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Fraud and the Auditor In the Real World^©

Fraud and the Auditor In the Real World^©

Presented by Hal Rosenthal to FICPA, Tallahassee, FL
September 12, 2000

Introduction

Information included in this seminar is based upon real life experiences. It is intended to assist auditors to better carry out their responsibilities in connection with detection and documentation of actual or potential fraudulent activities.

Implications of Investor Perceptions of Audit Assurance

While the source of the following chart has been lost, the reality of the concept it portrays should be given careful attention. It is based upon the users’ feeling of assurance that the audited financial statements are free from material misstatements. In actuality, it tells us a lot more.

	Error	Fraud
No assurance necessary	1.67%	2.51%
Reasonable assurance	51.05%	26.36%
Absolute assurance	47.28%	71.13%

Basically, insofar as the public is concerned, not just investors, virtually all believe that the mere association of a CPAs name with financial statements means that the statements can be relied upon. And, the public makes no real distinction between Error and Fraud.

When a member of the public believes it has been damaged, in whole or in part because it took reliance on financial statements based upon the fact that a CPA’s name was associated with them, the CPA may well find his or her self on the receiving end of a malpractice suit.

Importantly, the consequences of name association are not limited to a CPA’s services in connection with opinions on financial statements. They apply equally to most any service provided by CPAs. Accordingly, the range of reality-based exposure of CPAs to lawsuits and to other negative implications extend beyond those as may be considered in SAS No. 82, "Consideration of Fraud in a Financial Statement Audit."

Inherent Limitation of Auditing as a Means to Detect Fraud

Forensic thinking starts with an understanding of commercial activities and how those activities may or may not be expressed in records of account. Roughly, the transaction flow is;

Commercial activity --> coincidental documents --> money --> record --> record-keeping.

But, traditional auditing flows in the opposite direction.

A recording in the books of account can be anticipated from knowledge of the activity or transaction that is the source of such recording but anticipation of an actual activity or a transaction can not, in all instances, be concluded from an accounting record of the same (or omission thereof).

In connection with investigation of fraudulent activities, accounting records and results thereof should be presumed to be a tool that is available to a perpetrator and a source of "leads or lies" to the CPA.

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A Definition of Fraud (Association of Fraud Auditors)

"All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth, and includes all surprise, trick, cunning or dissembling, and any unfair way by which another is cheated."

Proving Fraud in Court

The following, suitable for framing, may be helpful:

The defendant has made a representation in regard to a material fact.

The representation of fact is false.

The defendant did not believe it to be true,
upon reasonable grounds.

It was made with the intent that it be acted upon.

Plaintiff reasonably believed it to be true.

Plaintiff acted upon it to his damage.

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CPA Liability Outside the Engagement

In 1990 there occurred what is referred to as "Re-statement of Torts." It applied at the Federal level but has been, more or less, adopted at the State level.

In particular, in the State of Florida, Privity (face to face) and Scienter (actual knowledge of wrong or reckless disregard of the truth) were no longer a prerequisite for liability to attach to CPAs.

One of several areas in which CPAs are culpable of "Aiding and Abetting" has to do with attestation engagements undertaken on behalf of commercial landlord clients in connection with operating costs of a project, such as an office building or a shopping center.

Nationwide, commercial tenants pay material amounts to landlords as reimbursements of the landlord’s operating expenses of the project. Many leases include references to audits of those operating expenses to be performed by independent CPAs selected by the landlord. The intention is to have the tenants believe that the amount of operating expenses billed to them by the landlord is correct.

Such attestations by CPAs are regularly found to coexist alongside recoverable overcharges to an individual commercial tenant in the hundreds-of-thousand dollar range and rise to some millions of dollars for the project as a whole.

To the extent the CPA knew or should have known its opinions concerning the operating expenses of the landlord were relied upon by tenants as to the fairness of charges made to the tenants by the landlord, the CPA is exposed to material damage claims by one or more tenants.

In truth, there is no connection whatever between the amounts charged to a particular commercial tenant pursuant to the terms of its lease and the services performed by the independent CPA. The CPA addresses operating expenses of a landlord entity or business segment in relation to the financial statements of that entity or segment. The presumption that if the operating expenses are not materially misstated the tenant(s) have not been overcharged is, in and of itself, wholly unfounded and is dangerous to CPAs.

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Fraudulent Transfers

Fraudulent transfers generally involve the question of form versus substance. Unless specifically looking for fraud, the CPA is normally involved in establishing the validity of transactions and their results through examination of the related documentation. But, fraudulent transfers tend to be extremely well documented (as being legitimate).

Techniques a CPA can use to get around the inherent obstacle to detection is to look at what I call the "Before and After" and the "Cudda/Shudda."

Take the case of a sale and leaseback. The company owned $700,000 (market value) of fully paid for equipment used in its manufacturing activities. It sold the equipment in exchange for a small down payment and a note receivable from the buyer and leased the equipment back for $200,000 per year. All standard documentation is in place.

Before, the company had no related annual cost associated with the equipment except maintenance and repair, for which it is still responsible. After, it is out of pocket $200,000 per year on the lease, it no longer owns the equipment and has not received payment on the note for over a year.

Cudda/Shudda; The company could have borrowed all or the majority of the market value using the equipment as collateral. Had it done so, the debt service could have been substantially less than the lease payment and ownership of the asset could have been retained.

The simplistic factors included in the above example are the results of investigation. The actual circumstances, pre-investigation, were not so evident. Both the company’s independent CPA and a prominent, outside expert CPA firm hired by the company’s counsel supported the legitimacy of the transaction. The reader should not assume that the facts were so obvious that, as a CPA, the reader would not have failed to automatically discern the truth through the use of standard auditing procedures.

Material transactions between related companies should be given special attention. Merely providing full disclosure of related party transactions does not take the CPA off the hook in the event of fraud. The source of improper intent may rest within the company on the other side of the transaction. If circumstances preclude you from making reasonable examination of the other company, watch out.

Formal badges of fraudulent transfers include; transferor insolvent after transfer or was insolvent at the time of transfer, transfer for less than arm’s length or less than reasonably equivalent value, transfer made so as to hinder, delay or defraud an actual or potential creditor of the transferor.

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Acquisition and Sale -- Due Diligence Services

Company A bought Company B for $20,000,000 plus other consideration. The COO and chairman of the Board of Company A held many meetings with key personnel of Company B and received a substantial quantity of Company B’s industry specific financial, sales and marketing information which they studied over a period of months. Company A’s independent CPA was hired to travel out of town to examine the records of Company B to the extent the CPA deemed appropriate.

After acquisition, it was found that the sales weren’t there, the mark-up wasn’t there and the profits weren’t there. Company A sued but was barred, initially, from proceeding because it had been given reasonable opportunity to exercise due diligence in connection with the acquisition.

I was engaged and found massive fraud including, but not limited to, material amounts of fictitious sales, non-existent inventory, false profitability and high six-figure annual skimming. These findings overcame the legal barrier and the case went to arbitration.

The sheer magnitude of the existing impropriety of Company B, pre-acquisition, suggests that Company A’s CPA should have made material discoveries to benefit its client. Whether or not that is so is not the central point. The operative error was the assumption by both Company A and its CPA firm that auditing (a subject in which the CPA firm is well trained) as opposed to investigation (a subject in which the CPA firm is not skilled) can or should be a sound basis for due diligence.

As should be the case, Company B’s independent CPA was sued for malpractice, intentional wrongdoing and for aiding and abetting civil theft. But, that which affects most CPAs are the circumstances applicable to Company A’s CPA.

While investigators cannot easily become trained CPAs, by virtue of their business and financial training CPAs are in a unique position to easily become effective investigators.

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Due Diligence Services for Lenders – Another Dimension

(Abstracted in part from Rosenthal sidebar appearing in Journal of Lending & Credit Risk Management)

As the saying goes in the commercial lending industry, "Everyone knows a good loan and everyone knows a bad loan. Successful lending is based on knowing which of those in the middle will turn out right."

Lenders have obvious reasons to be concerned about potentially fraudulent borrowers and attention is paid in that regard in deciding whether or not to extend credit. By comparison, hardly any attention is devoted to an equally important area of fraud, which just as regularly leads to default but involves no actual or potential wrongdoing on the part of the borrower.

We are talking about fraud at the level of the intended use of the credit.

If the borrowed funds are to be used to buy a franchise, examine the franchise. If the funds are for a corporate acquisition, look into the corporation that is to be acquired with equal or greater intensity as the borrower.

For all intents and purposes, there are always at least two "borrowers".

The value-added factor to the lender as a result of extending the scope of due diligence services is other than what might be imagined. Obviously, lenders compete on the basis of lending rates. Often overlooked is that they also compete on the basis of services rendered to the borrower.

What better service capability can be presented by a lender than the ability to more fully flesh out the reality of the loan transaction in order to better insure the success of the borrower in connection with the loan? Plus, the lender is not out of pocket because it typically earns a fee, by whatever name, to perform the due diligence service.

Hidden Assets, of a different kind

A large retail electronics dealer went into bankruptcy. Counsel for the creditors sought help in identifying assets of the debtor. Never looked into was the extended warranty scheme.

Here’s how it works. The stores sell many products, TV sets among them. Sales persons are encouraged to sell extended warranties on the picture tubes.

The company purchases coupons from another company which assumes the responsibility to pay for any necessary warranty work. Let’s say the coupons cost $12.50 each for an extended warranty of three years and are sold at $39.99.

The warranty revenue, net of the coupon cost, is properly reflected in the financial records of the company and any unsold coupons purchased by the company are handled as a prepaid expense item.

So, what is there to audit? Well, only about 1.8% of those picture tubes go bad within three years and the manufacturer covers the cost during the early period, which is the period during which a defective tube is usually noticed anyway.

The coupon money goes into a bank account, at interest, at a geographically remote location. The "warranty company" and the retailer’s designee (by contract only) have a 50/50 share in the bank account, which the parties split immediately after the three year period. No part of the split ever comes into the retailer’s company. Any funds disbursed from the bank account for actual repairs or replacement during the three- year period is negligible. Interest earned on the account is deemed sufficient to cover the warranty service pay-outs.

If the number of TV sets sold -- not counting special sales, manufacturers’ promotions and end of season clearance (usually during the month of January) - is only 100 units per store per week and there are only five stores, the retailer’s designee’s share of the split amounts to $162,500 per year. And that’s just for TVs.

Fraud "Auditing" Should Be a Function of Investigation

Such investigation includes auditing in the traditional sense and also specifically embraces another dimension of activity. The added activity is based upon a concept as depicted by the following pie chart.

Slice K represents what we know.

Slice DK represents what we don’t know.

Slice DKDK represents what we don’t know that we don’t know.

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Whether or not it will be admitted, most fields of human endeavor contemplate K and DK as the universe of knowledge applicable to its undertakings. Rarely is it so that procedures or techniques are applied to specifically embrace DKDK. Yet, in real life, it is the DKDK segment of the pie that presents the greatest opportunities and pitfalls.

Appreciation of the concept is especially valuable in fraud investigation. Either separate from auditing or in connection therewith, fraud investigation and its related techniques and procedures serve as a useful tool available to CPAs in connection with carrying out their responsibilities under SAS 82 and otherwise.

Such investigation techniques as may be used by CPAs should consider the concept described above.

A Valuable Investigative Technique

Many years ago when I was involved in management consulting in addition public accounting services I came upon a useful tool that I continue to use for multiple purposes.

It started as a method by which a company can be efficiently and effectively analyzed for purposes of system design and implementation.

In the process of its use over the years it became clear that it is also extremely effective as a means of ascertaining weaknesses of internal controls, determining the competency of key employees, developing a prompt and comprehensive understanding of the business, uncovering business operational opportunities and weaknesses and as a method by which to detect fraud. It is also valuable as a due diligence methodology. All for the same nickel, so to speak.

The method is simple. It involves the use of a basic systems flowchart template.

An interview of a company employee is initiated. It can be any employee; sales, warehouse, production, accounting or whatever. The process will automatically and without fail direct the interviewer to all persons who should be included in the process.

The interview starts with, "Tell me about any piece of paper that comes across your desk or that you create." It does not matter which one is first. None will be missed.

A document is produced and you ask what it is called. Using the template you draw a block representing that document. Place a small circle in the corner of the block and insert the letter "A" within it to correspond to the circled "A" you will write on a photocopy of the document that you will retain.

If the original document contains four copies, draw four copies. Each of them must be accounted for through to their final destination in the company.

As to what information the employee includes in the document, list each item on the flowchart. Ask how the employee obtains each piece of information. Draw that as well. Later you will interview the employee(s) in the department that represents the source of the information used by the current interviewee.

Ask where each copy goes and draw that as well. Later you will interview the employee(s) in the department that represents the transferee of the document created by the current interviewee and you will start with that specific document, being armed with a copy of the document and an understanding of what went into its creation.

The flowcharting activity acts as a positive control and a guide so as to miss nothing. It automatically directs you to where you need to be and, by so doing, accesses the DKDK zone.

The end result is not just to draw pictures but to ask whatever questions which come to mind while in the process. Your experience as a CPA and your accumulated business background will come to bear in the questions you ask and in the conclusions you derive from the process.

Computerization is handled the same as a physical document. The interviewee may say that he or she enters the checks received from customers. You first draw the batch of checks. Then you ask what information is entered. Next, ask what is it called in which the information is entered. Print an after-entry copy of it and label it on your flowchart with a circled sequential alphabetical identification. Then ask what the record is subsequently used for and by whom. Later, you will interview the employee(s) in the department(s) that further make use of the computer record.

Just follow the trail. Everything you draw must culminate somewhere or you are not done.

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Here are a few examples of the results obtained through the use of the process:

1.	A computer was identified as being one not known to current employees as having been brought over by an employee of an acquired company. The computer was immediately secured and the services of an expert was obtained for the purpose of breaking passwords and to recover deleted files still on the hard drive. Voluminous hard evidence of fraud in connection with the acquisition was uncovered.
2.	Using the "Cudda/Shudda" concept an employee was told that his explanation of the purpose of double shadow entries was implausible in light of how the circumstances could have been handled. The employee confessed that the true purpose was to alter subsidiary receivable accounts to hide skimming.
3.	During the interview of an employee involved in bill paying it was noticed that while there were controls on the use of the check signature imprinting die, the normal process of check printing caused the first few checks that came out of the printer to be "unusable." But, there was no control on what happens to the supposedly unusable checks. A background investigation showed that the employee was in financial difficulty and had two undisclosed felony convictions. Further investigation showed that his wife’s maiden name was used as the payee on various unauthorized disbursements made by way of the "unusable" checks. The internal control inadequacy of having bank statements and canceled checks delivered to an employee in that position was stopped as was the ability of such employee to alter the total of the monthly check disbursements subsequently used to arrive at the general ledger cash balance.
4.	Investigation of a timing delay between when the contents of meat delivery trucks were checked out in the early a.m. and when the check-out document was brought in to the accounting department in the late afternoon disclosed a conspiracy between a driver and a dock loader. The contents of the driver’s truck was regularly reduced by the dock man so as allow for a lesser total collection sum. The difference was shared by the driver and the dock man.
5.	When asked why the documents showing electronics products leaving the warehouse for repair by an outside company were not matched by receiving documents accounting for their reintroduction to stock, the warehouse foreman had no answer. Investigation disclosed that many of the products going out for repair included newly purchased items in unopened boxes and that the purchased items were never included within the physical inventory control. The repair company served the dual function as a receiver/distributor of stolen goods.
6.	When asked why the entry dates of computer entry records did not conform to transaction dates of the corresponding documents to which they relate, the employee confessed that her boss asked her to make the entries so as to pump up sales for the period.

Additional information will be provided during the seminar through discussion and the use of overhead projection. Also, participants are invited to visit the site, askhal.com/

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Forensic Accounting

"The use of intelligence
gathering techniques and accounting/ business skills to develop information and opinions for use by attorneys involved in civil litigation and to give trial testimony if called upon."

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