By Phil M. Goy
March 8, 2012
While fictional crime scene detectives get top billing on television, a less grisly branch of investigation-forensic accounting-takes place in real life far from the limelight. Forensic accountants are true detectives; they too identify and analyze material that can expose alleged financial crimes and serve as evidence in court.
Instead of blood spatter or DNA, the evidence is likely to be an accounting entry or document pointing to an improper or illegal action. And for all the drama of a murder investigation, forensic accountants at least have their CSI counterparts beat on one count: the sums involved can be astronomical as in Bernie Madoff’s Ponzi scheme, which involved billions of dollars. Madoff even had a bogus computer interface that he claimed was linked to the Depository Trust & Clearing Corporation (DTCC), an electronic storage system for transaction information.
The red flags and smoking guns take many forms. Consider the Enron scandal. Some of its most artful ruses were “off-balance sheet” units concealing some of the energy company’s debt. Meanwhile, in the notorious Tyco case, it was a mere sales tax audit at an art gallery that led New York State auditors to track the shipments of a $12 million painting to the home of Dennis Kozlowski, CEO of Tyco Inc., and ultimately to the discovery of wholesale misappropriation of company funds for personal use.
It’s not surprising that many frauds go on for years. In most cases, it takes an extremely skeptical look at financial records and their supporting documents to discover the problem before a company starts defaulting on debts or fails to pay its employees, vendors or investors. In run-of-the-mill forensic investigations, it is not unusual for the accountants to go through thousands of documents.
In one case involving personal loan guarantees, our team combed through numerous computers and file cabinets. They discovered that a transaction transferring assets to another of the borrower’s firms, with no sign of payment for them. That set the stage for an ongoing collection effort that may reach over six figures.
And just like CSI agents in their labs, forensic accountants have special tools they can use in their investigations, as well as many computerized applications they develop themselves. In general, these tools automate the process of identifying anomalies. Many basic computer applications can be customized into financial interrogation tools.
Accountants also employ the laws of statistics. People falsifying data frequently use numbers they consider to be random. In fact, they may deviate from the actual patterns that naturally occur in everyday life. Physicist Frank Benford identified the commonalities in natural data patterns in the 1930s, and accountants began using his insights in the 1970s to identify data errors and tampering. Once problems are identified, accountants can delve into supporting documents behind an accounting entry and take a closer look.
They also scrutinize out-of-the ordinary amounts during a particular time period. For example, if an amount stands out as too large or too small among similar items in the time frame, it may be worth a second look. In the Tyco case, New York State auditors zeroed in on a shipment fee that appeared to be unusually small for a $12 million transaction.
The earliest warning may come from the behavior of a culprit. Consider an example that one might call the case of the “overly hands-on sales executive.” While it doesn’t nearly rank with the Bernie Madoff case in terms of the sums involved, it is a lesson in how a perpetrator’s behavior can be a dead giveaway about fraud. The case was published in the journal Issues in Accounting Education last year.
An executive at a Florida computer leasing company was selling hundreds of thousands of dollars worth of returned equipment to unauthorized resellers and then pocketing their payments, according to the journal article. It took months to discover the problem.
The money was obtained in 36 separate transactions and involved nearly 2,500 computers. Each transaction bypassed the firm’s internal controls. The scam had rolled along smoothly for months until a customer “returned” off-lease computers to the strangest of locations: a fitness club that happened to belong to a friend of the executive. It turned out that some resellers were not on the list of authorized vendors and were not even equipped with loading docks to handle the computer shipments. After discovering this, one of the subordinates blew the whistle.
According to Issues in Accounting Education, there were more subtle red flags early on.
The manager was oddly interested in personally delving into some of his employees’ tasks, the whistleblower remembered. The manager had asked employees to let him know when large amounts of computer equipment were slated for return and then would handle them himself.
The lesson is that just about any person in an organization with access to a company’s financial records, products or money could perpetrate a fraud; and, forensic accountants can ferret it out.
Red Flags for Fraud
Red flags frequently crop up early in cases of fraud or other impropriety. They can range from atypical accounting entries to lavish personal spending by an employee. It pays to identify them early. For example:
The executive or owner suddenly begins to spend far more on personal consumption than in the past.
The owner of an insolvent firm continues to live in a luxurious extravagant manner beyond their current earnings.
A company may overstate the value of its assets to drive up the company’s share price.
An executive prefers to handle some business matters personally rather than let his or her departments handle them in the normal manner.
An executive violates the company’s internal controls, such as buying from non-approved vendors or selling to non-approved customers.
Phil M. Goy, CPA, CIRA, CTP, CFF, is a managing director of BBK, Ltd. and is the practice lead of the General Corporate Practice, which includes services to lenders, attorneys and a multitude of non-manufacturing businesses. He is also a member of the BBK Senior Leadership Team. He can be contacted at [email protected].