 f Sherlock Holmes—the world’s most
famous fictional detective—were solving today’s
biggest corporate crimes, he probably would be a
CPA, too. That’s because it takes both accounting
knowledge and the unique skills of a detective to
resolve allegations of fraud. This article addresses
how investigating fraud differs from the field of
auditing.
The scenario: During a routine audit of
your client, you discover the price the company
pays for widgets has doubled in the past year.
Moreover, you notice all of the business is going
to a new vendor. You check further and find the
price of widgets on the open market is half what
your client is currently paying. Maybe there is a
legitimate reason for this anomaly. Or maybe it’s
a fraud. What do you do now? | As a CPA your
responsibilities are clear: Statement on
Auditing Standards no. 99,
Consideration of Fraud in a
Financial Statement Audit, requires
independent auditors to assess the risk
that the financials are materially
misstated as a result of fraud. As in the
scenario above, most frauds aren’t
obvious. Most CPAs can determine
whether an error has a material effect
on the financials. But fraud is
something else; its hallmark is intent.
“Accidental frauds” don’t exist. To
prove intent almost always requires
going beyond the numbers. In the
simplest terms, books don’t
commit fraud; people do.
The process of resolving these
allegations is called fraud
examination . The discipline
involves a unique body of knowledge that
is related to auditing but differs in
significant ways (see exhibit 1
). Most fraud examiners actually are
hybrids—accountants with significant
investigative experience or
investigators with solid accounting
skills. Certified fraud examiners
(CFEs), many of whom also are CPAs, must
demonstrate knowledge in four areas: an
understanding of fraudulent financial
transactions, the legal elements of
fraud, criminological concepts and fraud
investigative skills. Or, at the risk of
quoting myself, “A good fraud examiner
is part cop, part accountant, part
psychologist and part lawyer.” |
|
“There are two
questions waiting for us at
the outset. The one is
whether any crime has been
committed at all; the second
is what is the crime and how
was it committed?”
The Hound of the
Baskervilles—
Arthur Conan Doyle
| |
You can’t become an expert by reading this
two-part series. But you can learn the process
that fraud examiners put into play.
Investigators frequently must defend themselves
against allegations of invasion of privacy, libel
and slander, public disclosure of private facts
and a host of other torts. That’s the adversarial
nature of fraud examination. Someone being
investigated for fraud frequently feels cornered
and adopts the strategy that the best defense is a
good offense.
| Exhibit 1
: Auditing vs.
Fraud Examination |
| Issue
|
Auditing
| Fraud
examination
|
| Timing
|
Recurring
Audits are conducted on a
regular, recurring basis. |
Nonrecurring
Fraud examinations are
nonrecurring. They are conducted
only with sufficient
predication. |
| Scope
| General
The scope of the audit is
an examination of financial
data. | Specific
The fraud examination is
conducted to resolve specific
allegations. |
| Objective
| Opinion
An audit is generally
conducted for the purpose of
expressing an opinion on the
financial statements or related
information. |
Affix blame
The fraud examination’s
goal is to determine whether
fraud has occurred or is
occurring and to determine who
is responsible. |
| Relationship
|
Nonadversarial
The audit process is
nonadversarial in nature. |
Adversarial
Fraud examinations,
because they involve efforts to
affix blame, are adversarial in
nature. |
| Methodology
| Audit
techniques
Audits are conducted by
examining financial data and
obtaining corroborating
evidence. |
Fraud examination
techniques
Fraud examinations are
conducted by (1) document
examination; (2) review of
outside data such as public
records; and (3) interviews.
| | Standard
|
Professional
skepticism
Auditors are required to
approach audits with
professional skepticism. |
Proof
Fraud examiners approach
the resolution of a fraud by
attempting to establish
sufficient proof to support or
refute a fraud allegation.
| | Source: Fraud
Examiners Manual, Association of
Certified Fraud Examiners, 2003.
| |
Fraud examination methodology assumes from the
outset that all fraud cases will end in
litigation. This places the burden on the fraud
examiner to see that his or her actions can
withstand the harsh light of the courtroom.
Evidence must be gathered legally, witnesses may
not be threatened or coerced and confessions must
be obtained voluntarily. The fraud
examination process centers on the fraud
theory approach , which has four sequential
steps: analyzing the available data, developing a
fraud theory, revising it as necessary and
confirming it.
ANALYZE THE DATA
The first step is
familiar ground for accountants: analyzing
financial information gleaned from the books and
records. In the scenario above, you typically
would gather documents reflecting all of the
business the company did with the new vendor:
invoices, purchase orders, vendor files, shipping
and receiving reports and canceled checks, for
example. Then you would closely examine these
data, conduct ratio analyses, vouch and trace
transactions and perform other audit tests to look
for anomalies.
DEVELOP A FRAUD THEORY
Based on what is
discovered during your analysis, a fraud examiner
will develop a theory—always assuming a worst-case
scenario—of what could have occurred. The theory
addresses one of the three major classifications
of occupational (internal) fraud: asset
misappropriations, corruption or fraudulent
financial statements. | In our example,
the fraud scheme likely involves the
misappropriation of assets (cash) or the
possibility a corrupt purchasing agent is
taking kickbacks to favor one particular
vendor who is selling widgets to the
client at an artificially high price. Each
of these two schemes has its own unique
clues but the same result: losses for your
client. Considering that at least two
possible schemes could account for the
significant increase in the price of the
widgets, let’s start with a list of what
the fraud examiner might find if the fraud
involved a corrupt purchasing agent in a
kickback scheme.
Paying higher than market
prices for goods or services.
When a crooked vendor pays
bribes to get business, the money
actually comes out of your client’s
pocket, not the vendor’s. The charge is
passed along to the victim with higher
prices.
Favoritism toward one vendor
to the exclusion of others.
If a purchasing agent is
getting paid to buy something from one
vendor, he or she knows where his or her
bread is buttered. As a result the
fraudster has the motivation to make all
purchases from the corrupt provider.
Increasing levels of
purchasing and billings.
Similarly, if a crooked
employee is getting a piece of the
action, he or she has the motive to buy
more volume and more often, which will
lead to
Substantial inventories.
A payoff based on volume
sometimes means the dishonest employee
will buy much more than necessary. Thus,
if the company has a seven-year supply
of widgets, there could be a sinister
reason why. | |
|
Slow service and/or substandard
products. Once a crooked vendor
is paying off a dishonest purchasing agent, there
is little motivation for the vendor to remain
competitive. After all, the crooked employee isn’t
in much of a position to complain.
Lack of controls over the purchasing
function. Most corruption
schemes are committed by one person acting alone.
That means the dishonest purchasing agent either
has too much authority, lacks proper oversight or
both.
Excessive spending or indebtedness by a
purchasing agent. For reasons
known only to those who commit fraud, illicit
income rarely is concealed or hoarded; fraudsters
generally either pay debts or purchase luxury
items such as expensive homes, cars, vacations,
clothing and jewelry.
REVISE THE THEORY
If the facts do not
point to a kickback scheme, the fraud examiner
will look for the possibility of a billing
scheme. Although both schemes have several
common elements, the latter raises its own red
flags. For example, if the price of
widgets has increased significantly, a crooked
employee could be buying the merchandise from its
original source, marking up the price and
reselling the widgets to the victim company at an
inflated price through a shell company. This is
called a pass-through billing scheme ,
which typically will display the following
earmarks:
A shell company. The most
likely scenario for this particular fraud might
involve a bogus company formed by the crooked
employee. If such a shell exists, it probably
won’t be listed in the phone book or have a credit
rating. A quick check can answer this question.
|
Inadequate controls over
vendors. A billing
scheme depends on getting a bogus vendor
approved and on the books. In almost all
of these cases, the person approving new
vendors and the person approving payments
to them is one and the same. Otherwise,
secondary approvals frequently are forged.
Once the fraud examiner has developed
and tested a fraud theory or theories,
he or she will determine whether to
proceed further. If he or she chooses to
go forward, the fraud examiner will need
to interview potential witnesses to
gather evidence to sustain an allegation
of fraud. Before proceeding to
this next step, the fraud examiner
likely will recommend you advise your
client and legal counsel of the
possibility of an illegal act. Many
organizations and attorneys prefer fraud
examinations be conducted in
anticipation of litigation, which
provides a confidential legal privilege
for the work. Moreover, some
investigations are covered under
provisions of the U.S. Fair Credit
Reporting Act, which may require the
target of an investigation to be
notified. And if the employee in
question belongs to a union, there may
be additional considerations. See your
attorney for details. |
|
| Exhibit
3 : The
Evidence-Gathering Order
| |
 Joseph
T. Wells, 2003.
| |
|
The law has little patience for
fishing expeditions, so the fraud
examiner must be on solid legal ground
before proceeding. After developing a
fraud theory, the antifraud expert must
be able to answer a simple but important
question: “Do we have sufficient basis
to continue?” Predication , the
standard adopted by certified fraud
examiners, asks: “Would the totality of
the circumstances lead a reasonable,
prudent and professionally trained
person to believe that a fraud has
occurred, is occurring or will occur?”
If the answer to your question is “no,”
then the fraud investigator must
discontinue the examination. If the
answer is a confident “yes,” the fraud
examination can proceed to the interview
stage. But adequate predication is so
important that the fraud examiner will
continually assess it throughout the
process (see exhibit 2 ). If, at
any point, it becomes clear the
predication can no longer be supported,
the work must stop. Otherwise, the fraud
examination continues to the next step:
confirming the theory through
interviews. | |
“It has long been an
axiom of mine that the
little things are infinitely
the most important.”
A Case of Identity—
Arthur Conan Doyle
| |
THE INTERVIEW ORDER
If Dr. Watson,
Holmes’ trusty sidekick, was investigating the
possibility of a crooked purchasing agent, he
might be tempted to save effort by interviewing
the suspect first. But Watson never investigated a
case by himself, and going straight to the
purchasing agent is something Sherlock never would
do. Experienced fraud examiners rarely confront a
suspect until they’ve talked to everyone else who
could be in the loop and gathered every scrap of
paper or other evidence that could relate to the
case.
| There are a number of reasons for this
approach, with practicality topping the
list: The fraud examiner will assume there
will be only one chance to interview any
suspect, so he or she will be
well-prepared. This important interview,
assuming adequate predication still
exists, will be much more productive if
all of the related facts and documentation
have been gathered in advance. Sometimes
when a suspect gets wind of an
investigation, key evidence has a way of
disappearing. The antifraud expert also
must assume the target will find out about
the inquiry from the other witnesses who
were interviewed. The goal is to postpone
this inevitability until the time is
right. But if the client is under the
mistaken impression that the work can be
completed under a cloak of secrecy, it is
necessary to refute this notion before
conducting the first interview. |
|
“All knowledge comes
useful to the detective.”
The Valley of Fear—
Arthur Conan Doyle
| |
| |
| | In understanding
the order in which fraud examiners
normally conduct interviews, it is helpful
to view your suspect in the center of
several outer rings (see exhibit 3
). Interviews start with the least
culpable persons and end with the most
culpable. There are two reasons for this
approach. First, if it becomes clear the
fraud examiner is on the wrong track, he
or she can discontinue the work before
accusing people of a crime they didn’t
commit. Second, the antifraud expert
cannot assume the target will confess,
although many do. So if interviews are
conducted in their logical order, there
may be sufficient evidence to prove or
disprove the case even without the
cooperation of the target.
THIRD-PARTY WITNESSES
Fraud
interviews usually begin with people who
can provide evidence by virtue of their
positions but who have no involvement in
the alleged offense—they are called
neutral third-party witnesses. |
 |
PRACTICAL
TIPS TO REMEMBER
|
 Independent
auditors are required by
Statement on Auditing
Standards no. 99,
Consideration of Fraud
in a Financial Statement
Audit, to assess the
risk that financials are
materially misstated.
The fraud
examination process begins
with the auditor’s analyzing
financial information taken
from the books and records.
Auditors
untrained in finding the roots
of a fraud and interviewing
techniques should call in an
antifraud specialist in the
face of suspicious evidence.
| |
| In the
example of the crooked purchasing agent, a
fraud examiner would start by interviewing
witnesses who can furnish information of a
general but important nature: for example,
the personnel clerk who maintains the
suspect’s pay records, the supervisor who
defines the suspect’s duties and
responsibilities or the salesman who sold
the suspect an expensive new automobile.
The reasons for proceeding in this manner
are twofold.
Documents must be
introduced by a witness. If, for
instance, it is discovered there are
checks the suspect paid to his shell
company, the person who is actually in
charge of maintaining the original
checks will be interviewed. In court,
that person would testify to the
authenticity of the originals.
The second point concedes
the intrusive nature of the process: If
there is insufficient predication to
proceed to the next level of interviews,
the fraud examination can be stopped
before people become needlessly upset.
|
|
“I have no data yet.
It is a capital mistake to
theorize before one has
data. Insensibly one begins
to twist facts to suit
theories, instead of
theories to suit facts.”
A Scandal in Bohemia—
Arthur Conan Doyle
| |
CORROBORATIVE WITNESSES
Once the neutral
third-party witnesses have been interviewed, the
fraud examiner will move on to corroborative
witnesses, people who have knowledge of the scheme
but are not involved in it. In our example of the
purchasing agent, these witnesses would typically
include coworkers, supervisors and subordinates.
To avoid any legal issues such as possible
defamation, the fraud examiner will only ask
questions and will not share the fraud theory.
(Defamation is the disclosure of damaging untrue
statements . By definition,
questions cannot be defamatory. See
your attorney for a more complete explanation.)
THE TARGET
The final
phase in confirming the fraud theory is to
confront any coconspirators and the
suspect, in that order. The expert will
interview them separately, knowing there
is little chance of getting them both to
confess collectively. This procedure,
called an admission-seeking interview,
involves a deliberate process that lays
out the evidence to the coconspirator and
target in a specific order. Similarly,
experts have to precisely phrase their
questions and correctly interpret the
answers. In next month’s column, we will
cover the methods fraud examiners use to
obtain voluntary and legally binding
confessions. | |
“One cannot always
have the success for which
one hopes. An investigator
needs facts and not legends
or rumours.”
The Hound of the
Baskervilles— Arthur
Conan Doyle
| |
JOSEPH T. WELLS, CPA, CFE, is founder and
chairman of the Association of Certified Fraud
Examiners and a professor of fraud examination at
the University of Texas at Austin. Mr. Wells is a
member of the Journal of Accountancy Hall
of Fame for winning the Lawler Award for the best
JofA article in both 2000 and 2002. His
e-mail address is
joe@cfenet.com . |
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