Forensic Accounting and Financial Statement Fraud, Volume II

Forensic Accounting Performance

Zabihollah Rezaee

• Publisher: Business Expert Press
• Year: 2019
• Print ISBN: 9781949991079
• eBook ISBN: 9781949991086
• Topic: Business
• Subtopic: Auditing
• Index: Business

Forensic accounting is gaining considerable attention as a rewarding and exciting field of accounting. Forensic accountants perform both fraud and non-fraud services. The American Institute of Certified Public Accountants (AICPA) released its proposed new standards for its members who perform investigation and litigation forensic accounting services in December 2018.

This second volume addresses fraud and non-fraud forensic accounting practice and performance. The author discusses forensic accounting roles and processes; forensic accounting techniques roles and responsibilities of corporate gatekeepers, including forensic accountants in creating a corporate culture of integrity and competency in preventing and discovering financial statement fraud. Also presented are challenges and opportunities in forensic accounting, and emerging issues in fraud investigation.

CHAPTER 1

Roles and Processes of Forensic Accounting

Executive Summary

Forensic accountants are often hired to investigate allegations of wrongdoing such as financial statement fraud (FSF), employee fraud, misappropriation of assets, misrepresentation of financial information, kickbacks, bribery, conspiracy, inside trading, valuation disputes, and money laundering, among other forensic accounting services. It is important for forensic accountants to understand the role of evidence, methods of gathering sufficient and competent evidence, evaluate evidence, reach conclusions, communicate findings, make recommendations, and testify before courts. This chapter discusses the roles of forensic accountants and processes of forensic accounting, including the types of evidence (i.e., direct and circumstantial), evidence-gathering procedures, evidence assessment, conclusions, opinions, recommendations, and testimony.

Introduction

Forensic accountants gather evidence by conducting evidence-gathering procedures, evaluate evidence in terms of sufficiency and competency, use evidence in forming opinions, communicate their opinions, make recommendations, and testify in courts about their opinions. This chapter presents fundamentals of forensic accounting in performing fraud and nonfraud services by examining the types of evidence (e.g., direct, circumstantial, testimonial, physical, and documentary), rules of evidence, methods of gathering and evaluating evidence, and reaching evidence-based conclusions. The expertise of forensic accountants is in higher demand than expected in the areas of expert witnessing, litigation consulting, and fraud investigation, because the advancement of technology has augmented the specialized skills of forensic accountants. The increasing prevalence of fraud justifies the growing demand for and interest in forensic accounting.

The Role of Forensic Accountants

Forensic accountants, also known as investigative auditors or forensic auditors, are professionals that are usually employed to investigate financial and nonfinancial matters owing to a dispute, fraudulent, or imminent legal proceedings. Effective performance of forensic accounting services require gathering of a huge amount of both structured (e.g., general ledger or transaction data) and unstructured data (e.g., e-mail, voice, or free-text fields in a database), together with an increasing amount of nontraditional data sources such as third-party watch lists, news media, free-text payment descriptions, e-mail communications, and social media. Data analytics with the use of Big Data has been employed by forensic accountants to transform unstructured data into useful, structured, and relevant information for decision making in performing forensic accounting services. Forensic accounting services are often performed by individuals, with multidisciplinary knowledge and experience in accounting, technology, criminology, psychology, and laws, who are professionally skeptical in asking the right questions, utilizing data science and data management expertise to translate questions into meaningful analytics and use systems and information technology (IT) infrastructures.¹

Individuals performing forensic accounting services are often working with professionals that are considered to have certifications such as the Certified Public Accountants (CPA), Certified Forensic Accounting Credential (CFAC), Certified Fraud Examiner (CFE), Forensic Certified Public Accountant (FCPA), Certified in Financial Forensics (CFF), and Certified Valuation Analyst (CVA), among others. These certifications enhance forensic accountants’ competency, skill sets, and reputation. The new AICPA proposed standards, released in December 2018, classify forensic accounting engagements as services provided by members for “investigation” or “litigation”.² The investigation engagements are services performed to reach a conclusion regarding concerns of wrongdoing in which the CPA performs necessary procedures to collect, analyze, evaluate, or interpret evidence on the merits of the concerns. The litigation engagements are actual or potential litigation services performed in connection with the resolution of disputes between parties in which the engagement does not need to be formal and may include alternative dispute resolution forum.

Forensic accountants should obtain sufficient understanding of how to plan and prepare for a forensic engagement, including considerations of whether to accept an engagement, defining the terms of the engagement, working with attorneys, identifying and managing resources, planning the engagement, and conducting the investigation. Accepting an engagement is an important step in the process of performing forensic accounting services. Forensic accountants base their opinion on the evidence gathered during their investigation. For example, a fraud investigation is the process of examining allegations of fraud, gathering convincing evidence, and reaching a resolution on the basis of evidence, reporting, testifying, and detection and prevention. Evidence is used as the foundation of a fraud examination, which is the basis for reaching conclusions. The evidence needs to be thorough, sufficient, competent, and credible in nature for the investigation to be appropriate. The sufficiency of the evidence is a matter of quantity about how much evidence is enough. The competency of the evidence is a matter of quality regarding whether the evidence is persuasive and credible.

The two main types of sufficient and competent evidence are documents and witness statements. The evidence should be evaluated and used as a basis for forming an opinion and writing a report. The report details the investigative process and the findings from the evidence used. Information often included in fraud reports are activities of the perpetrator(s), findings, and suggestions for improvement. Forensic accounting reports should be submitted to the interested parties. After the report has been issued, forensic accountants may be required to testify in court regarding the report and its findings. When testifying, the forensic accountant must take an oath to be honest and clear in communication and opinion.³ The effective planning for fraud and nonfraud forensic accounting services requires that forensic accountants understand the scope, type, and motives of fraud explained in the following sections.

Fraud Models

The nature, scope, and drivers of fraud can be defined in many ways, including the fraud triangle. The fraud triangle was initially conceptualized by Donald Cressey (1953) and consists of three components—incentive, opportunity, and rationalization.⁴ Fraud occurs when there are pressures or incentives to engage in fraud, opportunities to commit the fraud, and there is a rationalization for the actions taken; these can either be real or simply perceived by the fraudster. The American Institute of Certified Public Accountants (AICPA) issued the Statement of Auditing Standards No. 82 (SAS No. 82)⁵ and then SAS No. 99, “Consideration of Fraud in a Financial Statement Audit” in 2002,⁶ which promotes the fraud triangle as a theoretical framework in the investigation of FSF. The fraud diamond was later developed by Wolfe and Hermanson (2004) who added “capability component” as the fourth dimension of the fraud diamond.⁷ The fraud diamond model includes incentives/pressures, opportunities, rationalization, and capability. The fraud pentagon model consists of five components—pressures/incentives, opportunity, capability, rationalization, and accountability. The inclusion of enforcement/compliance was introduced by Hossain, Mitera, and Rezaee (2016).⁸ Exhibit 1.1 (Panels A, B, and C) presents all three models—fraud triangle, diamond, and pentagon—and they are further explained in the following paragraphs.

Exhibit 1.1

Models of Fraud

Panel A: Fraud Triangle

Panel B: Fraud Diamond

Panel C: Pentagon Model of Financial Reporting Fraud

Incentive is the motivation driven from conflicts of interest or a perceived pressure on individuals to commit FSF. In a corporate setting, incentive is typically examined in the context of operational/financial characteristics and as a motivating factor for management to adopt aggressive accounting policies and practices. Opportunity describes the conditions or corporate culture and environment that would allow management to commit FSF, which is often examined in the context of corporate governance effectiveness, adequate regulatory reforms, and vigorous enforcement of laws, rules, and regulations. Rationalization is a process by which management justifies its action in committing FSF and it can be addressed through psychological effects or mistakes in judgments in assessing the consequences of compromising ethical values or committing wrongdoings. Whereas incentive has been examined through the existence of internal and external pressures on management to achieve earnings targets or beat analyst earnings forecast and opportunity has been investigated through board and audit committee effectiveness and audit quality, rationalization has been difficult to examine because it is not easily measured.

To commit fraud, the fraudster must have adequate knowledge of the accounting systems and how they interact. Alongside the fraud models are four conditions that increase the likelihood of a person committing fraud; they are pressing financial need, opportunity, reasonable justification, and a lack of moral principle. The most serious of these aforementioned conditions is the lack of moral principle. This fraudster sees nothing wrong with committing fraud and will often continue to commit fraud as long as the opportunity is present. The conditions of people likely to commit fraud and all the fraud models have overlapping themes. The opportunity to commit fraud usually comes from a lack of or ineffective internal controls. Ineffective controls include the ability to override activities, no password constraints, and no preventions against collusion. If there is a strong separation of duties and multiple checks for areas with higher inherent risk, it is harder to commit fraud and easier to identify fraud. Rationalization, or justification, can stem from a real or perceived slight against the employee. It can also be rationalized by the employee by perceiving that the act is not actually stealing from the company. Also, the employee thinking that he or she is not hurting anyone or will be able to pay back the money before it is been noticed is ...

Table of contents

• Cover
• Halftitle Page
• Title Page
• Copyright Page
• Abstract
• Contents
• Preface
• Acknowledgments
• Chapter 1 Roles and Processes of Forensic Accounting
• Chapter 2 Forensic Accounting Techniques
• Chapter 3 Role of Forensic Accountants in Corporate Governance and in Detecting and Preventing Fraud
• Chapter 4 Challenges and Opportunities in Forensic Accounting
• Chapter 5 Emerging Issues in Forensic Accounting
• About the Author
• Index