ................................................................................................................... 167 Conclusion....................................................................................................................................... 170 Suggested Readings ....................................................................................................................... 170 Review Questions ............................................................................................................................ 173 Review Answers .............................................................................................................................. 175 Chapter 12 – Analysis Tools for Investigators ................................................................................. 177 Learning Objectives ......................................................................................................................... 177 Introduction...................................................................................................................................... 177 Why Use Analysis Tools at All? ........................................................................................................ 177 Associational Analysis ..................................................................................................................... 178 Temporal Analysis ........................................................................................................................... 192 Conclusion....................................................................................................................................... 196 Suggested Readings ....................................................................................................................... 197 Review Questions ............................................................................................................................ 198 Review Answers .............................................................................................................................. 199 Chapter 13 – Inferential Analysis ...................................................................................................... 201 Learning Objectives ......................................................................................................................... 201 Introduction...................................................................................................................................... 201 How Inferential Analysis Helps ......................................................................................................... 201 What Is an Inference Network? ........................................................................................................ 202 Investigative Inference Analysis ....................................................................................................... 204 The Key List .................................................................................................................................... 208 Constructing an Investigative Inference Chart .................................................................................. 208 Plotting the Chart ............................................................................................................................. 211 Some Tips for Charting Success ...................................................................................................... 214 Applying the Chart to the Investigative Process ................................................................................ 214 Conclusion....................................................................................................................................... 215 Suggested Readings ....................................................................................................................... 216 iii Table of Contents Review Questions ............................................................................................................................ 218 Review Answers .............................................................................................................................. 219 Chapter 14 – Documenting and Presenting the Case ...................................................................... 221 Learning Objectives ......................................................................................................................... 221 Introduction...................................................................................................................................... 221 Creating a System ........................................................................................................................... 221 The Casebook System ..................................................................................................................... 221 Report Writing.................................................................................................................................. 226 Testifying as a Financial Expert ....................................................................................................... 228 Conclusion....................................................................................................................................... 238 Suggested Readings ....................................................................................................................... 238 Review Questions ............................................................................................................................ 240 About the Authors ............................................................................................................................. 242 Glossary ............................................................................................................................................. 243 Index .................................................................................................................................................. 245 iv Preface The demand for forensic accounting continues to grow almost on a daily basis. Account- ing and business publications alike predict the trend requiring more forensic accountants will only continue. Forensic accounting has been described on many campuses and with- in many public accounting firms’ recruiting offices as the hottest area of accounting sought by candidates eager to enter the field of accounting. In response, colleges and uni- versities have been feverishly adding courses and degree programs at the certificate, un- dergraduate, and graduate levels, trying to address the demands of students anxious to learn more about this field. Simultaneously, more and more instances of financial crime and accounting- related litigation have been occurring, expanding both the contexts and the venues in which the skill set of a forensic accountant or fraud investigator can prove invaluable to- ward resolving the matter. While most people may possess a basic understanding of what traditional ac- counting may entail, few have any understanding about forensic accounting and fraud in- vestigation. Financial and nonfinancial people alike have an interest in learning more about these highly specialized fields of accounting, as cases of corporate or individual greed regularly dominate the media. Having a requisite background in accounting would be required for most of the books and materials available for these topics, many of which are excellent resources to those of us practicing in these fields. Forensic Accounting and Fraud Investigation for Non-Experts, Third Edition, was written with the non-accountant in mind, aimed to demystify what often is character- ized as complicated. The reality is most fraud and financial crime that occurs is not over- ly complicated, just made to appear that way either for concealment purposes or as a means of defense for the suspect or suspects when it ultimately is uncovered. The best fo- rensic accountants and fraud investigators are those individuals who can take what could be presented as complicated and explain it to a jury comprising non–financial experts in terms they can understand and comprehend. A goal in writing this book is to bridge the gap for those individuals who want to understand the process of forensic accounting and fraud investigation, yet do not possess any knowledge or experience in accounting. v