© D.L Crumbley Forensic Accounting: Some Strategies for Detecting & Preventing Fraud D Larry Crumbley, CPA, CFF, Cr.FA, MAFF, FCPA KPMG Endowed Professor Department of Accounting 2833 Business Education Complex Louisiana State University Baton Rouge, LA 70803 225-578-6231 225-578-6201 Fax dcrumbl@lsu.edu Dr Crumbley is the Editor of the Journal of Forensic and Investigative Accounting, free online, Former chair of the Executive Board of Accounting Advisors of the American Board of Forensic Accountants, Member of the NACVA’s Fraud Deterrence Board, and On the AICPA’s Fraud Task Force (2003-2004) A frequent contributor to the Forensic Examiner, Professor Crumbley is a co-author of CCH Master Auditing Guide, along with more than 50 other books and 350 articles His book entitled Forensic and Investigative Accounting,5th edition, is published by Commerce Clearing House (800224-7477) Some of his 13 educational novels have as the main character a forensic accountant His goal is to create a television series based upon the exciting life of a forensic accountant and litigation consultant © D.L Crumbley Forensic Report © D.L Crumbley TALLY STICKS © D.L Crumbley Definition of Forensic Auditor Someone who can look behind the facade not accept the records at their face value someone who has a suspicious mind that the documents he or she is looking at may not be what they purport to be and someone who has the expertise to go out and conduct very detailed interviews of individuals to develop the truth, especially if some are presumed to be lying Robert G Roche, a retired chief of the IRS Criminal Investigation Division of the IRS © D.L Crumbley Narrow vs Broad Definition • Narrow: Fraud Detection Is Major Area • Broad: Employed to seek, interpret, and communicate transactional and reporting event evidence in an objective, legally sustainable fashion, not only in situations where there are specific allegations of wrongdoing, but also in situations where interested parties judge that the risk of loss from wrongdoing is such that proper prudence requires legally sustainable evidence to support the conclusion that no wrongdoing is occurring (James Edwards) © D.L Crumbley Narrow Approach Accounting Forensic Accounting Internal and External Auditing Planning Risk Assessment Internal controls Audit Evidence Reporting Accounting Litigation Matters and Investigations Fraud Prevention and Deterrence Detection Investigation Remediation U.S Dept of Justice, Education and Training in Fraud and Forensic Accounting: A Guide for Educational Institutions, Stakeholder Organizations, Faculty and Students, Draft Copy, December 23, 2005 © D.L Crumbley Broad Approach Bankruptcy Family law Auditing Valuation Fraud Antitrust matters Insurance claims Accounting Analyses Damages © D.L Crumbley Definition of Forensic Accounting Forensic accounting is the application of accounting, tax, auditing, finance, quantitative analysis, investigative and research skills, and an understanding of the legal process for the purpose of identifying, collecting, analyzing, and interpreting financial or other data or issues in connection with: 1) Litigation services: providing assistance for actual, pending or potential legal or regulatory proceedings before a trier of fact in connection with the resolution of disputes between parties, or 2) Non-litigation services: performing analyses or investigations that may require the same skills used in 1, above, but may not involve the litigation process © D.L Crumbley Puff Adder © D.L Crumbley Short History Late 1800’s – Find fraud 1930’s- Puff Adder –encyclopedia 1933-1934-independent audits 1950’s-Eighth edition Montgomery auditing reduced formal stress on fraud detection January 1957- H.W Bevis, AR, questioned the benefit of discovering minor employee thefts 1960s-auditors claimed no responsibility Financial audits: Consistency Audit surveillance: test of details (disappeared) Stock market bubble 10.Panel on Audit Effectiveness (2000) 11.Enron/ WorldCom/ Parmalat/ HealthSouth 12.Sarbanes-Oxley/ PCAOB 13.SAS No 99 10 Some Exercises © D.L Crumbley Determine if the following situations are negative indicators of the financial health of a government unit a Cash and investments divided by current liabilities ratio is decreasing over several years b Current liabilities divided by total revenues ratio is decreasing c Fixed costs divided by total expenditures ratio is increasing d Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is increasing over time e Debt Service expenditures as a percentage of revenues is greater than 25% f Debt Service Expenditures divided by Gross Expenditures ratio is decreasing over time g Gross Revenues – Gross Expenditures : Decreasing over time Gross Expenditures h.The debt service expenditures as a percentage of revenues is 25% or larger i A fund balance is greater than 10% of revenues j Unreserved fund balance divided by gross expenditures ratio is decreasing over time k The quick ratio of a large state government is 2.2 to l Long-Term Debt divided by population ratio is decreasing over time m.Current Liabilities divided by Gross Revenues ratio is increasing over time n.Tax Levy divided by Tax Limit ratio is decreasing over time 127 Exercise Answers © D.L Crumbley Favorable 128 Exercise Answers © D.L Crumbley Determine if the following situations are negative indicators of the financial health of a government unit a Cash and investments divided by current liabilities ratio is decreasing over several years Negative b Current liabilities divided by total revenues ratio is decreasing Positive c Fixed costs divided by total expenditures ratio is increasing Negative d Real Property Taxes Receivables divided by Real Property Tax Revenue ratio is increasing over time Negative e Debt Service expenditures as a percentage of revenues is greater than 25% Negative f Debt Service Expenditures divided by Gross Expenditures ratio is decreasing over time Positive g Gross Revenues – Gross Expenditures : Decreasing over time Gross Expenditures Negative h.The debt service expenditures as a percentage of revenues is 25% or larger Negative i A fund balance is greater than 10% of revenues Favorable j Unreserved fund balance divided by gross expenditures ratio is decreasing over time Negative k The quick ratio of a large state government is 2.2 to Favorable l Long-Term Debt divided by population ratio is decreasing over time Favorable m.Current Liabilities divided by Gross Revenues ratio is increasing over time Negative n.Tax Levy divided by Tax Limit ratio is decreasing over time Favorable 129 Acquisition/Payment Cycle From 62 standard audit procedures, external and internal auditors judged these 20 procedures to be more efficient is detecting fraud in the acquisition and payment cycle (in descending order) • Examine bank reconciliation and observe whether they are prepared monthly by an employee who is independent of recording cash disbursement or custody of cash • Examine the supporting documentation such as vendor’s invoices, purchase orders, and receiving reports before signing of checks by an authorized persons • Examine the purchase requisitions, purchase orders, receiving reports, and vendors’ invoices which are attached to the vouchers for existence, propriety, reasonableness and authenticity •Examine internal controls to verify the cash disbursement are recorded for goods actually rendered to the company •Discuss with personnel and observe the segregation of duties between accounts payable and custody of signed checks for adequacy Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol 4, 2003, p 204-205 130 Acquisition/Payment Cycle (Contd.) • Confirm inventories in public warehouse and on consignment •Examine internal controls to insure the vendor’s invoices, purchase orders, and receiving reports are matched and approved for payment • Examine internal controls for the following documents: vendor’s invoices, receiving reports, purchase orders, and receiving reports • Trace a sample of acquisitions transactions by comparing the recorded transactions in the purchase journal with the vendor’s invoices, purchase requisitions, purchase orders, and receiving reports • Establish whether any unrecorded vendors’ invoices or unrecorded checks exist • Examine the internal control to verify the proper approvals of purchase requisitions and purchase orders • Reconciled recorded cash disbursement with disbursements on bank statements Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic 131 Accounting, Vol 4, 2003, p 204-205 Acquisition/Payment Cycle (Contd.) • Discover related party transactions • Examine the internal control to verify the approvals of payments on supporting documents at the time that checks are signed • Discuss with personnel and observe the procedures of examining the supporting documentation before the signing of checks by an authorized person • Examine canceled checks for authorized signatures, proper endorsements, and cancellation by the bank • Account for the numerical sequence of prenumbered documents (purchase orders, checks, receiving reports, and vouchers) • Trace a sample of cash payment transactions • Trace resolution of major discrepancy reports Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol 4, 2003, p 204-205 132 Sales/Collection Cycle These 10 audit procedures were judged as being more effective for detecting fraud in the sales and collection cycle (in descending order) • Observe the proper and appropriate segregation of duties • Review monthly bank reconciliation and observe independent reconciliation of bank accounts • Investigate the difference between accounts receivable confirmation and customer account receivable balances in the subsidiary ledger and describe all these exceptions, errors, irregularities, and disputes • Review sales journal, general ledger, cash receipts journal, accounts receivable subsidiary ledger, and accounts receivable trial balance for large or unusual amounts • Verify accounts receivable balance by mailing positive confirmations Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic 133 Accounting, Vol 4, 2003, p 209 Sales/Collection Cycle (Contd.) • Examine internal controls to verify that each cash receipts and credit sales transactions are properly recorded in the accounts receivable subsidiary ledger • Examine subsequent cash receipts and the credit file on all accounts over 120 days and evaluate whether the receivable are collectible • Compare dates of deposits with dates in the cash receipts journal and the prelisting cash receipts • Examine copies of invoices for supporting the bills of lading and customers’ orders Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol 4, 2003, p 209 134 Inventory/Warehouse Cycle These 14 standard audit procedures were judged by external and internal auditors as being more effective for detecting fraud in the inventory and warehousing cycle 9in descending order): • Discover related party transactions • Follow up exceptions to make sure they are resolved • Review major adjustments for propriety • Review inventory count procedures: a Accounting for items in transit (in and out); b Comparison of counts with inventory records; and c Reconciliation of difference between counts and inventory records • Review adequacy of physical security for the entire inventory • Confirm inventories in public warehouse • Review procedures for receiving, inspecting, and storing incoming items and for shipments out of the warehouses Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic 135 Accounting, Vol 4, 2003, p 206-207 Inventory/Warehouse Cycle (Contd.) • Trace shipments to sales records, inventory records, and bill of lading (shipping documents) • Determine if access to inventory area is limited to approval personnel • Observe the physical count of all location • Recount a sample of client’s counts to make sure the recorded counts are accurate on the tags (also check descriptions and unit of count, such as dozen or gross) • Trace inventory listed in the schedule to inventory tags and the auditor’s recorded counts for existence, descriptions, and quantity • Trace shipments to sales journal • Perform compilation tests to insure that inventory listing schedules agrees with the physical inventory counts Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic 136 Accounting, Vol 4, 2003, p 206-207 Payroll/Personnel Cycle These 12 audit procedures were judged the more effective for detecting fraud in the payroll and personnel cycle (in descending order): • Sample terminated employees and confirm that they are not included on subsequent payrolls and confirm propriety of termination payments • Observe the actual distribution of payroll checks to the employees • Observe the duties of employees being performed to insure that separation of duties between personnel, timekeeping, journalizing payroll transactions, posting payroll transactions, and payroll disbursement exists • Examine internal controls to verify that hiring, pay rates, payroll deductions, and terminations are authorized by the personnel department • Sample personnel files and physically observe the presence of personnel in the work place Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic 137 Accounting, Vol 4, 2003, p 208 Payroll/Personnel Cycle (Contd.) • Examine internal control over payroll records to verify that payroll transactions are properly authorized • Discover related party transactions • Review the files of new hires for appropriate approvals, pay rates, and dates of accession • Review the payroll journal, general ledger, and employee individual pay records for large or unusual amounts • Examine internal controls to verify that unclaimed payroll checks are secured in a vault or safe with restricted access • Examine internal controls to verify that employee time cards and job order work tickets are reconciled Glen D Moyes and C Richard Baker, “Auditors’ Beliefs About the Fraud Detection Effectiveness of Standard Audit Procedures,” Journal of Forensic Accounting, Vol 4, 2003, p 208 138 © D.L Crumbley Exercises You receive a tip on the company’s hot line that there has been some fraud in the collections area What five audit steps would you suggest using in order to find the fraud? During a brainstorming session, a suggestion is made that the most likelihood of fraud in a particular division is in the area of acquisition and payment cycle Outline five audit steps to help find any potential fraud While auditing a company you notice an employee in payroll who is living beyond his means (e.g., clothes, automobiles, housing) His wife does not work Suggest six audit steps to help satisfy you there is no fraud in the payroll and personnel cycle An anonymous e-mail is sent to an internal auditor that there is fraud in the inventory/ warehousing cycle Suggest some appropriate audit steps What is meant by the hockey stick pattern? 139 © D.L Crumbley 140 © D.L Crumbley The End Is Here 141