Forensic Accounting

173 Pages·2012·1.46 MB·English

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,
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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;
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• 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?
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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
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 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
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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.
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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.
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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.
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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
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