Essentials of Forensic Accounting

To my wife, Joan, and my late mother, Rita.

Mike Crain

To my friends, family, and colleagues.

William Hopwood

To my lovely wife, Angela, who supported me through the adventure of contributing to this book. I am also grateful to my mother-in-law, Shuzhen Chen, and my father-in-law, Maosheng Li, for their support.

Carl Pacini

To my wife, Sherry; my sons, Joshua and Angelo; and my late parents, George and Wilma.

George Young

AUTHOR BIOGRAPHIES

MICHAEL A. CRAIN, DBA, CPA/ABV, ASA, CFA, CFE

Michael A. Crain is a principal of The Financial Valuation Group of Ft. Lauderdale, Inc. He is a doctor of business administration (finance) from the Manchester Business School, University of Manchester in England. Mike has been a licensed CPA in Florida since 1984 and holds several certifications in valuation, fraud examination, and financial analysis. He has certifications of Chartered Financial Analyst (CFA) from the CFA Institute, Accredited in Business Valuation (ABV) from the AICPA, Accredited Senior Appraiser (ASA) in business valuation from the American Society of Appraisers, and CFE from the Association of Certified Fraud Examiners.

Mike practices mostly in the areas of forensic accounting, measurement of economic damages, and valuation of businesses and intangible assets. He is on the adjunct faculty of Florida Atlantic University in the College of Business, where he taught graduate valuation courses. He also taught corporate finance to global MBA students for Manchester Business School.

Mike previously worked in the auditing and consulting areas in public accounting firms, including an international firm where he was a senior manager. Mike served as a consulting and testifying expert in many commercial cases, working for both plaintiffs and defendants in state and federal courts. He also served as an arbitrator in commercial damages and minority shareholder cases and as a court-appointed accountant. Moreover, he served as a special investigator on behalf of the county attorney and board of county commissioners for a Florida county government to investigate their county manager. Mike was previously approved as an arbitrator for the American Arbitration Association’s Commercial Panel. Furthermore, he is an author, coauthor, and contributing author of several professional books and journal articles. Mike also received several awards, including the AICPA’s Lawler Award presented by the Journal of Accountancy for best article of the year, and was inducted into the AICPA’s Business Valuation Hall of Fame.

WILLIAM S. HOPWOOD, PHD

William S. Hopwood’s PhD is from the University of Florida. He has published numerous articles in major accounting journals, including The Accounting Review and Journal of Accounting Research. He is also a coauthor of widely-used textbooks in the areas of Forensic Accounting and Accounting Information Systems. He has been an active co-developer of the Florida Atlantic University’s Master of Accounting with a Concentration in Forensic Accounting, the first program of its kind in the United States. More recently, William developed a virtual digital forensics lab for Florida Atlantic University’s forensics students in the School of Accounting Executive Programs.

CARL PACINI, PHD, JD, CPA/CFF

Carl Pacini is an associate professor of accounting at the University of South Florida St. Petersburg (USFSP), where he teaches auditing and forensic accounting courses. Prior to USFSP, he taught for 10 years at Florida Gulf Coast University and for 2 1/2 years at Penn State University. He developed and taught numerous courses, including Auditing I, Auditing II, Introduction to Fraud Investigation, Advanced Fraud Investigation, Tax Fraud, Forensic Accounting Legal Issues, Introduction to Forensic Accounting, and Fraud Profiling. He received his PhD in accounting from Florida State University in 1997 and his law degree from the University of Notre Dame in 1979. He is a Florida CPA, a Certified Financial Services Auditor, is Certified in Financial Forensics (AICPA designation), and is a member of the Florida Bar. Carl made numerous continuing professional education (CPE) presentations to the Georgia Society of CPAs, Florida Institute of CPAs, American Association of Attorney-Certified Public Accountants (AAA-CPA), Institute of Internal Auditors, and groups in Pennsylvania. He also served as treasurer of the Financial and Investigative section of the AAA-CPA. He has published over 80 articles in various academic and practitioner journals, including the Journal of Forensic Accounting, Journal of Accountancy, The CPA Journal, Internal Auditor, Auditing: A Journal of Practice & Theory, Journal of Business Finance and Accounting, Abacus, Advances in Accounting, Research in Accounting Regulation, Journal of Management Information Systems, Fordham Journal of Corporate and Financial Law, and the American Business Law Journal.

GEORGE RICHARD YOUNG, PHD, CPA, CFE

George Richard Young is an associate professor at Florida Atlantic University (FAU), where he taught fraud examination, auditing, financial accounting, and tax. He is a Certified Public Accountant (CPA) and Certified Fraud Examiner (CFE) licensed in Illinois, where he practiced public accounting for nine years before entering academia. He earned his doctorate from the University of Texas at Arlington and has been academic director of the FAU School of Accounting Executive Programs since 2003. The School offers a master of accounting degree for forensic concentration and business valuation as well as a master of taxation degree. In 2014, George became the Associate Director of the School, a position that encompasses managing all master’s degree programs offered by the school, as well as curriculum and assessment for both undergraduate and master’s degree programs. George was a member of the Technical Working Task Group (sponsored by a National Institute of Justice grant administered by West Virginia University) that was charged with the responsibility to develop a model educational curriculum for fraud examination and forensic accounting. He is a coauthor of Forensic Accounting and Fraud Examination (McGraw-Hill, 2e) and a chair emeritus of the Association of Certified Fraud Examiners Higher Education Advisory Committee. George has published articles in academic journals such as Auditing: A Journal of Practice & Theory, Advances in Accounting Behavioral Research, Research on Accounting Ethics, Issues in Accounting Education, Journal of Forensic & Investigative Accounting, and practice journals such as The Journal of Accountancy, The CPA Journal, Fraud Magazine, Internal Auditor, and Taxation for Accountants.

PREFACE

Forensic accounting is a fascinating field of study and practice, encompassing knowledge from accounting, finance, law, psychology, criminology, and other disciplines. It involves the collection and evaluation of evidence, whether the forensic accountant is performing a fraud examination, providing litigation services, serving as a testifying expert or non-testifying consulting expert or determining the value of assets and liabilities. Forensic accountants can serve in a variety of roles, such as the prevention and detection of civil and criminal fraud, measuring economic damages in litigation matters, valuing business or intangible assets, and testifying as an expert in courts of law. Regardless of the particular service performed, forensic accountants generally need a diverse skill set, including the ability to think critically, use quantitative methods, conduct research and investigations, and communicate effectively.

The need for forensic accounting has existed for more than a hundred years and is now as important as it has ever been. One prominent area of forensic accounting is fraud prevention and detection. A reason for the ongoing need for forensic accountants in this area is that there will always be individuals who wish to exploit or gain an unfair advantage over other people. A second reason is that the world has changed in ways that facilitate the exploitation of others. For example, the proliferation of technology has made the perpetration of financial crimes easier and has decreased the risk of detection for the perpetrator. No longer do bank robbers have to physically appear at a bank with a gun to steal money; now they can sit in the safety of their homes and, with a few keystrokes, be unlawfully or unfairly enriched. On the other hand, technology is a tool in the arsenal of forensic accountants that can be used to expose many frauds. A third reason is that various markets have become increasingly complex. In these markets, financial assets, nonfinancial assets, and the structure of transactions have grown in sophistication and increased the demand for valuation services. In addition, the increased complexity of financial transactions has created opportunities for unscrupulous individuals to commit financial statement fraud.

To uncover fraud schemes, forensic accountants need knowledge of financial transactions, how they are recorded, and an awareness that fraud cannot always be found in business records and financial statements. They also need knowledge of types and sources of evidence, the process of evidence collection so as to preserve the chain of custody, and applicable laws and regulations. Also, forensic accountants must be able to think critically so they can assess situations, persons, and evidence to ensure that victims, to the extent possible, are made whole and fraudsters are brought to justice. Knowledge of forensic accounting can be used to recommend preventative strategies and measures that decrease the probability that fraud will be committed and increase the likelihood of early detection if it is committed.

Besides fraud investigation, forensic accountants engage in a wide variety of litigation services that include serving as a litigation consultant, expert witness, mediator, arbitrator, and bankruptcy trustee. Further, these services can involve many specialty practice areas. Examples of these specialty areas include due diligence in mergers or acquisitions, valuation of economic losses, the ability to resolve patent disputes, and assistance in the administration of estates and trusts. Business valuation is an especially broad practice area because almost any type of litigation or potential litigation can involve valuation issues. These issues include, for example, the value of intangibles in business acquisitions, asset values in divorce, economic damages in breach of contract case, the value of complex options, and the value of businesses.

When measuring economic damages and business valuation, forensic accountants generally need a variety of knowledge and skills such as financial analysis, finance, economics, industrial organization, critical thinking, and good communication techniques. On many occasions, these kinds of services are needed for matters in dispute that may be decided by triers of fact, such as a court of law or an arbitration panel.

This book focuses on methods, techniques, strategies, and thinking processes utilized in forensic accounting along with professional standards of practice, ethics, and law applicable to subfields in forensic accounting. When appropriate, this book encapsulates information from AICPA professional standards, practice aids, and other AICPA publications. It consists of three major sections. Section I introduces the forensic accounting profession. Section II provides a thorough coverage of relevant legal issues and the practice of forensic accounting. Section III covers various forensic accounting areas, including fraud, bankruptcy, digital forensics, matrimonial forensics, economic damages, and business valuation theory and applications. The overall coverage is consistent with the Content Specification Outline (CSO) for the Certified in Financial Forensics (CFF) examination at the time of our writing. Practitioners seeking the CFF certification may find our text useful when preparing for the exam. This book also expands on the CSO in many places, especially in the areas of digital forensics, expert witnessing, practice development, and fraud management.

Essentials of Forensic Accounting is designed for experienced and inexperienced forensic accounting practitioners and students who desire to enter the forensic accounting profession, as well as those who simply wish to know more about the comprehensive body of forensic accounting knowledge. Because the text covers many areas, it does not encompass the entire body of knowledge of particular topics. Some readers may peruse certain chapters and others may use the material contained in these pages as a springboard for the study of the various professional standards and AICPA practice aids. Extensive end-of-chapter materials make the book suitable for instructors and students of college and university courses that involve forensic accounting and fraud examination at the undergraduate and graduate levels. We hope that this book helps you understand the uniqueness of this fascinating area of study and encourages you to learn more about forensic accounting.

CONTENTS

Section I: Introduction

Chapter 1: The Forensic Accounting Profession

Learning Objectives

Introduction

The Essence of Forensic Accounting

Forensic Accounting Versus Traditional Accounting

Forensic Accounting Versus Auditing

The Historical Development of Forensic Accounting

Forensic Accounting Knowledge and Skills

Accounting

Auditing

Investigative

Criminology and Digital Forensics

Accounting Information Systems

Risk Analysis

Communication

Psychology

Information Technology

Problem Solving

Legal

Professional Opportunities in Forensic Accounting

Investigative Services

Fraud Risk Management

Expert Consulting

Expert Testimony

Business Valuation

Other

Professional Organizations and Certifications

AICPA (www.aicpa.org)

ASA (www.appraisers.org)

ACFE (www.acfe.com)

ISACA (www.isaca.org)

NACVA (www.nacva.com)

Organization of This Book

Summary

Review Questions

Short Answer Questions

Brief Cases

Internet Research Assignments

Chapter 2: Professional Ethics and Responsibilities

Learning Objectives

Introduction

Authoritative Guidance

Professional Ethics

Organization

Responses to Ethical Conflicts

ET Sections Most Applicable to Forensic Accountants

Other Sections That May Be Applicable

Disciplinary Procedures

State CPA Societies

State Boards of Accountancy

Other Codes of Conduct

Professional Responsibilities

SSCS No. 1, Consulting Services: Definitions and Standards

SSVS No. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset

Other Valuation Standards

Non-authoritative Guidance

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Section II: Fundamental Forensic Knowledge

Chapter 3: Civil and Criminal Procedure

Learning Objectives

Introduction

The American Court System

Steps in Civil Litigation (Rules of Civil Procedure)

Commencing a Civil Suit

Filing a Complaint

Joinder of Claims

Intervention

Moving the Civil Action Forward

The Defendant’s Response

Parties

Trial

Verdicts and Judgments

Post-Trial Motions

Enforcement of Judgments

Remedies

Appeals

Res Judicata

Steps in a Criminal Proceeding

Criminal Litigation

Arrest

Booking

First Appearance

Preliminary Hearing

Grand Jury Indictment or Information

Arraignment

Pretrial Motions

Trial

Sentencing

Appeals

Post-Conviction Remedies

Summary

Review Questions

Short Answers

Brief Cases

Cases

Internet Research Assignments

Chapter 4: Evidence

Learning Objectives

Introduction

Categories of Evidence

Testimonial, Physical, and Demonstrative Evidence

Federal Rules of Evidence

Relevance

Privilege(s)

Attorney-Client Privilege

Marital Privilege

Physician-Patient Privilege

Psychotherapist-Patient Privilege

Priest-Penitent Privilege

Privilege Against Self-Incrimination

Law Enforcement Privilege

Competency and Knowledge

Opinions Including Experts

Hearsay

Use of Originals

Documents

Witness Examination and Impeachment

Authentication

Burden of Proof

Presumptions

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 5: Discovery

Learning Objectives

Introduction

Discovery Standards

Discovery Sequence

Discovery Abuse

ESI (Electronically Stored Information)

Interrogatories

Depositions

Requests for Document Production, ESI, and Tangible Things or Entering Onto Land

Requests for Physical or Mental Examinations

Requests for Admission

Ways to Fight Discovery Abuse

Proposed Amendments to the FRCP

Improve Early and Effective Case Management

Enhancing the Means of Keeping Discovery Proportional

Advancing Cooperation

Additional Comments

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 6: Litigation Services

Learning Objectives

Introduction

Expert Consultant Versus Expert Witness

The Work of an Expert Witness

Federal Rules Governing Expert Testimony

FRE 702, Testimony by Expert Witnesses

FRE 702 and Motions in Limine

Qualifications

Reliable Principles and Methods

FRE 703, Bases of an Expert Opinion

Choosing Facts

Expressing Expert Opinions

FRE 704, Opinion on an Ultimate Issue

FRE 705, Disclosing the Facts or Data Underlying an Expert

FRE 706, Court-Appointed Experts

Disclosure of Expert Testimony

Depositions

Objectives of Opposing Attorneys in Depositions

Preparing for Depositions

Abuse by Opposing Counsel

Direct Examination

Cross-Examination

Opposing Counsel Tactics

The Extent of Questions in Cross-Examination

Expert Witness Liability

Alternative Dispute Resolution

Advantages of ADR

Disadvantages of ADR

Arbitration

Arbitration Awards

The Arbitration Process

Mediation

Variations in ADR Approaches

ADR and Accounting Litigation Support Practice

Online Dispute Resolution

Corporate ADR Programs

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 7: Engagement and Practice Management

Learning Objectives

Introduction

Forensic Accounting Services

General Types of Forensic Accounting Services

Specific Examples of Forensic Accounting Services

Forensic Accounting Services in Civil Trials

Forensic Accounting Services in Criminal Trials

Applicable Standards for CPAs

Engagement Management

Planning and Preparation

Initial Case Assessment

Deciding to Accept the Engagement

Understanding With the Client

Engagement Letters

Communicating With Counsel

Administrative Issues

Practice Development

Marketing

Marketing Options

The Expert’s Curriculum Vitae

Expert Liability

Abuse and Unreasonable Demands

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Section III: Specialized Forensic Knowledge

Chapter 8: Fraud Prevention, Detection, and Response

Learning Objectives

Introduction

Managing Fraud Risk

Fraud Risk Assessment

Standards-Based Information Security Management

Assessing Risks of Fraud

Information Security Assurance

Fraud Prevention

Fraud Detection

Fraud Versus Errors, Waste, and Inefficiency

Sources of Fraud Detection

Tip Lines

Fraud Detection by Accident

Fraud Detection by the External Auditors

Fraud Detection by Internal Auditors and Inspector Generals

Fraud Detection by Dedicated Departments

Fraud Detection Systems

Types of Fraud Indicators

Commercial Fraud Detection Systems

Developing an In-House Fraud Detection System

Special Modeling Approaches

Fraud Investigation and Response Protocols

Unified Case File

Legal Issues Regarding Fraud Investigations

Objectives of Fraud Investigations

Stopping an Ongoing Fraud

Providing Support for an Insurance Claim

Determining a Tax Loss

Deterring Future Fraud

Controlling Embarrassing Reports in the News Media

Discovering and Repairing Internal Control Weaknesses

Punishing the Guilty and Obtaining Restitution

Evidence Gathering

Fraud Theory Approach

The Fraud Theory and Court

Evidence Collection Process

Issues Associated With Gathering Specific Types of Evidence

Physical Evidence

Documentary Evidence

General Sources of Documentary Evidence

Derived Document Evidence

Questioned Document Analysis

Handwriting Analysis

Digital Forgeries

Observation Evidence

Interviewing

Order of Interviews

Preparing for Interviews

The Set and Setting for Interviews

Individual Interviews of Suspects

The Confession

Concluding Questions

Flow of the Interview

Advanced Methods for Assessing Honesty

Eye Movements

Surprising the Suspect

Accusing the Suspect

Persuasive Techniques

Types of Questions

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 9: Fraud Schemes and Applications

Learning Objectives

Introduction

Occupational Fraud

Corruption

Asset Misappropriation

Financial Statement Fraud

External and Individual Fraud

Occupational Fraud Schemes

Profile of a Typical Fraudster

Employee Fraud Schemes

Employee Corruption Schemes

Asset Misappropriation Schemes

Fraud Schemes, Electronic Systems, and Attack Vectors

Fraud Schemes and Collusion

Other Types of Employee Fraud

External and Individual Frauds

Vendor Frauds

Frauds From Customers and Competitors

Identity Theft Fraud

Types of Identity Theft

Investigating Identity Theft

Identity Theft Investigation Methods

How Identity Theft Rings Work

Money Laundering Fraud Schemes

Placement Techniques

Layering Techniques

Integration Techniques

Anti-Money-Laundering Laws

Organized Crime and Fraud

LCN Activities

LCN Organization Structure

Financial investigations Involving the LCN

Other Criminal Enterprise Groups

Terrorist Groups

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 10: Bankruptcy and Related Frauds

Learning Objectives

Introduction

Federal Rules of Bankruptcy Procedure

Investigating Fraud and Abuse

Documentary Sources for Concealed Assets

Investigating Businesses for Concealed Assets

Bust-Out Schemes

Bleed-Out Schemes

Investor Fraud Schemes

Red Flags for Investor Fraud Schemes

Examples of Investor Fraud Schemes

Health Care Fraud Schemes

Red Flags for Health Care Fraud Schemes

Examples of Health Care Fraud Schemes

Debtor-Creditor Collusive Schemes

Red Flags for Debtor-Creditor Collusive Schemes

Examples of Debtor-Creditor Collusive Schemes

Straw Buyer and Fictitious Bidder Schemes

Red Flags for Straw Buyer and Fictitious Bidder Schemes

Example of Straw Buyer and Fictitious Bidder Schemes

Civil Actions in Bankruptcy to Fight Fraud

IRS Case Files: Examples of Bankruptcy Fraud Investigations

Bankruptcy Fraud Versus Divorce Fraud

Bankruptcy Fraud Versus Fraud in the Administration of Estates and Trusts

Legal Processes for Investigations

Investigations and Involvement From the United States Trustee Program

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 11: Digital Forensics

Learning Objectives

Introduction

Legal Issues

Cases Involving Law Enforcement

Cases Involving Private Investigations

General Knowledge and Skills for Computer and Digital Forensics

Computer Forensics Responsibilities

Education, Training, and Qualifications

Digital Forensics Labs

Regional Computer Forensic Laboratories

Private Investigations Versus Law Enforcement Investigations

Types of Investigations

E-mail Investigation Cases

The BTK Serial Killer Case

Alex Rodriguez Sports Doping Case

Colombian Criminal Enterprise Case

Scott Peterson Murder Case

Casey Anthony Murder Case

Financial Fraud: Bernie Madoff Ponzi Scheme Case

Rod Blagojevich Public Corruption Case

Khalid Quazzani Counterterrorism Case

Alberto Gonzalez Hacking Case

Mortgage Fraud Case

Child Pornography Cases

Courtney Haynes Sexual Assault Case

Basic Versus Advanced Digital Forensics Skills

Software Used by Digital Forensics Examiners

Specific Functions and Capabilities of Popular Computer Forensics Software Products

Solid State and Mechanical Storage Devices

Advanced Digital Forensics and Computer-Assisted Audit Tools and Techniques

CAAT Software

Network Forensics

IP Tracing

Limitations of IP Tracing

IP Spoofing

Traffic Monitoring

Network Forensics Software

IP Look-Up Services

E-mail Tracing

Log Analyzers

Conducting Computer Forensics Investigations

Sizing Up the Situation

Securing Evidence

Secure the Site

Document the Site

Collect Evidence

Chain of Custody

Multiple Copies of Digital Data

Examining the Evidence

Analyzing the Evidence

Reporting

Law Enforcement Databases

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 12: Matrimonial Forensics

Learning Objectives

Introduction

The Role of the Forensic Accountant

Accepting an Engagement

Expertise

Integrity and Objectivity

Sufficient Staffing

Timing

The Divorce Process

Discovery

The Character of Property and Its Division

Tax Consequences of Asset Distributions

Stock in a Closely-Held Corporation

Nonqualified Stock Options

Incentive Stock Options

Deferred Compensation

Personal Residence

Identification of Assets, Liabilities, and Income

Tax Returns

Bank and Brokerage Statements

Credit Card Statements

Personal Financial Statements

Loan Agreements

Insurance Policies

Internet Services

Online Search Firms

Valuation and Quantification of Assets, Liabilities, and Income

Valuation of the Marital or Community Estate

Standards of Value

Valuation of Professional Practices

Licenses

Degrees and Certifications

Goodwill

Covenant Not to Compete

Buy-Sell Agreements

Valuation of Other Assets

Retirement Assets

Defined Benefit Pension Plans

Defined Contribution Pension Plans

Other Types of Qualified Retirement Plans

Nonqualified Plans

Deferred Compensation Plans

Valuation of Stock Options

Inclusion of Stock Options in the Marital Estate

Personal Residence

Alimony and Support

Alimony

Use of Insurance and Other Property as a Means of Securing Alimony

Property Distributions as Alimony

Child Support

Fraud in Matrimonial Engagements

Methods of Concealment

Summary

References

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 13: Financial Statement Misrepresentations

Learning Objectives

Introduction

Financial Statement Misrepresentations Defined

A Continuum of Seriousness

Financial Statement Fraud Versus Earnings Management

Common Methods Used to Commit Financial Statement Fraud

Improper Revenue Recognition

Sham Sales

Premature Revenue Recognition

Improper Cut-Off of Sales

Recognition of Conditional Sales

Misstatement of Percentage-of-Completion Contracts

Unauthorized Shipments

Consignment Sales

Bill-and-Hold Sales

Misstatement of Assets

Misstatement of Expenses and Liabilities

Off-the-Book Arrangements

Inappropriate Financial Presentation

Who Commits Financial Statement Fraud?

Perpetrators and the Fraud Triangle

Opportunity

Motivation

Rationalizations

Red Flags and Risk Factors

Investigation Techniques

Prevention of Financial Statement Fraud: Best Practices

SEC Investigations

The Foreign Corrupt Practices Act

FCPA Requirements

FCPA Investigations

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 14: Economic Damages

Learning Objectives

Introduction

General Knowledge for Damage Experts

Roles of Damage Experts

Proving Damages

General Kinds of Damages

Compensatory Damages

Punitive Damages

Legal Terminology

Commercial Litigation

Damages in Business Litigation

Lost Profits Damages

General Damage Models

Avoided Costs in Lost Profits Measurements

Practical Constraints Limiting Losses

Ex Ante and Ex Post Approaches

Unestablished Businesses

Loss of Value Damages

Extra Out-of-Pocket Costs

Mitigation

Legal Principles Related to Lost Profits Damages

Proximate Cause

Reasonable Certainty

Foreseeability

Expert Opinion Admissibility

Damages Related to Intellectual Property

Individual Litigation

Lost Wages

Employer Fringe Benefits

Extra Out-of-Pocket Costs

Medical and Rehabilitation Costs

Losses Related to Household Services

Time Value of Money in Individual Litigation

Taxes in Personal Litigation

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 15: Valuation Fundamentals

Learning Objectives

Introduction

General Knowledge

What Is Value?

Present Value

General Valuation Models

Three General Valuation Approaches

Income Approach

Introduction

Principles

Components

Income Approach in Business Valuation

Summary and Conclusion

Market Approach

Introduction

Theory

Scaling Prices With Price Multiples

Observing Prices in Business Valuation

Finding and Choosing Comparable Firms

Summary and Conclusion

Asset Approach

Introduction

When the Asset Approach Is Used

Practical Considerations

Methodologies

Cost Approach

Unrecorded Liabilities

Summary and Conclusion

Valuation Adjustments

Introduction

Adjustments When Valuing Fractional Equity Interests

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Chapter 16: Valuation Applications

Learning Objectives

Introduction

The Business Valuation Process

Applications of the General Valuation Approaches

The Income Approach in Practice

Common Valuation Models

Mid-Year Discounting Convention

Firm Valuation

Valuing Fractional Interests in Firms

Cost of Capital Practices

The Market Approach in Practice

Other Topics in Business Valuation

Economic Cash Flow and Earnings

Non-Operating Assets

Valuing Intangible Assets

Valuing Pass-Through Tax Entities

Models, Approaches, and Methods

Standards of Value and Premises of Value

Standards of Value

Premises of Value

Effect of Industry and Economy on Value

Effect of Shareholder Agreements on Value

Valuation Date

Valuation and the Law

Business Valuation Standards of Practice

Scope of SSVS (VS Section 100)

Types of Valuation Services

Reporting

Jurisdictional Exception

Authoritative Interpretations

Business Valuation Reports

Engagement Letter Terms in Valuation Projects

Assumptions and Limiting Conditions

Hypothetical Conditions

Summary

Review Questions

Short Answer Questions

Brief Cases

Cases

Internet Research Assignments

Appendix A Fraud-Related Laws

Overview of Various Common Law and Statutory Laws Related to Fraud

Sarbanes-Oxley Act

Federal Tax Crimes

Federal Securities Law Offenses (Securities Fraud)

Foreign Corrupt Practices Act

Federal False Claims Act

Federal Anti-Kickback Statute

Stark Law

Money Laundering Laws

Conspiracy

Aiding and Abetting

Obstruction of Justice

Appendix B Present Value

Introduction

Why Present Value Is Important

Basic Math Behind TVM Calculations

Components of TVM Calculations

Summary and Conclusion

Glossary

EULA

SECTION I

Introduction

CHAPTER 1

The Forensic Accounting Profession

LEARNING OBJECTIVES

Explain the nature of forensic accounting services

Explain the different categories of forensic accounting services

Elaborate on the different types of knowledge areas and skills required for forensic accounting

Explain the different professional opportunities available to forensic accountants

Discuss three major organizations and credentials important to forensic accountants

INTRODUCTION

THE ESSENCE OF FORENSIC ACCOUNTING

Forensic accounting involves the application of special skills such as accounting, auditing procedures, finance, quantitative methods, research, and investigations. It also involves knowledge of certain areas of the law. This knowledge combined with these skills enable forensic accountants to collect, analyze, and evaluate evidential matter and to interpret and communicate findings.

Key elements of this definition including the following:

Accounting. Forensic accounting is a branch of accounting. At its most general level, accounting involves the communication of financial information.

Special skills. Forensic accounting requires special skills that are not required of accountants in general.

Law. Forensic means pertaining to the law. Forensic accounting deals with financial issues that may come before a trier of fact in a court of law or other venue (such as arbitration).

Evidential matter. Especially important to forensic accounting is evidential matter that may bear on the truth or falsity of an assertion made before a trier of fact.

Interpretation and communication. In many cases, forensic accounts interpret evidence and communicate expert opinions for clients and a trier of fact.

Forensic accounting is typically divided into two areas:

Litigation services. The forensic accountant serves as a testifying expert or non-testifying consultant and provides assistance for actual or potential legal or regulatory proceedings before a trier of fact in connection with the resolution of disputes between parties. Litigation services include serving as an expert witness, a litigation consultant (that is, a non-testifying expert), and in various other roles in dispute-resolution or legal processes (for example, as a bankruptcy trustee.)

Investigative services. The forensic accountant serves as a consultant in cases that do not involve actual or threatened litigation, but do involve performing analyses or investigations that may require the same skills used in litigation services.

FORENSIC ACCOUNTING VERSUS TRADITIONAL ACCOUNTING

Traditional accounting involves recording, classifying, analyzing, and reporting financial data and information. The emphasis is on converting raw financial data into information useful for decision makers by using an applicable financial reporting framework. The useful information is typically presented to decision makers in the form of financial statements. In summary, the work product of the traditional accountant is one or more financial statements.

On the other hand, the typical work product of forensic accountants tends to be much different from that of traditional accountants. The scope of each forensic accounting project is unique and the work product flows from the scope of the particular project. Such work products often consist of a written or oral report of findings or recommendations or both. When testifying before a trier of fact as an expert witness, forensic accountants ordinarily express their findings as expert opinions. In this use, opinion is a term of art in judicial guidelines on evidence and the law, and differs from its use in the accounting literature.

FORENSIC ACCOUNTING VERSUS AUDITING

In some respects, forensic accounting is very much like auditing. Forensic accountants generally use procedures and exercise professional skepticism in a manner similarly used by auditors. For instance, both examine evidence (usually financial related) and form professional judgments on what they observe. But the overall objectives of these two kinds of engagements are very different. The objective of audit engagements usually is to express an audit opinion on whether financial statements, taken as a whole, are fairly presented. In contrast, forensic accounting engagements tend to be focused on one or more particular areas. Speaking simply, virtually all audit engagements have a single objective of expressing one opinion on a set of financial statements whereas each forensic accounting project is very uniquely focused on a client’s particular needs and the objective is usually to report recommendations or findings.

All forensic accounting work performed by CPAs1 is subject to Consulting Services (CS) section 100, Consulting Services: Definitions and Standards (AICPA, Professional Standards). In addition, forensic accounting services may be subject to other requirements such as applicable laws and regulations, rules of evidence, civil or criminal procedures, and other professional pronouncements such as other applicable professional standards. These other requirements are discussed in detail in subsequent chapters.

Forensic accountants sometimes engage in auditing work, but for purposes other than providing an opinion on an entity’s financial statements. For example, a forensic accountant may conduct a forensic engagement as part of an occupational fraud investigation. The result of such an investigation will likely be a report that identifies, for example, the amount of the fraud loss and any control weaknesses that led to the fraud. These fraud engagements are performed as consulting engagements and are governed by CS section 100.

Forensic accountants apply specialized skills (in the form of specialized procedures) that differ from those used by auditors of historical financial statements. For example, auditors may use observation techniques whereas forensic accountants may use surveillance techniques. The differences between techniques used by traditional auditors and forensic accountants are discussed in chapter 11, Digital Forensics.

Unlike traditional auditors, not all forensic accountants are required to be independent of their clients in the way the term is used in other accounting literature. Independence is required, though, when forensic accountants participate in attest engagements such as audits of financial statements for the purpose of opining on the fairness of their presentation and reviews of financial statements.

THE HISTORICAL DEVELOPMENT OF FORENSIC ACCOUNTING

Forensic accounting has existed for thousands of years. In ancient Egypt, accountants were known as the eyes and ears of the pharaoh. By some reports, ancient forensic accountants were adept at getting to the truth and, at times, they availed themselves of harsh interrogation techniques and even torture.

Accounting for Offerings at the Temple of Karnak

Source: Flickr/Becsh

No discussion of forensic accounting would be complete without at least a mention of Sherlock Holmes, a fictional character from the late 1800s, who is widely known for his astute observations, impeccable logic, powers of deduction, and use of forensic science. Throughout the development of modern forensic accounting, Sherlock Holmes has occasionally been held up as a role model for aspiring forensic accountants. Such veneration of Sherlock Holmes by the accounting community is completely appropriate, because forensic accountants frequently investigate the how, where, when, and why of financial frauds.

In the United States and Canada, perhaps the first case of an accountant testifying in court as an expert witness was in the 1817 Canadian case Meyer v. Sefton. However, it was not until over a hundred years later that the term forensic accounting was coined by Maurice Peloubet (1892–1976) in 1946 when he published an article titled, Forensic Accounting—Its Place in Today’s Economy. Peloubet was a very prominent accountant in his era. Information about him can be found on the website of the New York State Society of CPAs (www.nysscpa.org).

Maurice Peloubet

Source: Find a Grave

Since Peloubet published his article, forensic accounting as a practice area has continued to flourish. During World War II, the FBI hired large numbers of accountants to help with intelligence and counter-intelligence operations. In the 1960s, J. Edgar Hoover, the head of the FBI, hired large numbers of accountants to fight organized crime. The need for forensic accountants increased dramatically with the financial scandals that began in the 1980s and continues to persist. The Sarbanes-Oxley Act of 2002 significantly increased the interest in forensic accounting.

   Case in Point

In one of the most famous uses of forensic accounting skills, Frank Wilson of the Internal Revenue Service’s Special Intelligence Unit was assigned to investigate Alphonse Gabriel Al Capone who, in 1930, had become Chicago’s Public Enemy Number One due to his involvement in smuggling and bootlegging liquor and other illegal activities.

Prior to Frank’s investigation, Mr. Capone had only served prison time for possession of a firearm. After the 1927 U.S. Supreme Court ruling in United States v. Sullivan (274 U.S. 259 [1927]) that clarified that income from illegal sources was taxable, the government was able to move forward in prosecuting the head of the Capone organization. Unfortunately, finding evidence was not easy; Capone had never filed an income tax return, owned nothing in his name, and had conducted business through front men. Until Wilson examined a cash receipts ledger that contained the organization’s net profits for a gambling house and the name of Mr. Capone, no records had been discovered by the government to link Mr. Capone to income of any kind. In 1931, it was this document that led to a 23-count indictment including income tax evasion for the years 1925–1929, failing to file tax returns for the years 1928 and 1929, and conspiracy to violate Prohibition laws from 1922–1931.

Mr. Capone was found not guilty on 18 of the 23 counts. He was convicted on 3 counts of tax evasion (for years 1925, 1926, and 1927) and 2 counts of failing to file tax returns (for years 1928 and 1929). The judge sentenced him to a total of 10 years in federal prison and 1 year in the county jail. He was paroled on November 16, 1939, and shortly thereafter returned to his home in Palm Island, Florida where died, on January 25, 1947, from cardiac arrest.

Al Capone

FORENSIC ACCOUNTING KNOWLEDGE AND SKILLS

Forensic accounting requires knowledge and skills in many different areas. Although these areas are discussed individually, keep in mind that they overlap each other.

ACCOUNTING

Forensic accounting spans many areas of accounting, therefore broad accounting knowledge and skills are required. However, certain accounting knowledge and skills are required within specialized areas of forensic accounting. For example, a forensic accountant specializing in investigating occupational fraud might not need to be an up-to-date expert in international accounting standards, but would likely need specialized knowledge and skills relating to accounting information systems, digital forensics, and accounting information systems auditing procedures. Similarly, a forensic accountant specializing in estimating economic damages may need business valuation skills. The many specialized areas within forensic accounting are discussed in subsequent chapters.

AUDITING

Auditors are specialists in collecting, interpreting, and evaluating data and information. Such skills are essential to forensic accounting. As previously discussed, when forensic accountants testify before a trier of fact as an expert witness, they ordinarily express their findings as expert opinions. Their findings must be based on evidence, and evidence must be collected and interpreted. Therefore, forensic accountants should be skilled in collecting and interpreting evidence. Finally, as previously mentioned, forensic accounting requires knowledge and skills using specialized evidence gathering procedures.

INVESTIGATIVE

Special skills and knowledge are required to conduct forensic accounting investigations. These special skills and knowledge include an understanding of how to structure and manage investigations, the types of evidence that may be collected, how to maintain the chain of custody, the legal rights of those under investigation, how to identify different types of fraud schemes, how to conduct interviews, and how to detect deception.

CRIMINOLOGY AND DIGITAL FORENSICS

For criminal investigations, the forensic accountant should have a basic understanding of the various roles played by crime scene investigators, digital forensics experts, forensic scientists, forensic laboratories, prosecutors, and attorneys.

Almost all crimes these days involve digital devices, including computers.2 Therefore it is helpful for the forensic accountant investigating fraud to have a basic understanding of digital forensics in both the areas of computer forensics and network forensics. In addition, advanced digital forensics are employed by, for example, using computer-assisted audit tools and techniques (CAATTs) to extract and analyze digital data from enterprise resource planning (ERP) and accounting systems.

ACCOUNTING INFORMATION SYSTEMS

Key elements of accounting information systems include internal control and business processes. Internal fraud schemes typically involve the violation of weak or nonexistent internal controls within specific business processes. Therefore, the forensic accountant must have a good understanding of internal control processes and how they interface with business processes and the accounting information system. For example, a sales-skimming fraud scheme may involve the absence of reconciliation controls in the revenue cycle.

RISK ANALYSIS

Fraud risk management is an issue commonly dealt with by forensic accountants.3 Fraud risk management activities include fraud prevention, detection, and response. This type of management begins with fraud risk assessment.

COMMUNICATION

Communication skills are essential in all areas of accounting. However, such skills can become even more critical in the area of forensic accounting. Forensic accountants serving as testifying experts often write expert reports that are likely to be subject to intense scrutiny in depositions and cross-examinations at trial. Furthermore, forensic accountants may need to explain their opinions on direct examination at trial, which requires effective presentation skills.

PSYCHOLOGY

Understanding the suspect and, in particular, his or her motivations can aid forensic accountants who perform investigations. Motivation can, for instance, help identify the areas that should be investigated. For example, a CEO may be motivated to compete successfully with a sibling by attempting to increase the market price of stock by artificially inflating net asset values and income.

The law enforcement community has long known that one of the best ways to solve a fraud case is by obtaining a confession. The process of obtaining a confession in financial fraud cases is a very carefully orchestrated one that begins with collecting documentary evidence, proceeds to interviews with non-suspects, and often terminates with an interview with the prime suspect. The key to success in interviewing involves the ability to assess honesty versus deception. Consequently, forensic accountants, at times, are aided by the employment of techniques rooted in psychology, such as the analysis of body language and eye movements.

INFORMATION TECHNOLOGY