Essentials of Forensic Accounting Second Edition

Michael A. Crain, DBA, CPA/ABV, CFA, CFE William S. Hopwood, PhD Richard S. Gendler, JD, LLM, JSD George R. Young, PhD, CPA, CFE

Table of Contents

Section I: Introduction ...... 1

Chapter 1 – The Forensic Accounting Profession ...... 3 Learning Objectives ...... 3 Introduction ...... 3 The Essence of Forensic Accounting ...... 3 Forensic Accounting versus Traditional Accounting ...... 3 Forensic Accounting versus Auditing ...... 4 The Historical Development of Forensic Accounting ...... 4 Forensic Accounting Knowledge and Skills ...... 6 Accounting ...... 6 Auditing ...... 6 Investigative ...... 7 Criminology and Digital Forensics ...... 7 Accounting Information Systems ...... 7 Risk Analysis ...... 7 Communication ...... 7 Psychology ...... 7 Information Technology...... 8 Problem Solving...... 8 Legal ...... 8 Professional Opportunities in Forensic Accounting ...... 8 Investigative Services ...... 8 Fraud Risk Management ...... 9 Expert Consulting ...... 9 Expert Testimony ...... 9 Business Valuation ...... 9 Other ...... 10 Professional Organizations and Certifications...... 10 AICPA (www.aicpa-cima.com) ...... 10 ASA (www.appraisers.org) ...... 11 ACFE (www.acfe.com) ...... 11 ISACA (www.isaca.org)...... 11 NACVA (www.nacva.com) ...... 12 Organization of This Book ...... 12 Summary ...... 12 Review Questions ...... 14 Review Answers ...... 15

Chapter 2 – Professional Ethics and Responsibilities ...... 17 Learning Objectives ...... 17 Introduction ...... 17 Authoritative Guidance ...... 17 Professional Ethics ...... 18 Professional Responsibilities ...... 39 Non-Authoritative Guidance ...... 40 Summary ...... 41 Review Questions ...... 43 Review Answers ...... 44

Section II: Fundamental Forensic Knowledge ...... 47

Chapter 3 – Civil and Criminal Procedure ...... 49 Learning Objectives ...... 49 Introduction ...... 49

Table of Contents

The American Court System ...... 50 Steps in Civil Litigation (Rules of Civil Procedure) ...... 52 Commencing a Civil Suit ...... 52 Moving the Civil Action Forward ...... 55 The Defendant’s Response ...... 56 Parties ...... 58 Trial ...... 59 Verdicts and Judgments...... 60 Post-Trial Motions ...... 60 Enforcement of Judgments ...... 61 Remedies ...... 61 Appeals ...... 63 Res Judicata ...... 63 Steps in a Criminal Proceeding ...... 64 Criminal Litigation ...... 64 Arrest...... 64 Booking ...... 65 First Appearance ...... 65 Preliminary Hearing ...... 65 Grand Jury Indictment or Information ...... 65 Arraignment ...... 66 Pretrial Motions ...... 66 Trial ...... 68 Sentencing ...... 69 Appeals ...... 69 Post-Conviction Remedies ...... 69 Summary ...... 69 Review Questions ...... 71 Review Answers ...... 73

Chapter 4 – Evidence ...... 75 Learning Objectives ...... 75 Introduction ...... 75 Categories of Evidence ...... 75 Testimonial, Physical, and Demonstrative Evidence ...... 76 Federal Rules of Evidence ...... 76 Relevance ...... 77 Privilege(s) ...... 77 Attorney-Client Privilege...... 78 Marital Privilege ...... 84 Physician-Patient Privilege ...... 85 Psychotherapist-Patient Privilege ...... 85 Priest-Penitent Privilege ...... 85 Privilege against Self-Incrimination...... 85 Law Enforcement Privilege ...... 86 Competency and Knowledge ...... 86 Opinions Including Experts ...... 86 Hearsay ...... 88 Use of Originals ...... 91 Documents ...... 92 Witness Examination and Impeachment ...... 93 Authentication ...... 94 Burden of Proof ...... 96 Presumptions...... 96 Summary ...... 96 Review Questions ...... 98 Review Answers ...... 99

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Chapter 5 – Discovery ...... 101 Learning Objectives ...... 101 Introduction ...... 101 Discovery Standards ...... 101 Discovery Sequence ...... 103 Discovery Abuse ...... 104 ESI (Electronically Stored Information) ...... 105 Interrogatories ...... 105 Depositions ...... 108 Requests for Document Production, ESI, and Tangible Things or Entering Onto Land ...... 112 Requests for Physical or Mental Examinations ...... 114 Requests for Admission ...... 115 Ways to Fight Discovery Abuse...... 116 Recent Amendments to the FRCP ...... 118 Improve Early and Effective Case Management ...... 118 Enhancing the Means of Keeping Discovery Proportional ...... 118 Advancing Cooperation ...... 119 Summary ...... 119 Review Questions ...... 121 Review Answers ...... 122

Chapter 6 – Litigation Services ...... 125 Learning Objectives ...... 125 Introduction ...... 125 Expert Consultant versus Expert Witness ...... 126 The Work of an Expert Witness ...... 126 Federal Rules Governing Expert Testimony ...... 126 FRE 702, Testimony by Expert Witnesses...... 126 FRE 703, Bases of an Expert Opinion ...... 131 FRE 704, Opinion on an Ultimate Issue ...... 132 FRE 705, Disclosing the Facts or Data Underlying an Expert ...... 133 FRE 706, Court-Appointed Experts ...... 133 Disclosure of Expert Testimony ...... 134 Depositions ...... 135 Objectives of Opposing Attorneys in Depositions ...... 136 Direct Examination ...... 138 Cross-Examination ...... 139 Expert Witness Liability ...... 141 Alternative Dispute Resolution ...... 141 Advantages of ADR ...... 143 Disadvantages of ADR ...... 144 Arbitration ...... 144 Mediation ...... 145 Variations in ADR Approaches ...... 146 ADR and Accounting Litigation Support Practice ...... 146 Online Dispute Resolution ...... 147 Corporate ADR Programs ...... 148 Summary ...... 149 Review Questions ...... 151 Review Answers ...... 152

Chapter 7 – Engagement and Practice Management ...... 155 Learning Objectives ...... 155 Introduction ...... 155 Forensic Accounting Services ...... 155 General Types of Forensic Accounting Services ...... 155 Specific Examples of Forensic Accounting Services ...... 156

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Forensic Accounting Services in Civil Trials ...... 158 Forensic Accounting Services in Criminal Trials ...... 160 Applicable Standards for CPAs ...... 161 Engagement Management ...... 163 Planning and Preparation ...... 163 Communicating with Counsel ...... 169 Administrative Issues ...... 169 Practice Development ...... 170 Marketing...... 170 Expert Liability ...... 172 Abuse and Unreasonable Demands ...... 172 Summary ...... 174 Review Questions ...... 176 Review Answers ...... 177

Section III: Specialized Forensic Knowledge ...... 179

Chapter 8 – Fraud Prevention, Detection, and Response ...... 181 Learning Objectives ...... 181 Introduction ...... 181 Managing Fraud Risk ...... 181 Fraud Risk Assessment ...... 182 Standards-Based Information Security Management ...... 183 Assessing Risks of Fraud ...... 183 Information Security Assurance...... 184 Fraud Prevention ...... 184 Fraud Detection ...... 184 Fraud versus Errors, Waste, and Inefficiency ...... 185 Sources of Fraud Detection...... 185 Fraud Investigation and Response Protocols ...... 189 Unified Case File ...... 190 Legal Issues Regarding Fraud Investigations ...... 190 Objectives of Fraud Investigations ...... 191 Evidence Gathering ...... 193 Fraud Theory Approach ...... 194 Issues Associated with Gathering Specific Types of Evidence ...... 196 General Sources of Documentary Evidence ...... 196 Derived Document Evidence ...... 197 Questioned Document Analysis ...... 198 Observation Evidence ...... 198 Interviewing ...... 199 Advanced Methods for Assessing Honesty...... 203 Summary ...... 205 Review Questions ...... 207 Review Answers ...... 208

Chapter 9 – Fraud Schemes and Applications ...... 211 Learning Objectives ...... 211 Introduction ...... 211 Occupational Fraud ...... 211 Corruption...... 211 Asset Misappropriation ...... 211 Financial Statement Fraud ...... 212 External and Individual Fraud ...... 212 Occupational Fraud Schemes ...... 213 Profile of a Typical Fraudster ...... 213 Employee Fraud Schemes ...... 213

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External and Individual Frauds ...... 221 Vendor Frauds ...... 221 Frauds from Customers and Competitors ...... 222 Identity Theft Fraud ...... 222 Money Laundering Fraud Schemes...... 225 Placement Techniques ...... 226 Layering Techniques...... 227 Integration Techniques ...... 227 Anti-Money-Laundering Laws ...... 228 Organized Crime and Fraud ...... 229 LCN Activities ...... 229 LCN Organization Structure ...... 229 Financial Investigations Involving the LCN ...... 230 Other Criminal Enterprise Groups ...... 230 Terrorist Groups...... 230 Summary ...... 230 Review Questions ...... 232 Review Answers ...... 233

Chapter 10 – Bankruptcy and Related Frauds ...... 235 Learning Objectives ...... 235 Introduction ...... 235 Federal Rules of Bankruptcy Procedure ...... 238 Investigating Fraud and Abuse ...... 240 Investigating Businesses for Concealed Assets ...... 241 Investor Fraud Schemes ...... 245 Health Care Fraud Schemes ...... 245 Debtor-Creditor Collusive Schemes ...... 246 Straw Buyer and Fictitious Bidder Schemes ...... 246 Civil Actions in Bankruptcy to Fight Fraud ...... 247 IRS Case Files: Examples of Bankruptcy Fraud Investigations ...... 247 Bankruptcy Fraud versus Divorce Fraud ...... 249 Bankruptcy Fraud versus Fraud in the Administration of Estates and Trusts ...... 250 Legal Processes for Investigations ...... 251 Investigations and Involvement from the United States Trustee Program...... 253 Summary ...... 254 Review Questions ...... 256 Review Answers ...... 257

Chapter 11 – Digital Forensics and Data Analytics ...... 259 Learning Objectives ...... 259 Introduction ...... 259 Legal Issues ...... 261 Cases Involving Law Enforcement ...... 261 Cases Involving Private Investigations ...... 262 General Knowledge and Skills for Computer and Digital Forensics ...... 262 Computer Forensics Responsibilities ...... 264 Education, Training, and Qualifications ...... 264 Digital Forensics Labs ...... 265 Regional Computer Forensic Laboratories ...... 266 Private Investigations versus Law Enforcement Investigations ...... 267 Types of Investigations ...... 268 Email Investigation Cases ...... 268 The BTK Serial Killer Case...... 268 Alex Rodriguez Sports Doping Case ...... 269 Colombian Criminal Enterprise Case ...... 269 Scott Peterson Murder Case ...... 269

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Casey Anthony Murder Case ...... 269 Bernie Madoff Ponzi Scheme Case ...... 269 Rod Blagojevich Public Corruption Case ...... 269 Khalid Quazzani Counterterrorism Case ...... 270 Alberto Gonzalez Hacking Case ...... 270 Mortgage Fraud Case ...... 270 Child Pornography Cases ...... 270 Courtney Haynes Sexual Assault Case ...... 270 Basic versus Advanced Digital Forensics Skills ...... 270 Software Used By Digital Forensics Examiners ...... 272 Specific Functions and Capabilities of Popular Computer Forensics Software Products ...... 274 Solid State and Mechanical Storage Devices ...... 278 Advanced Digital Forensics and Computer-Assisted Audit Tools and Techniques...... 279 CAAT Software ...... 280 Network Forensics ...... 281 IP Tracing ...... 282 Limitations of IP Tracing...... 284 IP Spoofing ...... 284 Traffic Monitoring ...... 284 Network Forensics Software ...... 285 IP Lookup Services ...... 285 Email Tracing...... 285 Log Analyzers ...... 285 Conducting Computer Forensics Investigations ...... 285 Sizing Up the Situation ...... 286 Securing Evidence ...... 286 Chain of Custody ...... 287 Multiple Copies of Digital Data ...... 287 Examining the Evidence...... 288 Analyzing the Evidence ...... 288 Reporting ...... 288 Law Enforcement Databases ...... 288 Data Analytics and Big Data...... 289 Big Data ...... 290 The Various Levels of Data Analytics ...... 290 Harnessing Big Data ...... 290 ETL Processing ...... 291 Warehousing the Data ...... 291 Analyzing the Data ...... 292 Forensic Accounting Applications ...... 292 Summary ...... 292 Review Questions ...... 294 Review Answers ...... 295

Chapter 12 – Matrimonial Forensics ...... 297 Learning Objectives ...... 297 Introduction ...... 297 The Role of the Forensic Accountant ...... 297 Accepting an Engagement ...... 299 Expertise ...... 299 Integrity and Objectivity ...... 299 Sufficient Staffing ...... 300 Timing ...... 300 The Divorce Process...... 300 Discovery...... 302 The Character of Property and Its Division ...... 305 Tax Consequences of Asset Distributions ...... 306

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Stock in a Closely Held Corporation ...... 306 Nonqualified Stock Options ...... 307 Incentive Stock Options ...... 307 Deferred Compensation ...... 307 Personal Residence ...... 307 Identification of Assets, Liabilities, and Income ...... 308 Tax Returns ...... 308 Bank and Brokerage Statements ...... 308 Credit Card Statements...... 308 Personal Financial Statements ...... 308 Loan Agreements ...... 308 Insurance Policies ...... 309 Internet Services ...... 309 Online Search Firms ...... 309 Valuation and Quantification of Assets, Liabilities, and Income ...... 309 Valuation of the Marital or Community Estate ...... 309 Valuation of Professional Practices ...... 311 Valuation of Other Assets ...... 313 Retirement Assets ...... 313 Inclusion of Stock Options in the Marital Estate ...... 317 Personal Residence ...... 318 Alimony and Support...... 318 Alimony ...... 319 Use of Insurance and Other Property as a Means of Securing Alimony ...... 320 Property Distributions as Alimony ...... 320 Child Support ...... 321 Fraud in Matrimonial Engagements ...... 322 Methods of Concealment ...... 324 Summary ...... 326 References ...... 326 Review Questions ...... 327 Review Answers ...... 328

Chapter 13 – Financial Statement Misrepresentations ...... 331 Learning Objectives ...... 331 Introduction ...... 331 Financial Statement Misrepresentations Defined ...... 331 A Continuum of Seriousness ...... 332 Financial Statement Fraud versus Earnings Management ...... 333 Common Methods Used To Commit Financial Statement Fraud ...... 334 Improper Revenue Recognition ...... 334 Misstatement of Assets ...... 340 Misstatement of Expenses and Liabilities ...... 342 Off-the-Book Arrangements ...... 343 Inappropriate Financial Presentation ...... 344 Who Commits Financial Statement Fraud? ...... 345 Perpetrators and the Fraud Triangle ...... 345 Red Flags and Risk Factors ...... 349 Investigation Techniques ...... 351 Prevention of Financial Statement Fraud: Best Practices...... 356 SEC Investigations ...... 358 The Foreign Corrupt Practices Act ...... 359 FCPA Requirements ...... 359 FCPA Investigations ...... 359 Summary ...... 360 Review Questions ...... 362 Review Answers ...... 364

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Chapter 14 – Economic Damages ...... 367 Learning Objectives ...... 367 Introduction ...... 367 General Knowledge for Damage Experts ...... 367 Roles of Damage Experts ...... 367 Proving Damages ...... 368 General Kinds of Damages ...... 368 Commercial Litigation ...... 370 Damages in Business Litigation ...... 370 Legal Principles Related To Lost Profits Damages ...... 383 Damages Related To Intellectual Property ...... 384 Individual Litigation ...... 385 Lost Wages ...... 385 Employer Fringe Benefits ...... 386 Extra Out-of-Pocket Costs ...... 386 Time Value of Money in Individual Litigation ...... 387 Taxes in Personal Litigation ...... 387 Summary ...... 388 Review Questions ...... 390 Review Answers ...... 391

Chapter 15 – Valuation Fundamentals ...... 393 Learning Objectives ...... 393 Introduction ...... 393 General Knowledge ...... 394 What Is Value? ...... 394 Present Value ...... 394 General Valuation Models ...... 395 Three General Valuation Approaches ...... 395 Income Approach...... 396 Market Approach ...... 410 Asset Approach ...... 414 Valuation Adjustments ...... 418 Introduction ...... 418 Adjustments When Valuing Fractional Equity Interests ...... 419 Summary ...... 420 Review Questions ...... 421 Review Answers ...... 422

Chapter 16 – Valuation Applications ...... 425 Learning Objectives ...... 425 Introduction ...... 425 The Business Valuation Process ...... 425 Applications of the General Valuation Approaches ...... 426 The Income Approach in Practice ...... 426 The Market Approach in Practice ...... 435 Other Topics in Business Valuation ...... 436 Economic Cash Flow and Earnings ...... 436 Non-Operating Assets ...... 437 Valuing Intangible Assets ...... 437 Valuing Pass-Through Tax Entities ...... 437 Models, Approaches, and Methods ...... 438 Standards of Value and Premises of Value ...... 438 Effect of Industry and Economy on Value ...... 440 Effect of Shareholder Agreements on Value ...... 440 Valuation Date ...... 441 Valuation and the Law ...... 441

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Business Valuation Standards of Practice ...... 441 Authoritative Interpretations ...... 443 Business Valuation Reports ...... 443 Engagement Letter Terms In Valuation Projects ...... 444 Assumptions and Limiting Conditions ...... 445 Hypothetical Conditions ...... 446 Summary ...... 446 Review Questions ...... 448 Review Answers ...... 449

Appendix A – Fraud-Related Laws ...... 451

Appendix B – Present Value ...... 483

Glossary ...... 489

Index ...... 509

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