Forensic

and
Investigative
Accounting
What is Forensic Accounting?
An orderly analysis, investigation, inquiry, test,
inspection, or examination along a “paper trail” in the
search for fraud, embezzlement, or hidden assets

• Investigative accounting
Two parts:
• Litigation support

Treats all figures as suspect until proven otherwise

 Forensic Accounting Defined

• Forensic accounting focuses on the past,

Time: although it may do so in order to look forward.

• Forensic accounting is performed for a specific

Purpose: legal forum or in anticipation of presentation
before a legal forum.

• Forensic accountants may be employed in a wide

variety of risk management engagements within
Peremptory: business enterprise as a matter of right, without
the necessity of allegations (e.g., proactive).
 Forensic Accounting Defined

Forensic accounting is the action of

identifying, recording, settling, extracting,
sorting, reporting, and verifying past
financial data or other accounting activities
for settling current or prospective legal
disputes or using such past financial data for
projecting future financial data to settle
legal disputes.
 The History of Forensic Accounting

1931

World War II

1980s: Real estate bankruptcies, junk bond schemes, and lawsuits

1988 ACFE was formed in Austin, Texas

Initially called “investigative accounting”

Increase in regulatory, tax and criminal statutes became law

The Need for Forensic Accountants
• 37% of the country’s top 100 accounting firms are
increasing their forensic and fraud services
A survey found the • The average organization loses 6% of revenue to
following: employee fraud and abuse
• The typical perpetrator:

Colleges and universities are responding

Many frauds are not reported

Wells Report
There are 13,000 CFEs in the ACFE, compared to 2,300 just 10 years ago
What Does a Forensic Accountant Do?

Attempt to obtain the truth and develop an expert opinion

Sniff out corruption

Pore over financial documents, reconstruct records,

interview people, and present report interpreting and
explaining complicated financial information

Solve a large puzzle

The Services a Forensic Accountant Provides

Damages

Antitrust Analyses

Accounting

Valuation

General Consulting

Other Analyses
 The Fraud Triangle

Motive

Rationalization Opportunity

[Source: Michael Kurland, How to Solve A Murder: Macmillan, 1995, pp. 7-8]
 Proactive Fraud Auditing

Going fishing

Thinking like a fraud auditor

Choosing a fraud type

Procedures
 Reactive Fraud Auditing

Symptoms

Cost Variances

Expected Costs

Employee’s Lifestyle
 Fraud vs. White-Collar Crime
“White collar crime is criminal conduct that does not involve
violence or the threat of violence and usually takes place in a
professional work place”

Fraud happens anywhere, white-collar crime is in the workplace

Fraud is perpetrated by anyone, white-collar crime is by

business people/professionals.

Fraud is not always criminal, white-collar crime is mostly

criminal

Fraud does not always involve something of value, white- collar

crime does.
 Some White Collar Crimes

Antitrust.

Bankruptcy fraud.

Corporate/securities fraud.

Health care fraud.

Insurance fraud.

Mass marketing fraud.

Money laundering.

Mortgage fraud.
 Contrasting Auditing, Forensic Accounting, and
Fraud Examination
Characteristic Audit Fraud Examination Forensic Accounting

Time perspective: Historical Historical Future and historical

Primary focus: Periodic Reactive 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 rule-based

Purpose of report: Ensure GAAP Identify perpetrator of Fraud risk assessment

is followed fraud and strategic services

Professional stance: Non- Adversarial Adversarial and non-

adversarial adversarial
 Red Flags
• No Company Policy Manual
• Feeling of disorganized bookkeeping,
purchasing, receiving, and/or
warehousing departments
• Missing documents
• Unrecorded transactions
• No bank reconciliations
• Subsidiary ledgers out of balance
• No physical inventory counts
• Checks written to cash
• Large related party loans
• Excessive other revenue
• Negative operating cash flow
• Downward earnings trend
• Handwritten cheque
• Extensive fund transfers
• Unusual transactions (inconsistent)
• Deficient hiring policies and
procedures
• Employees’ lifestyles inconsistent
with salaries
• Employees who don’t take vacations
• Excessive insider sales of stock
• Unexplained resignations of upper
management
• Excessive debt/equity ratio
• Strange account titles
 What Is Fraud
It shall be
• a. To employ any device, scheme, or
unlawful for any artifice to defraud,
person, directly or • b. To make any untrue statement of a
indirectly, by the material fact or to omit to state a material
use of any means fact necessary in order to make the
or instrumentality statements made, in the light of the
circumstances under which they were
of interstate made not misleading or
commerce, or the • c. To engage in any act, practice or course
malls, or any of business which operates or would
facility of any operates as a fraud or deceit upon any
person, in connection with the purchase or
national securities sale of any security.
exchange,
For example a bank manager committing suicide
on desk with a suicide note under his hand
The most important traits of an investigator

Distrust the Obvious

Think differently and Develop an open mind

Look from different angles and all sides. You will get a
different revelation
Learnings from Ravana- a great Scholar and Shiva
Bhakt useful for auditors and investigators

Laxman was sent by Ram when Ravana was dying to get

advise and some learnings:

• - Never underestimate your adversary- he made

He got this mistake with Hanuman
• Trust only those advisors who have the courage
the to criticize you.
• Treat your servants, driver (charioteer), close
family members with discretion and keep your
following secrets close to you. They can harm you.
• You cannot win always, sometimes you may
tips think that you may be winning, but you may not
be.
Financial Statement Fraud Categories and Red Flags

• Overstated revenues pose such a huge fraud

problem
• e.g. AOL created ad revenues out of thin air. With an
Overstated obsession to get advertising revenue in the door, “Nobody
there appears to have paid much attention to whether the
Revenues business deals at issue were really producing ad ‘revenues’
by any acceptable definition….” At least $ 90 million of
revenues were expunged by mid of an year, with another $
400 million later on.

• Management estimates is another area for fraudulent

misstatements, such as asset valuation, estimates relating to
Management specific transactions (such as acquisitions, restructurings, or
disposals of a segment of a business), bad debt allowance, and
pension and other postretirement benefit obligations. Compare
Estimates current management judgments and assumptions with prior
periods and with those of other companies in the same
industry.
Financial Statement Fraud Categories and Red Flags (contd.)

Pro Formas • Pro formas (or cash earnings or operating earnings) are often issued with
many expenses excluded, resulting hide and seek" earnings. Accountants
Can Mislead must focus on the earnings figures that are prepared according to GAAP.

• The trend in operating income is just as important as the trend in

Earnings earnings. The accountant can use the cash flow statement to check the
reliability of earnings. If net income is moving up while cash flow from

Problems: operations is drifting downward, something may be wrong. (Cash from

operations should not increase or decrease at a different rate than net
income.) Ideally, net cash from operations grows steadily.
Masking • e.g. In 1998, 1999, and 2000 Xerox improperly used a $ 100 million
reserve to offset related expenses.

Reduced • Microsoft Corporation survived in 2001 because it had $ 13.4 billion in

cash flow from operations. However, WorldCom, Dynergy, Adelphia
Communications, and Tyco International prove that companies can
Cash Flow inflate their cash flow by improperly booking expenses as capital
expenditures.
Financial Statement Fraud Categories and Red Flags (Contd.)

Earnings Before • EBITDA is a popular valuation method for capital-intensive

industries. Capital-intensive companies (for which fixed assets are a
large part of the balance sheet) offer the best opportunities for
Interest, Taxes, shifting expenses onto the balance sheet by aggressive, unethical
companies. Auditors should look at the capitalized accounts
Depreciation, because of the possible fraud and abuse. Unless amounts paid out
will create a long-lasting asset, the expenditures must be expensed.
and • e.g. WorldCom’s improper accounting practice greatly inflated
EBITDA ( $ 10.5 billion rather than the real $ 6.3 billion in 2001). An
Amortization internal auditor found the WorldCom cooked books, and the
resulting financial restatement was more than six times that of
(EBITDA) Enron Corporation’s.

• Companies burdened by too much debt lack the financial flexibility

to respond to crises and to take advantage of opportunities.
Investment professionals pay special attention to a company's debt-
Excessive Debt to-equity ratio. Whereas the optimum ratio vanes from industry to
industry, the amount of stockholders' or owners' equity should
significantly exceed the amount of debt. Debt should grow
proportionately with sales and earnings.
Financial Statement Fraud Categories and Red Flags (Contd.)

• Forensic accountants uncover inventory problems by looking at the ratio of

accounts receivable to sales and the ratio of inventory to cost of goods sold. If
accounts receivable exceeds 15 percent of annual sales and inventory exceeds

Inventory 25 percent of cost of goods sold, red flags are raised If customers are not paying
their bills and/or the company is saddled with aging merchandise, problems will
eventually arise.
• e.g. Crazy Eddie, and electronic equipment retailer, allegedly recorded sales to

Problems other chains as if they were retail sales (rather than wholesale sales). For the
fiscal year ending March 1, 1985, an accountant, Sammy Antar, falsified
inventories by $ 3 million, and by the next year, the false inventory reached
more than $ 10 million. The fraud may have unraveled because Eddie’s wife
and sister caught him with another woman on New Year’s Eve

Sales and • Sales figures may be inflated in several ways that are difficult to detect. Forensic
accountants should compare the trend in sales with the trend in net income.
Special-purpose entities present special opportunities for masking problems in
sales and expenses, offering the means to manipulate stock prices, create

Expenses nonexistent assets, and disguise expenses.

• e.g. In 2000, Rent-Way disclosed that its CAO had artificially reduced the
company’s expenses – a reduction of $ 127 million. There was no one big

Problems
item, but there were a dozen smaller instance of hiding or understating
expenses, from automobile maintenance to insurance payments. The stock
plummeted 72 percent, from $23.44 to $6.50.
Financial Statement Fraud Categories and Red Flags (Contd.)

• Forensic accountants should beware of companies making write-offs

Big Bath directly against earnings—especially large amounts. This is called the "big
bath." Profits are depressed for that year, but future earnings look much
better. If accounts receivable are written off, sales may have been inflated.

Balance Sheet • Because the balance sheet is a snapshot of a business's financial position
at one moment, management may be tempted to manipulate balance
sheet accounts to be listed.
Account • e.g. For its 1997 fiscal year, America Online, Inc. showed $ 385 million in
assets on its balance sheet called deferred subscriber acquisition costs.
Problems This amount represented new subscriber advertising costs that should
have been charged against income as an expense.

• The Baptist Foundation of Arizona (BFA) set up two subsidiaries owned by

Bad Balance insiders during the 1989 real estate bubble bust. BFA then sold the
depressed real estate to the subsidiaries at book value and recorded notes
Sheets. receivables at the book value amount ( and not the FMV). Presto, a
cleaner balance sheet.
Financial Statement Fraud Categories and Red
Flags (Contd.)

Pension • Under pension plan accounting, the expected long-term

rate of return (not the actual rate of return or the dollars

Plan actually received) is what impacts net income. During

rising stock markets, pension fund investments can inflate
the bottom line. Small changes in assumptions can make a
Problems huge difference in net earnings.

• Companies may play around with reserve estimates that

Reserve are found on most balance sheets. Reserves are
established to cover future adverse developments, such as
warranty claims and bad debts. Because companies have
Estimates huge discretion as to their size, the smaller the reserve, the
less costly to the bottom line.
Financial Statement Fraud Categories and Red
Flags (Contd.)
• Family member owners may use a corporation as a personal piggy
bank at the expense of public investors and creditors. Forensic

Personal accountants must be especially careful with companies that are

controlled by a few family members.
• e.g. The founder and two sons of Adelphia Communication were

Piggy charged and handcuffed in 2002 by the SEC for allegedly looting
the cable TV provider and hiding more than $ 3.1 billion in off-
balance sheet debt from investor. These undisclosed funds were
used to buy timberland, invest in a golf course, and help run the

Bank Buffalo Sabres hockey team. The company falsified the number of
cable television subscribers and created fake management fees to
conceal the alleged fraud ( all under the watchful eyes of Deloitte
&Touche)

Barter • A number of Internet companies used barter transactions (or

noncash transactions) to increase their revenues. The problem is

Deals how to value this funny money.

Financial Fraud Detection Tools

Interviewing • One way to detect fraud is to interview company

personnel. The AICPA Fraud Task Force provides an

the interviewing template of 13 questions for CEOs, CFOs, and

controllers. While interviewing executives or suspects, a
forensic accountant must try to determine whether the
Executives individual is lying or being deceptive.

• Analytical procedures involve the study or comparison of the relationship

between two or more measures for the purpose of establishing the
reasonableness of each one compared. Five types of analytical
procedures help find unusual trends or relationships, errors, or fraud:

Analytics • Horizontal or percentage analysis,

• Vertical analysis,
• Variance analysis,
• Ratio analysis or benchmarking,
• Comparison withotheroperating information
 Financial Fraud Detection Tools

• Many financial statement fraud identifiers or red flags are detected

by percentage analysis (both horizontal and vertical) and by ratio
analysis. Horizontal analysis assists in the search of inequalities by
using the financial statements of some prior year as the base and
expressing the components of a future year as percentages of each
Percentage component in the base year. Vertical analysis (often referred to as
common-size statements) presents every item in a statement as a
percentage of the largest item in the statement. When vertical
Analysis analysis is used to compare financial statements from several
periods, changes in the relationships between items can easily be
determined. Ratio analysis is a subset of trend analysis that can be
used to compare relationships among financial statement accounts
over time to find the fakes. A number of ratios may be used to spot
red flags and fraud identifiers.

Using Checklists to • It is helpful to look at the fraud risk factors developed over time and
create checklists that can be used as part of the fraud fighter's arse
Help Detect Fraud
Financial Fraud Detection Tools
• Some fraud schemes cannot be effectively detected using
data-driven approaches. Searching relevant transaction
Behavioral data for patterns and unexplained relationships often fails
to yield results because the information may not be
recorded, per se, by the system. It is sometimes necessary
Approaches to inspect employees' attitudes, feelings, values, norms,
interaction, supportiveness, and satisfaction to detect
fraud.

• The SEC seems to be moving the traditional players in line,

but despite improvements in fighting fraud on all sides,
Conclusion there will be a need for forensic accountants who are
specially trained and more suited personality-wise to
remain independent and detect and fight fraud.
 Case Study I
The internal fraud was revealed, he felt stupid for allowing it to happen and the lesson cost him several
hundred thousands of dollars in uninsured losses.

A victim uncovered theft when his bookkeeper unexpectedly missed a few days of work and he opened a bank
statement. The simple act of thumbing through cancelled checks from one month’s bank statement prompted
a phone call to his attorney who directed him to a forensic accountant. The internal fraud was revealed, he felt
stupid for allowing it to happen and the lesson cost him several hundred thousands of dollars in uninsured
losses.

The forensic accountant uncovered evidence of a simple but effective embezzlement scheme. The bookkeeper
had set up vendors that were very similar to existing real vendors. For example, if the real vendor was ABC
Service Company then a fake vendor was established called ABC Service Co. The bookkeeper set up bank
accounts for the fake vendors. That was the hard part. The rest was easy. The business owner signed hundreds
of checks to the fake vendors thinking the checks went to legitimate business activity.

Since that worked so well, the bookkeeper began forging checks to pay the vendors, personal expenses, and
provide cash gifts to family and friends. And, since all that worked without detection by the business owner,
the bookkeeper took an unauthorized increase in salary.

It was bold. It was also easily discovered and should have been easily prevented. The bookkeeper was quickly
arrested and has spent time in jail.
 Case Study II

Jim Aaron owned a successful energy service company in Baton Rouge, Louisiana for 14 years. Stacy
Oxner helps Mr. Aaron with his recordkeeping. Mr. Aaron considers Stacy to be a trusted employee,
having worked for him for eleven years. She has worked long hours, often coming in early and working
late. She is an excellent employee.

Stacy had to go to the hospital for a hip replacement. While stacy was away from work the canceled
checks came from the bank to Mr. Aaron’s home. Feeling somewhat guilty for forcing Stacy to work
such long hours, Mr. Aaron opens the bank envelope. He is surprised to find several large checks made
out to Stacy: one for $ 14,000, another for $ 17,500 and a third one for $ 11,300.

Mr. Aaron never signs blank checks. He does not have a check writing machine, and the signatures on
these questionable checks are his signature. The signatures have not been forged.

How did this fraud occur? Discuss segregation of duties. Discuss opportunity in the fraud triangle with
respect to this situation.
 Fraud Prevention
Know your employee

Do a background check.

Open your own mail

Separate functions and duties

Don’t accept bad answers to good questions

Force vacations

Acknowledge your instinct

Common reasons why fraud goes unnoticed and forensic
audits are needed

Fraudsters/ deceivers are Intelligent

Technology

Stale procedures syndrome

Lack of perseverance
Two facets which are applicable to all investigations

Use of desktop internet investigation (useful in

audit too)

Use of the theory of impossibility and absurdity

to detect fraud.

If an investigator habitually applies these, his

success rate will increase phenomenally.
Concept of desktop audit and investigation

This is a technique you must use to conduct verifications,

research and information regarding vendors, products, third
parties, and almost anything you are auditing or investigating

Do this as frequently as possible to spot forgeries or establish

the authenticity of third parties, entities, documents such as
invoices, letters, agreements, wills, old records, title deeds,
letters of guarantee, LCs, and on rare occasions forgeries in
passports, treasury bonds, fixed deposit receipts from banks etc
Apply the theory of absurdity and impossibility

When you identify what is not possible or very unlikely,

the fallacy or deceit in given submissions will be exposed.

Also, in investigations evidence is often destroyed or

changed or altered or hidden. To find the supporting
evidence is therefore practically difficult.

Make it a habit to think of what is not possible or

impossible or unreasonable
 Some simple forensic tests

Juxtaposition test for testing authenticity of documents format and

content

Test of reasonableness or absurdity

Test of replication of content

Test of impossibility

Scrutiny of suspicious documents particularly those having alterations

Test of IMPOSSIBILITY: identify events
which are not possible and check them out

For example: Can be applied on volume

of stocks in a warehouse or production
with actual machine capacity
 Scrutiny of Alterations and suspicious
documents or large value cash payments

Forensic study of alterations –

try and discern consistency of
cancellations, smudges,
spaces and over writings
 Juxtaposition test

In simple words it means placing side by side

for comparison and spotting differences,
where there should be none. This can be very
effective in spotting manipulations
Where would one apply the juxtaposition test?

Document comparisons: Contracts agreements – copies lying with different departments

Vendor letterheads, bills and letter formats- all bidders’s documents and search for
common addresses, telephone numbers, fax numbers, fax/tel numbers, email addresses?

HR frauds- Juxtapose degree certificates, signatures on certificates, multiple reference

letters, etc

Fictitious Expense or purchase bills. Juxtapose bills from large volume vendors

Documents lying in multiple departments- e.g. copies of minutes of meetings or letters or

memoes issued to different departments

Signatures on important documents

 Test of absurdity or reasonableness

Think of events which may be possible but not

probable. Can a person arrive and depart at exactly
the same time every day ? If smart/swipe card
analysis shows such a pattern it is likely to be a
phantom employee
 Early warning bells and red flags
Close nexus with suppliers, customers and third parties

Missing records, details, etc

Discrepancies in inventories, cash, and assets

Behavioral indicators- chronic late sitting, arrogance and known bad habits like gambling, alcoholic
traits etc

Too much of power and authority in one or few individuals

Mismatch between standard of living and known sources of income

Arrears and sloppiness in bookkeeping, reconciliations etc

 Common accounting manipulations likely in

Cash Contras

Stock in transit

Accounting favours to debtors

Non reversal of stale cheques to create secret reserves

Not re depositing unpaid cash expenses such as wages,

reimbursements etc

Recycling of petty cash advances or IOUs

DENA BANK – ORIENTAL BANK CASE
FACTS OF THE CASE
Case study source: Various news paper reports

The fraudster posed as banker’s representative to various

PSUs and Corporates for making fixed deposits with the
bank.
PSUs and Corporates believed that they would be anyhow
be dealing with the Bank and transactions would happen
via regular banking channels, hence remain unsuspecting
and trusting.
The fraudster would change his role when he visited the
Banks and offered to bring huge deposits from companies.
He acted as representative of PSUs and Corporates.
FACTS OF THE CASE

In OBC Case, upon transfer of Rs. 110 cr. by JNPT to the Bank for creating of FD, the fraudster
asked the banker to immediately transfer the amount to his accomplice’s account Padmavati
International via a F AX communication.

Immediately, that transfer was followed by another trench of Rs. 70 cr. for FD creation. The
Bank again received instructions to transfer the amount to the creation. The Bank again
received instructions to transfer the amount to the accomplice’s account via FAX message.

Meanwhile, JNPT directly contacted Bank to enquire why FD Receipts were not yet delivered
to the company. It was then, they and Bankers realised that fraud has been perpetrated on
them.

The last trench of transfer was saved, but the earlier transfer of money is yet to be
recovered.
 DENA BANK – ORIENTAL BANK CASE

FACTS OF THE CASE

In DB case, the Bank received bulk deposits from Corporates and PSUs between 30 January 2014 and 5
May 2014. The modus operandi was similar.

The fraudster represented

• Fraudster convinced the organizations to create FD with the
organizations and as banker to the
Bank and
other.

collected the KYC documents,

obtaining signatures on forms,
filled them and collected the KYC
documents, obtaining signatures on
forms, filled them and helped them
through the entire process.
• Fraudster then submitted forged documents with the Bank
and obtained FDRs of Rs. 256.69 cr.
• The originals were collected by the fraudster as
representative of the organisations.
 DENA BANK – ORIENTAL BANK CASE

FACTS OF THE CASE

The FDRs were subsequently pledged with the Bank bythe ‘same signatories’ against which
overdraft facilities of Rs. 223.25 cr were obtained.

The funds were then surreptitiously transferred outof bank. DB stock lost The funds were
then surreptitiously transferred outof bank. DB stock lost 5% and OBC stock lost 3.5% upon
these revelations. Bank FD scam gets bigger, 9 FIRs filed, estimated fraud atleast Rs. 700 cr.
Preliminary inquiry by EOW currently on in another 10 cases. Finance Ministry has ordered a
forensic audit in these PSU Banks. Both the banks have complained to the CBI, which is also
looking into the matter.
DENA BANK – ORIENTAL BANK CASE

RED FLAGS

MIDDLE MAN

Audience participation….. Audience participation…..

 DENA BANK – ORIENTAL BANK CASE
INVESTIGATION

In addition to the usual, Document forensics: Paper and ink analysis, handwriting analysis,
signature analysis.

Following regulatory channels, analyzing the email and telephone call data records. Following
regulatory channels, analyzing the email and telephone call data records. Following regulatory
channels, analyzing the email and telephone call data records. Following regulatory channels,
analyzing the email and telephone call data records.

Establishing the linkages between the fraudsters location while perpetrating fraud,
communications with people within the organization and banks, etc.

Establishing the linkages between the fraudsters location while perpetrating fraud,
communications with people within the organization and banks, etc.

Mapping the procedural role of banking officials and the PSUs-Corporates officials with their job
description and the standard operating practices / rules governing their duties. Mapping the
procedural role of banking officials and the PSUs-Corporates officials wit
 • Defining safeguards is only
the first
• step of fraud control process
• Continuous risk reviews and
CONCLUSION adapting
• to changes in business
environment
• will help in mitigating the
fraud risks