Forensic Accounting's Impact on the Modern Business World

Forensic Accounting’s Impact on the Modern Business World

Birmingham Small Firm Practitioners Monthly Meeting Group June 29, 2020 Do not be tricked into thinking that there are no crocodiles just because the water is still. Malaysian Proverb

2 What is ’Fraud’? fraud noun \ ˈfrȯd \ 1. Deceit, Trickery; specifically, an intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right was accused of credit card fraud. 2. An act of deceiving or misrepresenting (Trick). Automobile insurance frauds. 3. A person who is not what he or she pretends to be (Imposter). He claimed to be a licensed psychologist, but he turned out to be a fraud. One who defrauds (Cheat). One that is not what it seems or is represented to be. The UFO picture was proved to be a fraud.

Retrieved May 26, 2020, from https://www.merriam-webster.com/dictionary/fraud

3 What is ’Forensic’? forensic adjective fo·ren·sic \ fə-ˈren(t)-sik , -ˈren-zik \

1. Belonging to, used in, or suitable to courts of judicature or to public discussion and debate a lawyer's forensic skills. 2. Argumentative, rhetorical forensic eloquence. 3. Relating to or dealing with the application of scientific knowledge to legal problems forensic medicine. forensic science • forensic pathologist • forensic experts

Retrieved May 16, 2020, from https://www.merriam-webster.com/dictionary/forensic

4 What is Forensic Accounting

Fraud Investigations

Business Valuations Forensic Accounting Bankruptcy is accounting work done for or in Forensic support of potential Accounting litigation. Damage Securities Calculations

Insurance Claims

5 Forensic Accountant – Desired Traits

Source – C. Davis, R. Farrell, and S. Ogilby, “Characteristics and Skills of the Forensic Accountant,” AICPA/FVS section, p. 11. 6 Forensic Accountant – Necessary Skills

Source – C. Davis, R. Farrell, and S. Ogilby, “Characteristics and Skills of the Forensic Accountant,” AICPA/FVS section, p. 11. 7 Knowledge and Skills Pyramid

8 Audits: Financial, Fraud & Forensic

Characteristic Fin. Audit Fraud Examination Forensic Accounting Time perspective: Historical Historical Future and historical Primary focus: Periodic Reactive (predication) Proactive and ongoing

Investigation scope: Narrow Narrow Broad ranging

Main work product is: Audit Opinion Fraud case report Forensic audit report

Main responsibility to: Company and Defrauded party Concerned principal or public third party Guidelines are: Rules-based Principles-based; under Principles-based audit rules, it is rules- based Purpose of report: Ensure GAAP Identify perpetrator of Fraud risk assessment and is followed fraud strategic services

Professional stance: Non- Adversarial Adversarial and Non- Adversarial Adversarial 9 Which Industries Hire Forensic Accountants?

Accounting

Financial Education

Healthcare Corporations

Legal Government

10 Certified Fraud Examiner (CFE) Statistics

• Financial audits generally use sampling methodologies and do not review every transaction. • Forensic audits look at the details underlying specific transactions, attempting to determine why relevant amounts either do not or should not add up. • Forensic audits generally rely on additional tests of detail rather than relying on test of internal controls. • Forensic audits do not limit the scope of analysis based on materiality thresholds. • Forensic audits generally do not assume management/employees have integrity (heightened skepticism). • Forensic audits generally seek best legal evidence (rules of evidence). 13 Forensic Analysis vs. Fraud Investigation

• While in some cases forensic accounting involves fraud – it could also involve valuations, damage calculations, securities, bankruptcy, etc. • Many fraud analyses could be considered forensic accounting - but not all forensic accounting involves fraud examination. • Because fraud examiners are taught to conduct their examinations with an eye towards litigation, most fraud examinations generally will fall under the category of forensic accounting.

14 Fraud in Action: Case Studies – Part I

15 The Motivations

• Consider the human condition – The Seven Heavenly virtues – The Seven Deadly sins

• An intentional act to do wrong to others – Financial in nature – In pursuit of a personal gain

• Times change … human nature does not!

16 The South Sea Bubble

• Robert Harley (1661-1724) – Earl Mortimer • John Blunt • Key issues – Circle of credible friends – Stock price manipulation

17 The Mississippi Bubble

• John Law (1671-1729) • Born in Edinburgh • Key issues – Brilliant – Access to the French monarchy

18 Want to Buy the Eiffel Tower?

• Victor Lustig (1890 -1947) • Born in Austro-Hungarian Empire • Referred to himself as a “Count” • Sold the Eiffel Tower • Major counterfeiter • Once scammed Al Capone

19 Want to Buy a Match?

• Ivar Krueger (1880 -1932) • Swedish engineer and industrialist • Known as the “Match King” • Controlled ¾ of the world’s match production • Referred to as the “Leonardo of Larceny”

20 What is Occupational Fraud?

• In general, Occupational Fraud represents the use of one’s position/job for personal gain through the deliberate misuse or misapplication of employer resources or assets. • Simply stated, occupational fraud occurs when a manager, executive, employee, etc. commits fraud against his or her employer. • Some forms of Occupational Fraud are referred to as Internal Fraud or Employee Fraud • Some forms of Occupational Frauds are referred to as Management Fraud

21 Occupational Fraud Type Statistics

22 Other Types of Fraud

• External Frauds Against Companies include a broad range of schemes committed by perpetrators that do not work for the victim organization. • Vendor fraud • Theft of proprietary information • Health care fraud • Insurance fraud • Hacking • Tax fraud

• Frauds Against Individuals include a wide range of schemes that target individuals. • Identity theft • Telemarketing frauds • Ponzi schemes • 419 frauds • Phishing schemes • Strawman frauds

23 Largest Bankruptcies in US History

n/a

(PG&E) ? 24 Source: BankruptcyData.com, a division of New Generation Research, as of 2019. ‘Major’ Internal Control Fails

2003 2001

1998 2002

25 Sarbanes-Oxley Act (SOX)

• Signed into law on July 30, 2002 • Major Provisions: • Created the Public Company Accounting Oversight Board (PCAOB) • Requires auditor independence • Strengthens corporate responsibility • Mandates enhanced financial disclosures • Prohibits certain analyst/consultant conflicts • Strengthens corporate and criminal fraud accountability • Requires CEO and CFO responsibility for financial statements and tax returns

• Strengthens corporate fraud penalties 26 Did you know……

• The Association of Certified Fraud Examiners’ (ACFE) 2020 Report to the Nation on Occupational Fraud and Abuse estimates that the typical organization loses 5% of revenues each year to fraud. • Applying that estimated loss to the world’s 2019 estimated gross domestic product yields a fraud loss estimate of $4.3 trillion. • Private Companies suffer the most instances of occupational fraud (44% of all reported cases in the ACFE 2020 study) while Not-for-Profits had the lowest number of the reported frauds (about 9% of the reported cases in that same study). • Tips are consistently the most common fraud detection method. Over 40% of all frauds presented in the ACFE’s 2020 report were detected by a tip – almost three times the rate of next most common detection method. • The most common reason given by a victim organization for not involving law enforcement when fraud was discovered was that internal discipline was deemed sufficient (which surpassed fear of bad publicity).

Rationalization

Based on - Donald R. Cressey, Other People's Money (Montclair: Patterson Smith, 1973) p. 30. 28 Motivations Underlying Fraud - Diamond

Capability/Capacity Possesses necessary Source: Wolfe, D.T. & Hermanson, D.R. (2004, December). The fraud diamond: Considering the four elements of fraud. The CPA Journal, 38-42. traits or abilities; can pull it off; has positional authority.

29 Motivations Underlying Fraud - Pentagon

Source: Wolfe, D.T. & Hermanson, D.R. (2004, December). The fraud diamond: Considering the P.D. Goldmann, Fraud in the Markets, four elements of fraud. The CPA Journal, 38-42. John Wiley & Sons, 2010, pp. 24-25.

Disenfranchisement 30 Behavioral Red Flags

• Lives beyond means • Experiencing financial/family difficulties • Controlling behaviorisms – problems sharing duties • “Wheeler-Dealer” personae • Defensive nature • Substance abuse problems • Unusually close relationships w/ customers or vendors

31 Behavioral Red Flags

32 Fraud in Action: Case Studies – Part II

33 The Ponzi Scheme

• Charles Ponzi (1882-1949) • Lasted only a year • Ponzi moved in banking • A legitimate idea … – But never actually acted on – Volumes were not possible

34 Call it a “Madoff Scheme”?

• Bernie Madoff (1938- ) • Started in brokerage • Family legacy and ethnic ties • Founded his own firm in 1960 • Bernard L. Madoff Investment Securities LLC • Became the “King of Hot Chocolate”

35 The Story of Barings Bank

• Barings Bank – established in 1762 • Based in London • Not the biggest, but considered one of the best • One of the lenders to the United States for the Louisiana Purchase • Global presence in the 20th century • Taken out of business in 1995 due to loss of 827 million pounds 36 The Story of Barings Bank

• Nick Leeson • Born 1967 - 28 years old when Barings fell • Started in the back office … involved in controls • In 1992, sent to Singapore to operate a trading desk • Granted brokers license … even though he had been denied one in Great Britain due to a fraudulent application • In early January 1995 he places an overnight short straddle • Kyoto earthquake hits overnight • In desperation, he goes long in derivatives on the Nikkei … it does not recover • In February 1995, he leaves a note and disappears

37 KOSS Fraud

• The company … • Massachusetts based, founded in 1971 • Based in Milwaukee • Specializes in headphones and headsets • Trouble hits in 2010!

• Publicly traded, but very small … • Purchased a bankrupt SEC company to go public • Market cap in 2009 was under $75 million • Almost 80% owned by Koss family • Approximately $35 million in annual revenues

• 73 employees 38 KOSS Fraud

• Meet Sujata Sachdeva, born 1964 • Family in India extremely wealthy • Worked for Arthur Andersen • Hired in 1992 • Making about $200k per year in 2009 • 2005-10 -- Embezzles over $30 million!! • 2009 … Amex calls Michael Koss to advise him wire transfers being used to pay CFO credit card bills • A series of control failures … • Koss approves invoices over $5k, but not for wires or cashiers checks • Accounting software 30 years old … lacked key control features • Sachdeva and co-conspirator controlled account reconciliations .. No owner review • Small market cap excused KOSS from an internal controls opinion from Grant Thornton 39 KOSS Fraud

• Sachdeva • Sentenced to 11 years in prison • Full restitution • Released in 2017 after 6 years • Koss sued everyone possible • Went after everyone • Hired Michael Avenatti to be their attorney • Reached an $8.5m settlement with Grant Thornton • Failed in lawsuit against Park Bank

? 40 Theranos

• A case of the kid next door … • Who is Elizabeth Holmes? • Born 1984, grew up in Houston • Father: VP at Enron • Mother: Congressional staffer • Fluent in Mandarin • Admired Steve Jobs • Accepted to Stanford • Chemical Engineering • Stayed one year 41 Theranos

• Theranos – founded in 2003 • Dean of the Stanford school of engineering backed her efforts • Key product … small blood samples to yield lots of data … • $6 million in capital raised in 2004 • Fast Forward to 2010 … • $92 million in VC money • All-Star investors and Board

42 Theranos

• Investors included … • Rupert Murdoch • Larry Ellison (Oracle) • Betsy Devos • Board members included … • George Schultz (former Secretary of State) • Henry Kissinger • William Perry (former Secretary of Defense) • James Mattis • Bill Frist • Sam Nunn

43 Theranos

• By 2014 Theranos has … • $400 million in VC money • Valued at $10 billion • Contracts with Walgreens and Cleveland Clinic • The product … inaccurate testing results • Use of non-proprietary equipment • In 2016, the Centers for Medicare and Medicaid Services (“CMS”) closed Theranos lab due after inspection • By 2018 … • Company closes all operations • SEC charges Holmes and Ramesh Balwani (president) with fraud 44 Theranos

• Legal Issues • Holmes and Balwani indicted on wire fraud charges • Trial scheduled for late 2020 • Accounting and Financial Issues • Private company • Never registered under SEC reg D • Investor “package” was superficial • Never had audited financial statements • In 2014 Theranos claimed $100 million in revenues, but actually only made $100,000 profit ? 45 Most Common Anti-Fraud Controls

How is Who Fraud Reports Discovered? Fraud?

• Cash driven business • Internal controls weak or unmonitored – failure to correct known weaknesses • Management compensation linked to short-term financial results / Use of earnouts tied to performance • Company or department dominated by one or two managers • Employees poorly trained and/or poorly paid • High management and/or employee turnover • Significant related party transactions out of the ordinary course of business

48 Symptoms of Fraud

• Financial statement review and analytical procedures • Versus historical performance • Versus industry performance • Altered, forged or unusual documents • Unusual relationships • Weak internal controls • Overly complex organizational structure • Weak corporate culture • Personal conduct (employee/management lifestyle changes) • Low employee morale 49 Preventing and Detecting Fraud

• Effective and consistently enforced internal controls • Segregation of duties • Management oversight • Analytical procedures - ratio/relationship analysis to identify irregularities • Random internal audits • External audits • Effective and consistently enforced employee code of conduct • Signed employee handbook requirement • Workplace cameras – warehouse/distribution facilities • Anonymous hotline (Sarbanes-Oxley) 50 Preventing Fraud

• Creating a positive culture: • Hiring honest people and providing fraud awareness training. • Creating a positive work environment. • Providing an employee assistance program (EAP) that helps employees deal with personal pressures. • Management must exhibit effective Modeling and Labeling in their actions and words. • Remember the impact a rock’s size has on the ripple it creates ….

51 Preventing Fraud

• Eliminating opportunities for fraud: • Have good internal controls • Discourage collusion • Monitor employees and provide a whistle-blowing system • Create an expectation of punishment • Conduct proactive auditing

52 Internal Controls

• An effective internal control: • Matches the check and balance to the type of risk • Primary risks related to financial statements include: • Accounting and reporting correctly • Protection of assets • Involves a cost / benefit analysis • Inherent limitations of Internal Controls include: • Human Error • Management Override • Deliberate circumvention

• Collusion 53 Anatomy of a Fraudster – 2020 Edition

Male 31-45 Years Old 72% of occupational Approximately 53% of fraud perpetrators fraud perpetrators

First Time Offender Colludes Most repeat fraudsters have no 51% of reported frauds public record to review involved >1 perpetrator

College Educated Manager or Above 88% of fraud perpetrators had While employees comprised some college education almost 41% of reported cases, managers and above were responsible for 55%. In addition, Tenure median losses on fraud 55% of reported frauds were attributed to owners / committed by perpetrators with 0-5 executives were much greater years tenure, median losses than that of managers and attributed to frauds with tenure >5 employees. years were almost twice as large.

Criminal versus Civil – Burden of Proof – Cost – Discovery – Time

55 Criminal vs. Civil

56 Pieces of the Puzzle

57 The Criminal Investigation

58 Michigan Law – Embezzlement (MCL 750.174)

59 Summary

• Occupational fraud is a large problem both in terms of frequency and losses. • The ethical tone of a company starts at the top. • A proactive prevention approach is most effective. • Communication of anti-fraud policies is important. • Anonymous Tips and Fraud Hotlines are the most effective detection methods (should be available and encouraged). • Vigilance for the red flags of fraud is important. • Failure to prosecute reduces background check effectiveness.

60 Concluding Thought ….

The most cost-effective way to deal with fraud is to prevent it in the first place - requires a proactive approach.

61 Questions

62 63 William M. Greshak, J.D., CFA, CFE, CMA Professor of Finance & Economics, Walsh College (248) 823-1256 [direct line] [email protected]

William M. Greshak, JD, CFE, CMA, is a Professor in the Finance and Economics Department of Walsh College and recently served as the College’s Faculty Senate President. Mr. Greshak began his teaching career at Walsh in 1993 before relocating out-of-state in 1998 and returning to Walsh in 2010. His primary areas of educational instruction include financial modeling, financial markets and institutions, investments, financial management, financial statement analysis, financial fraud, and capstone corporate case studies.

Mr. Greshak also has over 16 years professional experience consulting with businesses involving a wide array of financial issues including forensic accounting, fraud investigations, projections, corporate valuations, internal investigations, mergers and acquisitions, industry/performance trends, fraud detection and deterrence, and internal controls covering a wide range of industries. In addition to his professional business consulting experience, he has also served as a state prosecutor where he prosecuted both misdemeanor and felony fraud violations in district as well as circuit court.

He earned his Juris Doctor from the Wayne State University School of Law (which included a semester abroad in Russia and Poland studying international law), Masters in the Science of Finance (MSF) from Walsh College, and his Bachelors of Business Administration (BBA) from Walsh College. 64 John A. Moore, PhD, CPA Professor of Finance & Economics, Walsh College (248) 823-1356 [direct line] [email protected]

John A. Moore is a Professor and chair of the Finance and Economics Department of Walsh College. Dr. Moore has taught college level business courses since 1994. John’s major areas of research and teaching include political economy and policy making, the impact of technology on national economies, investments and commercial real estate.

Dr. Moore has spent over three decades in the private sector as a CPA and later as a chief financial officer, primarily in the field of commercial real estate.

John earned a BBA in accounting from the University of Notre Dame, possesses three graduate degrees and earned his doctoral degree in history from Wayne State University, where his specialization was in the field of business and economic history.

Dr. Moore has also been heavily involved in governance. He has previously served as the president of the Economic & Business History Society and sits on the boards of Cedar Management Company LLC and the Center for the Study of Citizenship. He also is a member of the Catholic Schools council of the Archdiocese of Detroit. John previously served as the Board chair at De La Salle Collegiate high School. 65 About Walsh College

• All-business college, offering business and related IT programs: undergraduate, graduate, and certificate • Private, not-for-profit business college with costs comparable to public institutions • Founded in 1922 – Campuses in Troy, Novi, Port Huron and Clinton Twp. • Fully accredited: HLC & ACBSP www.walshcollege.edu/accreditation