Study Notes Specialization Forensic Accounting MODULE-6 SP-611 ICPAP Institute of Certified Public Accountants of Pakistan Forensic Accounting ICPAP 1. Introduction to Forensic Accounting The History of Forensic Accounting: Fraud has become an industry, not just for the fraudster. Academics study it, investigators investigate it, lawyers litigate on it, and conference-goers debate it. But the industry is built on managing the consequences of fraud rather than on preventing fraud. The investigation of fraud is only one of the services offered by the professional forensic investigator. Equally important is the creation of a culture and environment which is aimed at the prevention of fraud and a response policy which is designed to respond to fraud detection as effectively as possible. According to a report released by Nedcor, crime cost South Africa R31 billion rends in 1994/1995. A large part of this amount can be attributed to white-collar crime. Fraud and its roots - greed and arrogance - are human nature. As business people, we must recognize fraud as a permanent risk, a risk we must take action to manage. Fraud is theft. It hits an enterprise in the pocket and has a direct effect on the bottom line. Despite the fact that statistics indicate a dramatic escalation in the incidents of fraud over the past decade, certain company executives still dismiss the suggestion that they may be victim of, or exposed to the risk of fraud. The extent of fraud and white-collar crime resulted in the formation of various specialized units in law-enforcement agencies. It also resulted in a major demand for accountants in the fields of forensic accounting as such crimes can only be proved with forensic reports and testimony by experts The outcome of fraud investigations may be critical to the survival of the business. Even the smallest engagement ay has serious consequences for individuals, innocent or guilty. It is accordingly vital that the appropriate experience is brought to bear. A specialist forensic accountant must always be consulted on potential engagements where fraud is at issue. General type investigation procedures are not adequate to investigate fraud. Different standards of evidence and of control and collection of material apply. There are no small fraud investigation engagements. Seemingly small frauds are frequently the tip of the major iceberg. All engagements must therefore be carried out to the same high professional standards. Fraud investigation work is wide ranging. The same investigation may be covered determining whether fraud has occurred and, if so, the nature of the loss and those responsible; tracing of assets lost and legal action against those responsible to obtain recovery; disciplinary proceedings; civil and criminal litigation. Few clients will have previous experience of fraud investigations and investigations will often be undertaken in an atmosphere of serious concern, and perhaps crisis. Effective assistance will be dependent on the forensic investigator's ability to help the client manage the crisis, shape his expectations and take action quickly and with discretion. It must be recognized that the outcome of investigations may rest not only on the quality of the investigation but on the decisions made by the client, and it is therefore vitally important that the client be accurately and correctly advised at the outset. It is thus of utmost importance that when fraud of any kind is suspected, Page | 1 Forensic Accounting ICPAP a experienced forensic team manage and investigate the matter. This can only benefit the client in the long run. What is Forensic Accounting? Forensic accounting can be defined as assistance in disputes regarding allegations or suspicion of fraud, which are likely to involve litigation, expert determination, and enquiry by an appropriate authority and investigations of suspected fraud, irregularity or impropriety which could potentially lead to civil, criminal or disciplinary proceedings. The focus is primarily on accounting issues, but the role of the forensic accountant may extend to more general investigation which includes evidence gathering. It is because of the fact that by definition, forensic assignments are related to judicial or quasi-judicial dispute resolution, that the forensic investigator requires a basic understanding of the applicable statutory and common law, the law of evidence and the law of procedure. The most competently conducted investigation will be of no value to the client should the evidence gathered be ruled to be inadmissible or the expert accounting witness be found to fall short in respect of the requirements of expertise, credibility, or independence. The Qualities of a Professional Forensic Team: It is essential that a professional forensic team has: • Knowledge of the elements of economic crime; • The ability to collect evidence and to exercise proper control over large volumes of documentary evidence; • The appropriate skills and level of relevant experience; • Investigation background; • the ability to work in a team with instructing attorneys and police and have the ability to co- ordinate, manage and administer the litigation support, assemble the documents, and organize meetings; • Knowledge of legal aspects such as the basic rules of evidence relating to admissibility of evidence and the drawing of inferences; • an understanding of what needs to be proved so that evidence documented in his or her reports, letters and affidavits are compiled in a concise, logical and persuasive manner; • The ability to testify and stand up to cross-examination in a court of law. Where Forensic Accounting can be applied? Forensic Accounting may be conducted into the following : Fraud and white collar crime investigations; Page | 2 Forensic Accounting ICPAP • Criminal and civil investigations; • Preparation of expert reports, reviews and evidence; • giving oral evidence in court; • insolvency and liquidation support investigation; • Fraud prevention and awareness strategies; • Fraud and fund tracing; • Civil and criminal actions regarding fraud and financial irregularities; • Breach of contract; • Breach of warranty, particularly on company acquisitions; • Insurance claims; • Liquidation support; • Regulatory enquiries; • Special and confidential investigations; • Fraud and risk management surveys and reports. A forensic accounting engagement and investigation is typically substantially longer than any other investigation. Continuity of staff on the part of the client is therefore often difficult to maintain. This makes it all the more essential that the forensic accountant conducts his work in a manner which is concise, detailed documented Forensic Accounting as Prevention As regards an appropriate response to fraud which has been detected, every institution requires an integrated corporate strategy. An amoral business environment corrupts honest employees. The economy cannot afford business to become a facilitator for crime and dishonesty, merely because it has become convenient not to bring culprits to justice. In developing an appropriate fraud response plan, it is essential that an institution considers the following steps: What are the organization’s major risk areas and what is its policy stance on perpetrators of fraud? What is the level of fraud awareness within an organisation? Page | 3 Forensic Accounting ICPAP Are controls effective? Are customers or trading partners aware of the company's policy on fraud? Do employees understand the company's attitude to fraud and dishonesty? Can employees report fraud confidentially? Are recruitment practices compatible with an honest workforce? Do disciplinary proceedings dispense justice even-handedly and more importantly, are the seen to do so? The Key areas of Forensic Accounting  Fraud Investigation  Resolving Commercial Disputes  Family Law  Insurance Claims  Valuations  Business Intelligence  Data Recovery & Conversion That's a big list of things, so let's give you a brief explanation for each of them: Fraud Investigation The bread and butter of Forensic accountants: this is where you become the detective, work out what went wrong, who did it, how they did it and how much money they've stolen. And you're expected to present all your analysis in court or to the police. You can go here for fuller details on forensic accounting and fraud investigation. Commercial Disputes The list is endless:  legal contracts get breached (one party doesn't do what the other party expected)  construction workers fall off buildings  slanderous comments get made resulting in loss of business  employees get sacked unfairly Page | 4 Forensic Accounting ICPAP  people steal copyrighted work but of course claim otherwise Forensic accountants have to assess the impact of these disputes and in many cases tragedies. As an example, let's say an aircraft maker is expecting a supply of engines from a another company within an agreed timeframe. The engine supplier fails to meet the deadline and has now breached the contract. Inevitably a huge fight will break out, the lawyers get called in and not long after so do we. And it could be for either side as they seek to justify their positions. At the end of the day the job is to work out just how much money one party is expected to pay the other in compensation. Insurance Claims We're sure everyone can relate to this. You lose something. You claim it on insurance. Now imagine huge claims on complex transactions. There's work to be done to estimate just how much the loss actually is and to then convince the insurance company that it's accurate. Family Law When couples break-up the financial side of things usually turns nasty pretty quickly as each party lays claim to what is rightfully theirs. The Forensic Accountant has to get in there and assess who has what, checking the assets/liabilities that exist, placing a value on them and then explaining all of that to the lawyers and the couples. And of course, it may all to go court. Valuations Most people would think of this work arising where business and partnerships need to break- up, like any bad marriage unfortunately. However, but it doesn't necessarily mean a dispute has caused it. For example, a businessman retires and wants to sell his part of the company to a daughter, son or colleague. Key work includes: Valuing a company for a sale (in part or in whole) Company valuations for bank purposes to borrow funds Valuing the shares (or share options) in a company for potential sale or purchase Page | 5 Forensic Accounting ICPAP The challenge here is getting the various parties involved agreeing to the valuation. Not easy in the slightest as buyers want it cheap and sellers want it expensive. Business Intelligence Here's where things turn a bit brighter. Whilst the first five items on our list are mainly about the resolution of problems, Business Intelligence is all about providing - to management - insight into how their business is running which will help them to focus on where to deploy their resources. For example, it will helps management discover where money is being lost so that a decision to divest (sell) a company can be made. Forensic Accounting and Forensic Investigation The concept of Forensic Accounting (never mind a fraud investigation) can be tricky if you've never heard of it before. We explained on our "What is Forensic Accounting?" page that there were actually many different "things" that an accountant in the forensic field could actually do. But fraud investigation is the original and best known area. And if you're already working in this field we make no apologies for the level of simplicity we're using here to explain what it's all about. Most people trying to find out information in this field usually get bamboozled with flowery jargon and big words. Hopefully we're going to avoid that and give you the following: An example of a simple fraud Explain the concepts of Prevent and Detection Controls Why Controls Fail Why Big Companies = Big Frauds Let's say you run a company. And you put your trust in your employee - Dave - to run the payroll for you every month. That means he has to pay all your employees their monthly salaries. You put some controls in place to make sure Dave is doing the right thing. That could mean Dave supplying you with a sheet of paper showing you which employees are being paid and how much. You review it and sign at the bottom. Dave then goes off and pays all these employees correctly. Page | 6 Forensic Accounting ICPAP But, unknown to you, he adds in an extra employee to be paid that you don't know about. Oh dear. And it turns about to be Dave paying himself extra wages. And he ends up doing this for years. And then one day Dave doesn't turn up to work and is now living on a beach in South America using his "extra" wages. Nice one Dave. Prevention and Detection Fraud There's two ways a company could have stopped this happening. Welcome to the world of Prevention and Detection Controls. And collectively they are sometimes referred to as Internal Controls. Prevention Controls: had the company been smart enough they would have implemented controls to stop (i.e. prevent) Dave in the first place. For example, Dave prepares the list of people to be paid but someone else makes the payment. Or two people have to sign the payroll checks (or authorize on internet banking) before they are released. Detection Controls: these controls come in after the payroll has been paid. For example, someone different from Dave (i.e. you!) gets the bank statements the following day and you check that the amount that's left the bank account ties back to the sheet of paper that you signed the previous day. Hopefully you notice that the two amounts are different and you immediately investigate what's happened. That way, you may not have prevented Dave's bad behaviour but you certainly would have detected it very quickly. Why controls fail? So, if you could have stopped the fraud happening in the first place (or at least limited it) then why do frauds by the truckload continue to happen? You can design as many controls as you feel like, but if you forgot to stick with them then you have what are known as "control breakdowns" The main reason is the human factor. Or if we weren't being as nice - people are lazy, forgetful, too busy, didn't understand what was needed of them. Whatever the reason - the controls fail. And in the worst case - fraud - someone deliberately ignores the control. Page | 7 Forensic Accounting ICPAP Big Companies = Big Frauds Now, take our simple example and then think about a huge multi-national company with numerous processes around how their cash is spent and collected - which could be payroll, invoicing clients, stock control and operating expenses. Imagine the sheer number of controls that need to be implemented to make sure that all the cash paid out or received is accurate and properly accounted for. These controls will be a combination of complex computer systems and lots of people. And they can breakdown either unintentionally (system bugs, genuine human error). Or a person (or a group of persons) can get together and maliciously set out to commit a fraud. That's called collusion. And if they get away with it....then the numbers can be massive. So, what is Forensic Accounting? We're hoping you now have a better understanding of how frauds can be committed in any size of company and the importance of controls. And we're now also hoping that our definition of Forensic Accounting will make more sense to you. Forensic Accountants are usually called in after a fraud has already been committed. The internal controls have failed. Money has been lost. Particularly in large companies it may not be clear (or they may not have a clue!) what happened. The company needs to find out. And that's when they call in the accountants, the lawyers, the police and other government organizations if things get really nasty. And the role of the Forensic Accountants is to: Investigate and gather evidence. Interview staff Analyze that information. Review the controls and how they failed. Query the data systems Work with the lawyers, police and anyone else who's involved from outside the company Document their findings in a clear and concise format which is delivered to the Company Prepare further reports/documents that will be used by the Company to launch a legal case against the fraudulent employees. Appear in court to explain the investigation work that they've carried out and the conclusions they reached. Page | 8 Forensic Accounting ICPAP FORENSIC ACCOUNTANT AND AUDITS It is important to define the term forensic accountant to ensure readers understand concepts and narratives throughout the book. One of the key points to understand about forensic accountants is the difference and roles of financial audits versus fraud audits. This section will discuss some of the issues and differences. Forensic Accounting Defined In this book, the term forensic accounting refers to the comprehensive view of fraud investigation. It includes preventing frauds and analyzing antifraud controls. Forensic accounting would include the audit of accounting records in search for evidence of fraud; a fraud audit. A fraud investigation to prove or disprove a fraud would be part of forensic accounting. It also includes the gathering of nonfinancial information, such as interviews of all related parties to a fraud, when applicable. Forensic accounting includes writing a report to management or court. Serving as an expert witness and litigation support are part of forensic accounting. Although relatively new to the accounting profession, the role of a forensic expert in other professions has been in place for some time. Webster’s Dictionary defines the word forensic as ‘‘belonging to, used in, or suitable to courts of judicature or to public discussions and debate.’’ Accordingly, the term forensic in the accounting profession deals with the relation and application of financial facts to legal problems. Forensic accounting evidence, therefore, is oriented to a court of law. Financial Auditors, Fraud Auditors, and Forensic Accountants In the lexicon of accounting, terms such as fraud auditing, forensic accounting, fraud examination, fraud investigation, investigative accounting, litigation support, and valuation analysis are not clearly defined. Some distinctions apply between fraud auditing and forensic accounting. Fraud auditing involves a specialized approach and methodology to discern fraud; that is, the auditor is looking for evidence of fraud. The purpose is to prove or disprove a fraud exists. Historically, forensic accountants, however, have been called in after evidence or suspicion of fraud has surfaced through an allegation, complaint, or discovery. Forensic accountants are experienced, trained, and knowledgeable in all the different processes of fraud investigation including: how to interview people (especially the suspect) effectively, how to write effective reports for clients and courts, how to provide expert testimony in court, and rules of evidence. The ACFE refers to this definition of forensic accounting as fraud examination. In recent years, the broadest of these terms in the antifraud profession is forensic accounting, which typically refers to the incorporation of all the terms Page | 9