Fraud Auditing and Forensic Accounting

Tommie W. Singleton, Aaron J. Singleton

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470877913
• Edition: 4
• Topic: Business
• Subtopic: Revisione contabile
• Index: Business

FRAUD AUDITING AND FORENSIC ACCOUNTING

With the responsibility of detecting and preventing fraud falling heavily on the accounting profession, every accountant needs to recognize fraud and learn the tools and strategies necessary to catch it in time. Providing valuable information to those responsible for dealing with prevention and discovery of financial deception, Fraud Auditing and Forensic Accounting, Fourth Edition helps accountants develop an investigative eye toward both internal and external fraud and provides tips for coping with fraud when it is found to have occurred.

Completely updated and revised, the new edition presents:

• Brand-new chapters devoted to fraud response as well as to the physiological aspects of the fraudster
• A closer look at how forensic accountants get their job done
• More about Computer-Assisted Audit Tools (CAATs) and digital forensics
• Technological aspects of fraud auditing and forensic accounting
• Extended discussion on fraud schemes
• Case studies demonstrating industry-tested methods for dealing with fraud, all drawn from a wide variety of actual incidents

Inside this book, you will find step-by-step keys to fraud investigation and the most current methods for dealing with financial fraud within your organization. Written by recognized experts in the field of white-collar crime, this Fourth Edition provides you, whether you are a beginning forensic accountant or an experienced investigator, with industry-tested methods for detecting, investigating, and preventing financial schemes.

CHAPTER ONE
Background of Fraud Auditing and Forensic Accounting

There’s a sucker born every minute.

—P. T. Barnum

Trust everyone, but cut the deck.

—P. T. Barnum

INTRODUCTION

In the first decade of the twenty-first century, the news has been filled with reports on frauds and indicators that it is increasing in its scope and costs to the U.S. economy. Almost everyone has read about corporate financial statement frauds such as Enron and WorldCom, or frauds against the government such as false claims following Katrina, or huge Ponzi schemes such as the Madoff scam that set a new record for losses associated with a fraud. Many people have been directly affected by identity theft. The economic downturn that began in 2008 has made it hard to rebound from such losses. To make matters worse, reports on activities related to fraud bear bad news.

A 2007 report from the Federal Bureau of Investigation (FBI) estimates that fraud in non-health insurance costs more than $40 billion per year, or put another way, costs the average U.S. family between $400 and $700 per year in increased premiums!¹ In the same report, the FBI estimates that costs associated with fraudulent claims following the Katrina hurricane disaster accounted for as much as $6 billion. The FBI also reports that suspicious activity reports (SAR) filed by banks increased 36 percent for 2008 over 2007. Of the SARs filed in 2007, 7 percent indicated a specific dollar loss, which totaled more than $813 million.² The FBI was investigating over $1 billion in mortgage frauds in 2008.³ All these facts existed before the economic meltdown and scrutiny brought to the subprime mortgage industry.

The Internet Crime Complaint Center (IC3) is a federal watchdog agency formed as a partnership of the National White Collar Crime Center (NW3C) and the FBI that serves as a center to receive, process, and refer criminal complaints regarding the rapidly expanding area of cybercrime. Its 2008 Annual Report shows a 33 percent increase in complaint submissions over 2007, which is the trend over this decade. The total losses from 2008 complaints were $265 million with a median loss of $931,000 per complaint.⁴

The National Insurance Crime Bureau (NICB) says that 10 percent of all property or casualty insurance claims, 15 percent of auto theft claims, and 20 percent of workers’ compensation claims involve some form of fraud. According to the NICB, auto insurance theft costs $20 to 30 billion a year. The NICB reports that questionable claims reports in the first half of 2009 has increased 13 percent over first half of 2008 and the numbers in nearly all referral categories are rising as well.

The Association of Certified Fraud Examiners (ACFE) provides periodic surveys of fraud and reports the results to the public in its Report to the Nation (RTTN). Results were published in 1996, 2002, 2004, 2006, and 2008. The 1996 RTTN reported an estimate of over $400 billion in losses due to fraud, which increased over the years to an estimated $994 billion in 2008. Fraud clearly continues to cost organizations and society huge sums of money, both recently and throughout the history of commercial business.

BRIEF HISTORY OF FRAUD AND THE ANTIFRAUD PROFESSION⁵

According to some, forensic accounting is one of the oldest professions and dates back to the Egyptians. The “eyes and ears” of the king was a person who basically served as a forensic accountant for Pharaoh, watchful over inventories of grain, gold, and other assets. The person had to be trustworthy, responsible, and able to handle a position of influence.

In the United States, fraud began at least as early as the Pilgrims and early settlers. Since early America was largely agricultural, many frauds centered around land schemes. Perhaps the most infamous colonial era land scheme was the purchase of Manhattan Island (what is now Brooklyn), bought from the Canarsie Indians. The land was bought for trinkets worth about $24. In this case, the Native Americans tricked the white man, as the Canarsie Indians sold land not even connected to Manhattan Island, and Manhattan Island was inhabited by Manhattan Indians, to whom the Dutch had to pay a second time for the land. Land swindles grew as America expanded west.

The advent of business organizations created new opportunities for fraud. The earliest corporations were formed in seventeenth-century Europe. Nations chartered new corporations and gave them public missions in exchange for a legal right to exist, separation of ownership from management, and limited liability that protected shareholders from losses of the business entity. One such corporation, the Massachusetts Bay Company, was chartered by Charles I in 1628 and had a mission of colonizing the New World.

The first major corporate fraud is probably the fraud known as the South Sea Bubble. The South Sea Company was formed in 1711 with exclusive trading rights to Spanish South America. The company made its first trading voyage in 1717 and made little actual profit to offset the £10 million of government bonds it had assumed. South Sea then had to borrow £2 million more. Tension between England and Spain led to the capture of South Sea ships by Spain in 1718. In 1719, the company proposed a scheme by which it would take on the entire remaining national debt in Britain, over £30 million, using its own stock at 5 percent in exchange for government bonds lasting until 1727. Although the Bank of England offered also to assume the debt, Parliament approved the assumption of the debt by the South Sea Company. Its stock rose from £128 in January 1720 to £550 by the end of May that year, in a speculation frenzy.

The company drove the price of the stock up through artificial means; largely taking the form of new subscriptions combined with the circulation of pro-trade-with-Spain stories designed to give the impression that the stock could only go higher. Not only did capital stay in England, but many Dutch investors bought South Sea stock, thus increasing the inflationary pressure.⁶

Other joint-stock companies then joined the market, usually making fraudulent claims about foreign ventures, and were nicknamed “bubbles.” In June 1720, the Bubble Act was passed, which required all joint-stock companies to have a royal charter. Partly because it had a royal charter, the South Sea Company shares rocketed to £890 in early June 1720. The price finally reached £1,000 in early August, and a sell-off that began in June began to accelerate. The sell-off was begun largely by directors them-selves cashing in on huge stock profits. As the stock price began to decline, the company directors attempted to talk up and prop up the stock (e.g., having agents buy stock) but to no avail—the stockholders had lost confidence and a run started in September. By the end of the month, the stock price dropped to a low of £150.

With investors outraged, and as many of them were aristocrats, Parliament was recalled in December and an investigation began. As part of that investigation, an external auditor, Charles Snell, was hired to examine the books of the South Sea Company. This hiring was the first time in the history of accounting that an outside auditor was brought in to audit books, and marks the beginning of Chartered Accountants in England and thus the beginning of Certified Public Accountants (CPAs) and financial audits as we know them today. Thus CPAs owe their profession, at least to a large extent, to a fraud.

In 1721, Snell submitted his report. He uncovered widespread corruption and fraud among the directors in particular and among company officials and their friends at Westminster. Unfortunately, some of the key players had already fled the country with the incriminating records in their possession. Those who remained were examined and some estates were confiscated.

At about the same time, France was experiencing an almost identical fraud from a corporation originally known as the Mississippi Company that had exclusive trading rights to North America in the French-owned Mississippi River area. Using similar tactics of exaggerating the potential profits, the company owner, famous economist John Law, was able to cause a frenzied upward spiral of its stock prices, only to see it collapse after the Regent of Orleans dismissed him in 1720. The company sought bankruptcy protection in 1721. Like South Sea, it was a fraud perpetrated by the exaggerations of executive management.

In 1817, the Meyer v. Sefton case involved a bankrupt estate. Since the nature of the evidence was such it could not be examined in court, the judge allowed the expert witness who had examined the bankrupt’s accounts to testify to his examination. Forensic accounting professor and author Dr. Larry Crumbley considers this accountant to be the first forensic accountant in history and the beginning of forensic accounting as a profession.

In 1920, Charles Ponzi planned to arbitrage postal coupons, buying them from Spain and selling them to the U.S. Postal Service, using foreign exchange rates as leverage to make a profit. In order to raise capital for the scheme, he promised outlandish returns to investors—50 percent in 90 days. Ponzi paid the first returns with the cash proceeds from those coming in later, then he personally took the proceeds from later entrants to the scheme. He was imprisoned for defrauding 40,000 people of $15 million. To this day, that type of scheme is referred to as a Ponzi scheme.

In the 1920s, Samuel Insull was involved in a fraud scheme similar to the railroad and South Sea Bubble schemes, but it occurred in the electric utility business. Insull sold millions of dollars of common stock in electric utility companies to unwary investors. The stock was greatly overpriced in terms of the utilities’ real assets. When the stock market collapsed in 1929, it was apparent that Insull’s holding company was insolvent and had been for some time.

Some researchers, such as Dr. Dale Flesher and Dr. Tonya Flesher, have presented sound arguments that the Securities Act of 1933 and the Securities Exchange Act of 1934 are a direct result of the Ivar Kreuger (“Match king”) fraud rather than the stock market crash of 1929. Kreuger & Toll, a multibillion-dollar conglomerate, was a huge fraud built on shell companies and unaudited financial statements. Kreuger & Toll securities were among the most widely held in the United States. When the company went under in 1932, after Kreuger had committed suicide, investors lost millions in the largest bankruptcy of its time. Therefore, the argument goes, the existence of these legislative acts requiring financial audits of all companies with listed securities and the Securities and Exchange Commission (SEC) is the result of a major financial fraud, and can be seen by comparing the tenets of the acts against the financial fraud perpetrated by Kreuger versus the stock market crash itself. The acts of 1933 and 1934 essentially created the demand for financial auditors and the CPA profession that exists to this d...