ch00_FM_4707 8/29/06 4:35 PM Page i Forensic Accounting and Fraud Investigation for Non-Experts SECOND EDITION Howard Silverstone Michael Sheetz WILEY John Wiley & Sons, Inc. ch00_FM_4707 8/29/06 4:35 PM Page iv ch00_FM_4707 8/29/06 4:35 PM Page i Forensic Accounting and Fraud Investigation for Non-Experts SECOND EDITION Howard Silverstone Michael Sheetz WILEY John Wiley & Sons, Inc. ch00_FM_4707 8/29/06 4:35 PM Page ii 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. 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HV8079.F7S55 2007 363.25’963—dc22 2006015452 Printed in the United States of America 10987654321 ch00_FM_4707 8/29/06 4:35 PM Page iii 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 ch00_FM_4707 8/29/06 4:35 PM Page iv ch00_FM_4707 8/29/06 4:35 PM Page v CONTENTS Acknowledgments ix Part I Fraud and Forensic Accounting Overview 1 1FRAUD 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 2UNDERSTANDING THE BASICS OF FINANCIAL ACCOUNTING 25 INTRODUCTION 25 THE FIVE ACCOUNTING CYCLES 27 JOURNALS 34 TYING THE THREAD 36 SUGGESTED READINGS 36 3THE ENTITIES 38 PROPRIETORSHIPS 39 PARTNERSHIPS 39 CORPORATIONS 41 BUSINESS ENTERPRISES IN THE GLOBAL ENVIRONMENT 42 SUGGESTED READINGS 47 v ch00_FM_4707 8/29/06 4:35 PM Page vi vi Contents 4FUNDAMENTAL 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 5THE 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 6BUSINESS 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 7BUSINESS VILLAINS 90 INTRODUCTION 90 ORGANIZED CRIME AND BUSINESS 90 MONEY LAUNDERING 98 CONCLUSION 105 SUGGESTED READINGS 106 ch00_FM_4707 8/29/06 4:35 PM Page vii Contents vii 8THE INVESTIGATIVE PROCESS 111 INTRODUCTION 111 CASE INITIATION 112 CASE EVALUATION 114 GOAL SETTING AND PLANNING 116 INVESTIGATION 123 CONCLUSION 131 SUGGESTED READINGS 132 9INTERVIEWING 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 ch00_FM_4707 8/29/06 4:35 PM Page viii 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 ch00_FM_4707 8/29/06 4:35 PM Page ix 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 ch00_FM_4707 8/29/06 4:35 PM Page x ch01_4707 8/28/06 2:04 PM Page 1 PART I FRAUD AND FORENSIC ACCOUNTING OVERVIEW ch01_4707 8/28/06 2:04 PM Page 2 ch01_4707 8/28/06 2:04 PM Page 3 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 conse- quences for the economy, corporations, and individuals. It is an opportunis- tic 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 delib- erate 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 au- thorities 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 ch01_4707 8/28/06 2:04 PM Page 4 4 Forensic Accounting and Fraud Investigation for Non-Experts notions of harm, wrongdoing, and deceit. The modern definition derived from case law focuses on the intent of the fraudster(s) to separate the trusting vic- tim from property or a legal right through deception for his or her own bene- fit. This deception involves any false or misleading words or actions or omissions or concealment of facts that will cause legal injury. Criminal pros- ecution of fraud must prove beyond a reasonable doubt that an act meeting the relevant legal definition of fraud has been committed by the accused. In civil cases, liability must be demonstrated on a balance of probabilities.