Forensic Accounting and Fraud Investigation for Non-Experts

Forensic Accounting and Fraud Investigation for Non-Experts SECOND EDITION Howard Silverstone Michael Sheetz WILEY John Wiley & Sons, Inc.

This book is printed on acid-free paper. Copyright 2007 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our Web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Silverstone, Howard. Forensic accounting and fraud investigation for non-experts / Howard Silverstone, Michael Sheetz. 2nd ed. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-471-78487-6 (cloth) ISBN-10: 0-471-78487-7 (cloth) 1. Fraud investigation. 2. Forensic accounting. 3. Fraud Prevention. I. Sheetz, Michael. II. Title. HV8079.F7S55 2007 363.25 963 dc22 2006015452 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

This book is dedicated to my family for putting up with so many Sunday afternoons and late nights that I was enmeshed in the world of forensic accounting. Howard Silverstone This book is dedicated to Susan Sheetz, my wife, whose tireless patience, endless encouragement, and unyielding optimism has made my life immeasurably better. Michael Sheetz

CONTENTS Acknowledgments ix Part I Fraud and Forensic Accounting Overview 1 1 FRAUD IN SOCIETY 3 WHAT IS FRAUD? 3 TYPES OF FRAUD 6 WHAT THE NUMBERS TELL US ABOUT FRAUD 11 THE SOCIAL CONSEQUENCES OF ECONOMIC CRIME 21 SUGGESTED READINGS 22 2 UNDERSTANDING THE BASICS OF FINANCIAL ACCOUNTING 25 INTRODUCTION 25 THE FIVE ACCOUNTING CYCLES 27 JOURNALS 34 TYING THE THREAD 36 SUGGESTED READINGS 36 3 THE ENTITIES 38 PROPRIETORSHIPS 39 PARTNERSHIPS 39 CORPORATIONS 41 BUSINESS ENTERPRISES IN THE GLOBAL ENVIRONMENT 42 SUGGESTED READINGS 47 v

vi Contents 4 FUNDAMENTAL PRINCIPLES OF ANALYSIS 49 GOOD ANALYSIS = DUE DILIGENCE? 49 WHY DO IT? 50 OTHER FACTORS TO CONSIDER 51 ANALYSIS FOR THE NON-EXPERT 52 TO THE FUTURE 58 SUGGESTED READINGS 59 5 THE ROLE OF THE ACCOUNTING PROFESSIONAL 61 THE IMPORTANCE OF ACCOUNTING PROFESSIONALS IN THE INVESTIGATION 61 THE AUDIT PROCESS 65 INTERNAL CONTROLS 68 Part II Financial Crime Investigation 71 6 BUSINESS AS A VICTIM 73 INTRODUCTION 73 EMPLOYEE THEFTS 74 PAYROLL FRAUD 78 FRAUDULENT BILLING SCHEMES 80 FRAUD COMMITTED BY OUTSIDERS 81 MANAGEMENT THEFTS 82 CORPORATE THEFTS 85 IDENTITY THEFT 86 SUGGESTED READINGS 88 7 BUSINESS VILLAINS 90 INTRODUCTION 90 ORGANIZED CRIME AND BUSINESS 90 MONEY LAUNDERING 98 CONCLUSION 105 SUGGESTED READINGS 106

Contents vii 8 THE INVESTIGATIVE PROCESS 111 INTRODUCTION 111 CASE INITIATION 112 CASE EVALUATION 114 GOAL SETTING AND PLANNING 116 INVESTIGATION 123 CONCLUSION 131 SUGGESTED READINGS 132 9 INTERVIEWING FINANCIALLY SOPHISTICATED WITNESSES 134 INTRODUCTION 134 THE INTERVIEW 135 INTERVIEWING FINANCIALLY SOPHISTICATED WITNESSES 152 CONCLUSION 155 SUGGESTED READINGS 156 10 PROVING CASES THROUGH DOCUMENTARY EVIDENCE 160 INTRODUCTION 160 DOCUMENT COLLECTION 161 DOCUMENT ORGANIZATION 176 THE PROCESS OF PROOF 180 THE LOGIC OF ARGUMENT 182 PROOF THROUGH INFERENCE 187 CONCLUSION 191 SUGGESTED READINGS 192 11 ANALYSIS TOOLS FOR INVESTIGATORS 196 INTRODUCTION 196 WHY USE ANALYSIS TOOLS AT ALL? 196 ASSOCIATIONAL ANALYSIS 198 TEMPORAL ANALYSIS 217 CONCLUSION 224 SUGGESTED READINGS 225

viii Contents 12 INFERENTIAL ANALYSIS 227 INTRODUCTION 227 HOW INFERENTIAL ANALYSIS HELPS 227 WHAT IS AN INFERENCE NETWORK? 228 INVESTIGATIVE INFERENCE ANALYSIS 231 THE KEY LIST 237 CONSTRUCTING AN INVESTIGATIVE INFERENCE CHART 238 PLOTTING THE CHART 242 SOME TIPS FOR CHARTING SUCCESS 247 APPLYING THE CHART TO THE INVESTIGATIVE PROCESS 248 CONCLUSION 249 SUGGESTED READINGS 250 13 DOCUMENTING AND PRESENTING THE CASE 254 INTRODUCTION 254 CREATING A SYSTEM 254 THE CASEBOOK SYSTEM 255 REPORT WRITING 263 TESTIFYING AS A FINANCIAL EXPERT 266 CONCLUSION 282 SUGGESTED READINGS 283 Index 287

ACKNOWLEDGMENTS I would like to thank my long-time colleagues and friends for their support, especially Jim and Marie Stavros for helping me to realize the American dream! Thanks also to Kip Hamilton, Steve Butler and others for their insight and case examples. Extra special thanks to my wife Debbie, and my children, Jonathan, Alec, and Emma, for their support. Thanks also to my mother, Coba, for taking a 3,000-mile journey into the twenty-first century, and to my father, Nat, whose spirit is still so strong. Howard Silverstone I would like to thank Dr. Grace Telesco, who provided invaluable editorial and organizational assistance during the preparation of this edition. Additionally, I would like to thank my colleagues in academia, law enforcement, and the court system, without whose comments, suggestions, and encouragement I would not have been able to complete this work. In particular, I owe Gladys Perez and Captain Richard Facchine an especially heartfelt thanks for all their support and encouragement. Michael Sheetz ix

PART I FRAUD AND FORENSIC ACCOUNTING OVERVIEW

1 FRAUD IN SOCIETY Yes! Finally captured Martha Stewart. You know, with all the massive and almost completely unpunished fraud perpetrated on the American public by such companies as Enron, Global Crossing, Tyco and Adelphia, we finally got the ringleader. Maybe now we can lower the nation s terror alert to periwinkle. 1 WHAT IS FRAUD? Fraud is an activity that takes place in a social setting and has severe consequences for the economy, corporations, and individuals. It is an opportunistic infection that bursts forth when greed meets the possibility of deception. The fraud investigator is like the attending physician looking and listening for the signs and symptoms that reveal an outbreak. The Association of Certified Fraud Examiners defines occupational fraud as: The use of one s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization s resources or assets. 2 Before dealing with the accounting details and the investigation itself, we introduce some attempts by the courts, law enforcement, and regulatory authorities to define fraud. Since the subject of this book is workplace fraud, we then outline the nature of workplace fraud through a look at the accounting cycle. We complete the tour with a look at the motives of fraudsters and the consequences of their acts. The modern definition of fraud is derived primarily from case and statute law, but many of the ancient elements remain. Those roots can be traced to fraus, a Latin noun carrying a wide range of meanings clustered around the 3