Forensic and Investigative Accounting © 2007 CCH. All Rights Reserved. 4025 W. Peterson Ave....

Forensic and Investigative AccountingForensic and Investigative Accounting

© 2007 CCH. All Rights © 2007 CCH. All Rights Reserved.Reserved.

4025 W. Peterson Ave.4025 W. Peterson Ave.

Chicago, IL 60646-6085Chicago, IL 60646-6085

1 800 248 32481 800 248 3248

www.CCHGroup.comwww.CCHGroup.com

Chapter 4

Detecting Fraud in Financial Reporting

Chapter 4 Forensic and Investigative Accounting 2

Definition of FraudDefinition of Fraud

Four major legal elements of fraud would be:Four major legal elements of fraud would be: A false representation or willful omission A false representation or willful omission

regarding a material fact.regarding a material fact. The fraudster knew the representation was The fraudster knew the representation was

false.false. The target relied on this misappropriation.The target relied on this misappropriation. The victim suffered damages or incurred a The victim suffered damages or incurred a

loss.loss.


Audit ProceduresAudit Procedures

Audit evidence is gathered in two fieldwork Audit evidence is gathered in two fieldwork stages:stages:

1.1. Internal control testing phase.Internal control testing phase.

2.2. Account balance testing phase.Account balance testing phase.


DefinitionsDefinitions

MaterialityMateriality is the measure of whether is the measure of whether something is significant enough to change an something is significant enough to change an investor’s investment decision.investor’s investment decision.

Control riskControl risk is risk that a material error in the is risk that a material error in the balance or transaction class will not be balance or transaction class will not be prevented or detected.prevented or detected.


DefinitionsDefinitions

Inherent riskInherent risk is risk that an account or is risk that an account or transactions contain material misstatements transactions contain material misstatements before the effects of the controls.before the effects of the controls.

Detection riskDetection risk is risk that audit procedures is risk that audit procedures will not turn up material error when it will not turn up material error when it exists.exists.


External Auditors and Fraud DetectionExternal Auditors and Fraud Detection

Although auditors have previously had the Although auditors have previously had the responsibility to detect material misstatement responsibility to detect material misstatement caused by fraud, SAS No. 82 details more caused by fraud, SAS No. 82 details more precisely what is required to fulfill those precisely what is required to fulfill those responsibilities. responsibilities.

(continued on next slide)(continued on next slide)


External Auditors and Fraud DetectionExternal Auditors and Fraud Detection

Now, auditors must specifically assess and Now, auditors must specifically assess and respond to the risk of material misstatement respond to the risk of material misstatement due to fraud and must assess that risk from the due to fraud and must assess that risk from the perspective of the broad categories in the perspective of the broad categories in the SAS. External auditors have to satisfy new SAS. External auditors have to satisfy new documentation and communication documentation and communication requirements. SAS No. 82 superseded by SAS requirements. SAS No. 82 superseded by SAS No. 99.No. 99.


SAS No. 99 RecommendationsSAS No. 99 Recommendations

Increased emphasis on professional Increased emphasis on professional skepticism.skepticism.

Discussions with management.Discussions with management. Unpredictable audit tests.Unpredictable audit tests. Responding to management override of Responding to management override of

controls.controls.


SAS No. 99: SkepticismSAS No. 99: Skepticism

An auditor is instructed to conduct an audit An auditor is instructed to conduct an audit “with a questioning mind that recognizes “with a questioning mind that recognizes the possibility that a material misstatement the possibility that a material misstatement due to fraud could be present, regardless of due to fraud could be present, regardless of any past experience with the entity and any past experience with the entity and regardless of the auditor’s belief about regardless of the auditor’s belief about management’s honesty and integrity.”management’s honesty and integrity.”

FA’s motto should be “Trust no one; FA’s motto should be “Trust no one; question everything; verify.”question everything; verify.”


Public Company Accounting Public Company Accounting Oversight Board (PCAOB)Oversight Board (PCAOB)

The Sarbanes-Oxley Act of 2002 created a The Sarbanes-Oxley Act of 2002 created a new, five-member oversight group called the new, five-member oversight group called the PCAOB.PCAOB.

The PCAOB is empowered to set accounting The PCAOB is empowered to set accounting standards that establish auditing, quality standards that establish auditing, quality control, and ethical standards for accountants. control, and ethical standards for accountants.



Public Company Accounting Public Company Accounting Oversight Board (PCAOB)Oversight Board (PCAOB)

The PCAOB is also empowered to adopt or The PCAOB is also empowered to adopt or amend standards issued or recommended by amend standards issued or recommended by private accounting industry groups or to private accounting industry groups or to adopt its own standards independent of such adopt its own standards independent of such private industry standards or private industry standards or recommendations.recommendations.


WalkthroughsWalkthroughs

According to the PCAOB, in a walkthrough, According to the PCAOB, in a walkthrough, an an auditorauditor traces “company transactions and events traces “company transactions and events – both those that are routine and recurring and – both those that are routine and recurring and those that are unusual – from origination, those that are unusual – from origination, through the company’s accounting and through the company’s accounting and information systems and financial report information systems and financial report preparation processes, to their being reported in preparation processes, to their being reported in the company’s financial statements.”the company’s financial statements.”

Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003.


Internal Auditors and Fraud DetectionInternal Auditors and Fraud Detection

The Institute of Internal Auditors’ Due The Institute of Internal Auditors’ Due Professional Care Standard (Section 280) Professional Care Standard (Section 280) assigns the internal auditor the task of assisting assigns the internal auditor the task of assisting in the control of fraud by examining and in the control of fraud by examining and evaluating the adequacy and effectiveness of the evaluating the adequacy and effectiveness of the internal control system.internal control system.



Internal Auditors and Fraud DetectionInternal Auditors and Fraud Detection

However, Section 280 says that management However, Section 280 says that management has the primary responsibility for the has the primary responsibility for the deterrence of fraud, and management is deterrence of fraud, and management is responsible for establishing and maintaining responsible for establishing and maintaining the control systems. the control systems.

In general, internal auditors are more In general, internal auditors are more concerned with employee fraud than with concerned with employee fraud than with management and other external fraud.management and other external fraud.


When Fraud Is DiscoveredWhen Fraud Is Discovered

1.1. Notify management or the board when the Notify management or the board when the incidence of significant fraud has been incidence of significant fraud has been established to a reasonable certainty.established to a reasonable certainty.

2.2. If the results of a fraud investigation indicate If the results of a fraud investigation indicate that previously undiscovered fraud materially that previously undiscovered fraud materially adversely affected previous financial adversely affected previous financial statements, for one or more years, the internal statements, for one or more years, the internal auditor should inform appropriate management auditor should inform appropriate management and the audit committee of the board of and the audit committee of the board of directors of the discovery.directors of the discovery.



When Fraud Is DiscoveredWhen Fraud Is Discovered

3.3. A written report should include all findings, A written report should include all findings, conclusions, recommendations, and conclusions, recommendations, and corrective actions taken.corrective actions taken.

4.4. A draft of the written report should be A draft of the written report should be submitted to legal counsel for review, submitted to legal counsel for review, especially where the internal auditor chooses especially where the internal auditor chooses to invoke client privilege.to invoke client privilege.


Audit CommitteeAudit Committee

The audit committee is the subcommittee of The audit committee is the subcommittee of an organization’s board of directors charged an organization’s board of directors charged with overseeing the organization’s financial with overseeing the organization’s financial reporting and internal control processes. The reporting and internal control processes. The audit committee’s biggest responsibility is audit committee’s biggest responsibility is monitoring the component parts of the audit monitoring the component parts of the audit process.process.


Management’s RoleManagement’s Role

The Sarbanes-Oxley Act of 2002 mandates The Sarbanes-Oxley Act of 2002 mandates that CEOs and CFOs certify in periodic that CEOs and CFOs certify in periodic reports containing financial statements filed reports containing financial statements filed with the SEC the appropriateness of financial with the SEC the appropriateness of financial statements and disclosures.statements and disclosures.


Board of Directors’ RoleBoard of Directors’ Role

Oversee the integrity, quality, transparency, Oversee the integrity, quality, transparency, and reliability of the financial reporting and reliability of the financial reporting process.process.

Oversee the adequacy and effectiveness of Oversee the adequacy and effectiveness of the internal control structure in preventing, the internal control structure in preventing, detecting, and correcting material detecting, and correcting material misstatements in the financial statements.misstatements in the financial statements.

Oversee the effectiveness, efficacy, and Oversee the effectiveness, efficacy, and objectivity of audit functions.objectivity of audit functions.


Enter the Forensic AccountantEnter the Forensic Accountant

Forensic accountants may be brought in to:Forensic accountants may be brought in to:

– Investigate the minute any irregularities Investigate the minute any irregularities surface.surface.

– Measure risk factors and create policy that Measure risk factors and create policy that brings the forensic accountant in when brings the forensic accountant in when certain scores are attained.certain scores are attained.

– Check in randomly as a matter of routine.Check in randomly as a matter of routine.


Audit TestsAudit Tests

The Panel on Audit Effectiveness recommended The Panel on Audit Effectiveness recommended that surprise or unpredictable elements should be that surprise or unpredictable elements should be incorporated into audit tests, including:incorporated into audit tests, including:

– Recounts of inventory and unannounced visits Recounts of inventory and unannounced visits to locations.to locations.

– Interviews of financial and nonfinancial client Interviews of financial and nonfinancial client personnel in different locations.personnel in different locations.



Audit TestsAudit Tests

– Requests for written confirmations from Requests for written confirmations from client employees regarding matters about client employees regarding matters about which they have made representations to the which they have made representations to the auditors.auditors.

– Tests of accounts not normally performed Tests of accounts not normally performed annually.annually.

– Tests of accounts traditionally or frequently Tests of accounts traditionally or frequently deemed “low risk.”deemed “low risk.”


Financial Statement Fraud Financial Statement Fraud Categories and Red FlagsCategories and Red Flags

Overstated revenues.Overstated revenues. Management estimates.Management estimates. Pro formas can mislead.Pro formas can mislead. Earnings problems: masking reduced cash flow.Earnings problems: masking reduced cash flow. Earnings before interest, tax, depreciation, and Earnings before interest, tax, depreciation, and

amortization (EBITDA).amortization (EBITDA). Excessive debt.Excessive debt. Inventory problems.Inventory problems.


Financial Statement Fraud Financial Statement Fraud Categories and Red FlagsCategories and Red Flags

CPA problems.CPA problems. Sales and expenses problems.Sales and expenses problems. Big bath.Big bath. Balance sheet account problems.Balance sheet account problems. Pension plan problems.Pension plan problems. Reserve estimates (cookie jar accounting).Reserve estimates (cookie jar accounting). Personal piggy bank.Personal piggy bank. Barter deals.Barter deals.


HealthSouthHealthSouth

From 1999 to 2001, HealthSouth’s net income From 1999 to 2001, HealthSouth’s net income increased nearly 500 percent, but revenue grew increased nearly 500 percent, but revenue grew only five percent.only five percent.

On March 19, 2003, the SEC said that On March 19, 2003, the SEC said that HealthSouth faked at least $1.4 billion in profit HealthSouth faked at least $1.4 billion in profit since 1999.since 1999.

Professional fees associated with the Professional fees associated with the reconstruction of HealthSouth’s financial records reconstruction of HealthSouth’s financial records and restatement of 2001 and 2002 consolidated and restatement of 2001 and 2002 consolidated financial statements totaled over $270 million.financial statements totaled over $270 million.


Financial Fraud Detection ToolsFinancial Fraud Detection Tools

Interviewing the executives.Interviewing the executives. Analytics.Analytics. Percentage analysis:Percentage analysis:

– Horizontal analysis.Horizontal analysis.

– Vertical analysis.Vertical analysis.

– Ratio analysis.Ratio analysis.


Financial Fraud Detection ToolsFinancial Fraud Detection Tools

Using checklists to help detect fraud:Using checklists to help detect fraud:

– SAS checklist.SAS checklist.

– Attitudes/Rationalizations checklist.Attitudes/Rationalizations checklist.

– Audit test activities checklist.Audit test activities checklist.

– Miscellaneous fraud indicator checklist.Miscellaneous fraud indicator checklist.


Behavioral ApproachesBehavioral Approaches

Some fraud schemes cannot be effectively Some fraud schemes cannot be effectively detected using data-driven approaches. detected using data-driven approaches. Instead, behavioral considerations may help Instead, behavioral considerations may help an auditor find fraud. Employee attitudes, an auditor find fraud. Employee attitudes, feelings, values, norms, interaction with feelings, values, norms, interaction with peers, and general satisfaction should all be peers, and general satisfaction should all be considered when looking for fraud.considered when looking for fraud.

Forensic and Investigative Accounting © 2007 CCH. All Rights Reserved. 4025 W. Peterson Ave....

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