Seventh Seventh EDITION EDITION FORENSIC AND INVESTIGATIVE ACCOUNTING CRUMBLEY | HEITGER | SMITH Forensic and Investigative Accounting Seventh Edition D. Larry Crumbley, CPA, CFF, MAFF, Cr.FA Emeritus Professor Department of Accounting Louisiana State University Lester E. Heitger, CPA BKD Distinguished Professor of Forensic Accounting School of Accountancy Missouri State University G. Stevenson Smith, CPA, CMA John Massey Endowed Professor of Accounting Department of Accounting and Finance Southeastern Oklahoma State University Chapter 17 includes material adapted from CCH Business Valuation Guide by George B. Hawkins, ASA, CFA and Michael A. Paschall, ASA, CFA, J.D. Editorial Staff Editor ......................................Sandra Lim Production .............................. Don Torres, Diana Roozeboom Cover Design .......................... Laila Gaidulis This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service and that the authors are not offering such advice in this publication. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. ISBN 978-0-8080-4073-6 ©2015 CCH Incorporated. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 CCHGroup.com No claim is made to original government works; however, within this Product or Publication, the following are subject to CCH Incorporated’s copyright: (1) the gathering, compilation, and arrangement of such government materials; (2) the magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory and other notes and references; and (4) the commentary and other materials. Printed in the United States of America iii Preface Forensic and Investigative Accounting fills a void in accounting education literature by providing the first broad-based text covering all the important topics that have come to be identified with modern forensic accounting. Certainly, there are books on fraud auditing, litigation support, valuation damages, cybercrime, and other key forensic topics, but other textbooks are not specifically written to cover the forensic accounting waterfront. The authors hope that teachers will find Forensic and Investigative Accounting, 7th Edition, a particularly powerful teaching and learning tool. The twin towers of forensic accounting—litigation support and investigative auditing—are covered in detail. The 7th edition includes valuable research from the 2014 AICPA Survey of International Forensic Accounting Trends, EY’s Global Forensic Data Analysis Survey, KPMG’s 2013 Integrity Survey, PWC’s 2014 Global Economic Crime Survey, Deloitte’s Snap 2013 Fraud Survey, Seventh Kroll’s 2013/2014 Global Fraud Report, and the 2013/2014 Global Retail Theft Barometer. Some of the new topics are COSO Cube Updated, Standards for Internal Control in Federal Government (2014), Securities Whistleblower Incentives and Protection provisions, Financial Secrecy Index, Defense Department’s Contract Audit Manual, International Standards for Professional Practices of Internal Auditors, forensic data analytics, chessboard fraud risk assessment technique, additional details on avoiding Daubert challenges, more eyewitnesses and spotlight stories, and new problems, cases, and pop quizzes. This edition brings the reader up-to-date with the latest cybercrime activity, valuation, and damages cases, and it documents the latest corruption schemes and explains how to find and prevent them. Please visit http://www.cchgroup.com/Resources for any periodic updates or clarifications that may become available related to the 7th Edition of Forensic and Investigative Accounting as well CCH’s Daily Tax Day News, Tax Briefings and other items of interest. This textbook is a valuable, recommended study aid that can assist beginning and experienced forensic accounting practitioners in preparing for certification exams. Today’s forensic accounting teachers and students have a difficult task in studying this developing topic, but they are compensated by the fact that forensic accounting is red hot and relevant. These students can find jobs and obtain nice pay checks. In 2002, Congress took up the financial markets reform mantle and passed the Sarbanes-Oxley Act, which was in part designed to restore financial accountability by preventing and punishing fraud. The Act created a new independent accounting oversight group called the Public Company Accounting Oversight Board (PCAOB), subject to Securities and Exchange Commission review. Sarbanes-Oxley, recent SEC actions, aggressive actions against external auditors by the PCAOB, international pronouncements by the Institute of Internal Auditors and the AICPA, and new rules promulgated by the various stock exchanges have all worked to change the perception of who is responsible for detecting and fighting fraud in financial statements and throughout the corporation and other entities. External auditors, internal auditors, company management, and audit committees are all charged in one way or another with fighting fraud under new initiatives. Yet, the task of fraud detection has proven so difficult (e.g., Bernard Madoff, Sir Robert Allen Stanford, Rita Crundwell, and Satyam Computer Services) that the continued growth in forensic accounting specialists seems assured along with the development of the forensic accounting discipline to match wits with new advanced technological and fraud schemes. The federal government’s Affordable Care Act and the shortfalls in many states’ budgets should provide much work for forensic accountants. Students and teachers alike will find that forensic accounting also is extremely interesting, and the authors of Forensic and Investigative Accounting, 7th Edition worked hard to build a sense of interest and yes, even excitement into the text. Some would argue that forensic accountants are more like “Quincy” (a once popular TV show about a crime-solving coroner) or the CSI characters than the traditional starch-collared, numbers-cruncher. Forensic accountants work on books and records, but often in the context of legal conflicts and even criminal activities. Forensic and Investigative Accounting, 7th Edition demonstrates that this developing discipline is challenging. As the text demonstrates, an effective forensic accountant needs an understanding of accounting, investigative auditing techniques, computers, criminology, and courtroom procedures. Many forensic accountants will further specialize and have varying concentrations of these five sets of knowledge and skills. All three authors are teachers, forensic accountants, and perhaps most of all, forensic accounting fans. While there are many complex forensic issues explained in this book, the authors worked hard to try to convey to students the contemporaneous nature of forensic accounting—forensic accounting is constantly developing in the news, in the legal and regulatory system, and as part of the accounting industry. iv FORENSIC AND INVESTIGATIVE ACCOUNTING The authors believe that forensic accounting should be fun to teach, and with the many Internet-related assignments in the chapter exercises, students are encouraged to continue to seek out new stories and developments as they occur. Of course, studying a discipline that is experiencing such dramatic change will be challenging. However, there are plenty of fundamental concepts and topics that require a good deal of earnest attention and concentration that will help keep both students and teachers anchored to reality. In today’s climate all accountants—external, internal, corporate accountants and yes, the forensicaccounting specialist—must develop forensic competencies. The authors believe it will only be a matter of time before all accounting majors will take one or more forensic-type courses. The authors agree with James Gordon Brown, Prime Minister of England, that “what the use of finger prints was to the 19th century and DNA analysis was to the 20th, forensic accounting will be to the 21st century.” July 2015 D. Larry Crumbley Lester E. Heitger G. Stevenson Smith v About the Authors Dr. D. Larry Crumbley, CPA, MAFF, Cr.FA, CFF , is Emeritus Professor in the Department of Accounting, Louisiana State University and Executive in Residence at Pfeiffer University. He has published more than 350 articles in accounting journals and authored more than 60 books, including 13 educational novels, including The Big R: A Forensic Accounting Action Adventure andTrap Doors and Trojan Horses: An Auditing Action Adventure. He is the longtime editor of the Oil, Gas & Energy Quarterly (36 years) and founding editor of the Journal of Forensic Accounting: Auditing, Fraud & Risk. Professor Crumbley was a member of the AICPA’s Litigation and Dispute Resolution Services Subcommittee Fraud Task Force and was on the Fraud Deterrence Board of National Association of Certified Valuation Analysts. He has served on the Executive Board of the American Board of Forensic Accounting (ACFEI). He was the organizer of and first president of the Forensic & Investigative Accounting section in the AAA. He is the editor of the Journal of Forensic and Investigative Accounting. He has traveled to more than 130 countries and lectured in a number of these countries. Professor Lester E. Heitger, CPA , taught for many years in the Accounting Department at Indiana University in Bloomington, Indiana. While there, he created and taught a graduate level course in Forensic and Investigative Accounting. He now holds the position as the BKD Distinguished Professor of Forensic Accounting in the School of Accountancy at Missouri State University, where he has developed and teaches several forensic accounting courses, and he has helped develop a Certificate in Forensic Accounting in the graduate accounting program. He served as a member of the task force funded by the United States Justice Department, White Collar Crimes Division that created the “Model Curriculum in Forensic Accounting.” Professor Heitger has been active in litigation support and expert witnessing over the past 30 years. He has worked as a forensic accountant on over 50 cases testifying as an expert witness in state and federal courts and in the United State Tax Court. He has also testified in alternative dispute resolution environments such as arbitrations and mediations. He continues to be very active as an expert witness and as a litigation support specialist. He is currently President of the Forensic Accounting (FA) section of the American Accounting Association. In 2014, Professor Heitger became the Chair of the Higher Education Initiative Committee of the ACFE. G. Stevenson Smith, CPA, CMA, Ph.D., is the John Massey Endowed Professor of Accounting and Chair of the Department of Accounting and Finance in the John Massey School of Business at Southeastern Oklahoma State University. Dr. Smith received his Ph.D. from the University of Arkansas and his M.B.A. from Michigan State University. Dr. Smith has authored three books dealing with financial management for the American Library Association. His most recent title is, Cost Control for Nonprofits in Crisis (ALA 2011). His most recent book is The Money Compass: Where Your Money Went and How to Get it Back. (Hoboken, NJ: John Wiley & Sons, Inc). He has authored numerous articles on forensic accounting that have been published in Journal of Forensic Accounting, Journal of Financial Fraud, Fraud Magazine, Digital Investigation, and the Journal of Digital Forensics, Security and Law. His HTCIA White Paper on RFID received the Best Paper Award at the HTCIA’s International Conference in 2007. His professional experience includes working for the Securities and Exchange Commission in Washington, D.C., as a financial analyst. He has been a Visiting Professor at the University of Victoria in Wellington, New Zealand and a Visiting Fellow at the University of New England in Armdale, Australia. In 2011, he was a Fulbright Scholar at the University of Pula in Croatia, where he lectured and developed research on forensic issues in Eastern Europe. vii Acknowledgments CaseWare IDEA Inc. provided students with access to the demo version of IDEA® – Data Analysis Software and support resources. Audimation Services, Inc., a CaseWare partner and the U.S. distributor of CaseWare IDEA® contributed a case study and corresponding data sets. Additional information is available at www.audimation.com/academic. IDEA companion for the Tallahassee Bean Counter problem provided by Audimation Services, Inc., a CaseWare partner and the U.S. distributor of IDEA®. Data sets and accompanying documentation for the HR Project in Chapter 13 provided by Audimation Services, Inc., a CaseWare partner and the U.S. distributor of IDEA®. Chapter 18 project is adapted from the case article by Brian Ballou, Associate Professor, Miami University; Jennifer Mueller, Assistant Professor, Auburn University; and Paul Zikmund, Director Forensic Audit, Tyco International (US) Inc. and is included here with permission of the authors and the Journal Of Forensic Accounting, Vol. V (September 2004), pp. 433-456. Chapter 18 project is adapted from, Carol Callaway Dee and Cindy Durtschi, “Return of the Tallahassee BeanCounters: A Case in Forensic Accounting,” Issues In Accounting Education, Vol. 25, No. 2., pp. 279-321, and is included here with permission from The American Accounting Association. The full text of many AAA articles are available online at http://aaapubs.org/. Finally, we’d like to thank our fellow instructors who adopt this book and the students who support our efforts. D. Larry Crumbley Lester E. Heitger G. Stevenson Smith How to Use This Book Forensic and Investigative Accounting is organized to engage students in the study of forensic accounting. Special features, end-of-chapter exercises, appendices, and a forensic glossary are provided to further assist students in the learning process. Chapter Openings All chapters begin with the same elements: a list of the learning objectives and an overview. This information provides a framework for understanding the material that will be studied in the chapter. Special Features Hundreds of forensic stories, featured factoids, and illustrations are interjected throughout the chapters. Eyewitness features are typically descriptive short snippets expressing a forensic event, action, or slant on an issue. Spotlight features are used to interject a longer story in the forensic news or a statement on a forensic concept. Ethics features are used when a forensic related standard or ethics-related authority is reproduced. Law and Order features identify a legal case or regulatory ruling. Examples are used when a specific situation is used to illustrate an important point. End-of-Chapter Materials Every chapter ends with a conclusion that ties together the ideas presented in the chapter and with the chapter opening and overview help to give students a point of reference for additional study. End of chapter exercises are used to help the student assess his or her understanding of the chapter’s salient points. Some will help direct the student to additional research. The exercises also provide the instructor with a ready means to evaluate student understanding of the material. End-of-Book Materials A special forensic glossary is offered at the end of the book that can be referenced throughout the student’s reading. Appendices offer additional source materials for extended reading and research. Website Please visit http://www.cchgroup.com/Resources for any periodic updates or clarifications that may become available related to the 7th Edition of Forensic and Investigative Accounting as well as CCH’s Daily Tax Day News, Tax Briefings and other items of interest. Contents A detailed Table of Contents for each chapter begins on page xiii. Chapter 1 Chapter 2 Page Part 1: The Field and Practice of Forensic Accounting Introduction to Forensic and Investigative Accounting .............................. 1-1 Forensic Accounting Education, Institutions, and Specialties ................... 2-1 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Part 2: Uncovering Accounting Crime Fraudulent Financial Reporting ................................................................. 3-1 Detecting Fraud in Financial Reporting .................................................... 4-1 Employee Fraud: The Misappropriation of Assets ...................................... 5-1 Indirect Methods of Reconstructing Income ............................................. 6-1 Money Laundering and Transnational Financial Flows .............................. 7-1 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Part 3: Courtroom Procedures and Litigation Support Litigation Services Provided by Accountants .............................................. 8-1 Proper Evidence Management ................................................................... 9-1 Commercial Damages ............................................................................. 10-1 Litigation Support in Special Situations ................................................... 11-1 Computing Economic Damages .............................................................. 12-1 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Part 4: Cybercrime Investigation of Electronic Data: A Brief Introduction ............................ 13-1 Digital Forensics Analysis ........................................................................ 14-1 Cybercrime Management: Legal Issues .................................................... 15-1 Cybercrime Loss Valuations ..................................................................... 16-1 Part 5: Business Valuations Chapter 17 Business Valuations ................................................................................. 17-1 Part 6: Forensic Capstone Illustration Chapter 18 Forensic Accounting in Action ................................................................ 18-1 Appendices ................................................................................................A-1 Glossary of Terms .................................................................................... G-1 Topical Index ............................................................................................I-1 xiii Table of Contents CHAPTER 1 INTRODUCTION TO FORENSIC AND INVESTIGATIVE ACCOUNTING Definition and Development of Forensic Accounting Defining Forensic Accounting ........................................................................¶ 1001 Historical Roots of Accounting .......................................................................¶ 1011 History of Financial Reports and Legal Challenges .........................................¶ 1021 Threads of Forensic Accounting ......................................................................¶ 1031 Accounting Literature Parallels Accounting Practice........................................¶ 1041 The Phrase “Forensic Accounting” Is Born ......................................................¶ 1051 Forensic Accounting and Investigative Accounting Come of Age The Forensic Accountant Becomes an Investigator ..........................................¶ 1061 FBI and Forensics ...........................................................................................¶ 1071 First Forensic Accounting Books in United States ...........................................¶ 1081 AICPA Practice Aid ........................................................................................¶ 1091 American Management Association Course ....................................................¶ 1101 The Panel on Audit Effectiveness ....................................................................¶ 1111 AICPA Fraud Task Force Report .....................................................................¶ 1121 Controversy Surrounding the Accountant’s Role in Fraud Detection ...................¶ 1131 American Accounting Association Forensic Accounting Section ........................¶ 1135 Foreign Corrupt Practices Act .........................................................................¶ 1141 Securities Whistleblower Incentive and Protection Provisions of Dodd-Frank Act ......................................................................................... ¶ 1143 Conclusion .....................................................................................................¶ 1146 CHAPTER 2 FORENSIC ACCOUNTING EDUCATION, INSTITUTIONS, AND SPECIALTIES Preparing to Become a Forensic Accountant