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Business Finance Magazine
October 2002
WILL FORENSIC ACCOUNTING GO MAINSTREAM?
"Maybe they're in storage."
That's what Kessler International forensic accountants were told when, as part of the due diligence process, they were charged with tracking down expensive paintings listed on the balance sheet of a client's acquisition target. The forensic accountants looked in storage. No dice. Then they looked again. Ditto.
"One of our guys happened to go out for a cup of coffee one day," recalls Michael Kessler, president of the New York City-based forensic accounting and corporate investigation firm. "He happened to be looking at the cars in the parking lot on the way back when something caught his eye. Inside one of the cars, he saw the paintings covered in bubble wrap."
CFOs should notice several key facts that Kessler's tale reveals about forensic accounting in the post-Enron era. First, forensic accountants are paying more visits to company storerooms, accounting offices and parking lots -- and for good reason. The Austin, Texas-based Association of Certified Fraud Examiners (ACFE) estimates that 6 percent of corporate revenue in the United States (roughly $600 billion) will be lost to fraud this year. Second, those who commit fraud seem to be getting bolder. Third, some of the conditions that lead to fraudulent activity, such as a difficult economy and the availability of sophisticated technologies that aid in fraud perpetration, are ripe right now. And fourth, despite advancements in detection technologies and some movement of forensic techniques into auditing processes, most fraud remains incredibly difficult to ferret out. Finding it requires a combination of street smarts, high-tech tools and luck. A recent ACFE survey of fraud examiners identifies "by accident" as the second most common detection method (see Initial Detection on page 34).
"Finding fraud is sort of like taking a metal detector to the city dump," says Larry Crumbley, Ph.D., KPMG-endowed professor at Louisiana State University in Baton Rouge and one of the authors of "The 2002 U.S. Master Auditing Guide" (CCH Inc., 2002). "You find a lot of stuff, and a lot of that stuff doesn't help you. You have to keep plugging along."
Kessler reports his firm has seen an increase in the demand for its services since the Enron scandal broke. "More people are concerned about their own operations and want us to come in and take a look-see," he says. "Many times, corporations will call us on a proactive basis. They're not going to wait until the horse is out of the barn."
Howard Silverstone, a principal with risk consultancy Kroll Inc., sees a correlation between economic conditions and the demand for forensic expertise. "I would say an increase in the demand for our services started after the dot-com collapse," he says. "And then it continued in another wave after September 11, when the economy really slid again. When companies start to lose money, I think people want to scrutinize where they lose money and [pinpoint] the weaknesses in their systems."
There's other evidence that forensic accounting activity is surging. This year the American Board of Forensic Accounting announced the creation of a Certified Forensic Accountant (Cr.FA) designation. No doubt the newly certified investigators will be busy. The ACFE's "2002 Report to the Nation on Occupational Fraud and Abuse," based on feedback from fraud examiners involved in 663 cases that encompassed more than $7 billion in losses (see Methods of Fraud below), estimates that the volume of corporate revenue that will be lost in the United States this year translates to about $4,500 per American worker. Additionally, 21 percent of the respondents to a recent Ernst & Young consumer telephone survey admitted that they have been involved in corporate fraud.
Fleshing Out "Forensic"
Occupational fraud and abuse, according to the ACFE, falls into three familiar buckets: corruption (conflicts of interest, bribery, illegal gratuities and extortion); asset misappropriations (involving cash, inventory and items like, say, a Monet in bubble wrap); and fraudulent statements. But what exactly do forensic accountants and auditors do?
"Someone will hear that the forensic accountants are coming, and the first thing said is, 'Who's stolen money?' " Silverstone reports. "I always emphasize that the word 'forensic' means 'evidence gathered and suitable for dissemination in a public forum.' Just because you have a forensic accountant in doesn't mean there has to be a precipitous event."
At Kroll, commercial litigation offerings -- through which forensic accountants quantify a business loss or insurance claim -- are the most commonly requested service. Forensic accounting firms also conduct due diligence for clients involved in M&A activity. They consult on the topics of fraud controls, corporate security and employee screening. And they offer other services, such as competitive intelligence analyses.
"A good forensic accountant is like a three-layer wedding cake," says Crumbley. "On the bottom layer, that individual has to have a solid background in accounting. The second, smaller layer translates to a background in auditing, risk assessment and fraud detection. A third, even smaller layer represents a legal background --understanding the courtroom and how to testify."
Crumbley offers another metaphor that emphasizes the differences among various accounting-related titles. He says staff accountants and internal auditors are seeing-eye dogs, external auditors are watchdogs, and forensic accountants are bloodhounds. So, how can CFOs think more like bloodhounds to prevent problems from occurring in the first place?
Cause and Effect
Stephen Seliskar, Cleveland-based national leader of Ernst & Young's fraud, forensic and investigation service, identifies four prerequisites of fraud: need, desire, opportunity and ability. Many employees who commit fraud later claim they did so because of financial hardships, such as debt, high medical bills or a salary freeze. But needing money is only the first step. "You and I and most of the rest of the world may go through the same crises and never resort to fraud," Seliskar says.
Sometimes disenchantment with the company can boost the desire element of fraud. According to the ACFE survey, a worker's attitude toward his employer is a factor in whether he decides to steal. Employees who are happy with the way they are treated are less likely to commit fraud than their disgruntled counterparts. Attitudes quickly sour when the economy dips, when senior executives as a group are seen as committing widespread improprieties or when cost-reduction efforts directly affect employees.
Once an individual has both need and desire, an opportunity must present itself. Although a company's internal controls can never be iron-clad, stronger controls translate to fewer opportunities for employees who are wont to steal.
Ability -- a combination of intelligence, skill and, increasingly, technological savvy -- completes the causation chain. "The ability of the fraudster to manage fraud is a major element," says Seliskar, who notes that the self-propelling nature of fraud often causes schemes to spiral out of the perpetrator's control. "The sheer volume of activity and the labor required to perpetuate those activities month after month increases. With a computer, you can sit there and design it and really manage it."
How technology affects fraud is open to debate. As much as he values his firm's proprietary fraud-detecting applications, Seliskar believes those committing fraud also benefit from technology. "I think software packages and computers are an enabler, if for no other reason than their capability to create documents that appear to be authentic," he says. Crumbley thinks the increased use of automated accounting systems has nudged auditors away from looking into transactions.
But Kraig Haberer, director of product marketing for financials with SAP in New York City, disagrees. A former PricewaterhouseCoopers auditor, he says that when technology is aligned with the right business processes (i.e., those that restrict opportunities for fraudulent activity), it can minimize risk. He also notes that the less manual intervention finance and accounting processes require, the fewer opportunities a company allows for lapses in employee judgment.
Plus, the spread of new performance-management processes and applications helps finance executives consolidate information and integrate strategic, operational and financial planning. This software helps finance managers, internal auditors and external auditors develop a better feel for when something doesn't quite jell, no matter how authentic a report looks. "Technology can be an aid to preventing fraudulent situations, but by no means is it the only tool you can or should use," Haberer says. "At the end of the day, technology will never replace judgment."
Criminal Referrals
Judgment plays a central role in prevention, and CFOs tend to oversee the areas in which decisions that deter potential criminals are made. Forensics experts encourage finance executives to keep tabs on each of the elements that contribute to fraud. Of those, need and opportunity may be the most straightforward to monitor.
The certified fraud examiners responding to the ACFE survey ranked prevention measures, from most effective to least effective, this way: stronger internal controls, background checks on new employees, regular fraud audits, established fraud policies, willingness of companies to prosecute, ethics training for employees, anonymous reporting mech- anisms and workplace surveillance.
"Make sure you know who your employees are, not only when you hire them, but also as they're working for you on a continuing basis," Seliskar says. Be aware when key employees develop financial needs. The ACFE survey suggests that finance leaders should pay particularly close attention to well-educated male executives, who tend to commit the most costly fraud. In addition, forensic accountants question the wisdom of giving younger employees lead roles in external audits.
Silverstone says companies should also require employees to sign a statement each year that spells out what fraud consists of (including taking software home to upgrade a personal PC) and states that they have not engaged in any of those activities.
When these preventative measures fail, enforcement is crucial. How can CFOs, CEOs, general counsel, external counsel, controllers, directors of internal audit and security directors know when it's time to call in the hounds? "When you go to a family doctor and get a prescription but don't feel better, do you want another prescription or do you want to get to a specialist?" asks Seliskar. "You need to get to the specialist if there's a real problem." He adds, "Having a policy that the forensic auditors will be called in when a red flag is raised acts as a strong deterrent."
To aid forensic accountants, Kessler says, CFOs need to "make the records available when they're asked for." He notes that forensic investigations should not be disruptive. The majority of employees may not even know when an investigation is taking place. "We go in there as just another set of auditors," says Kessler, who favors a Columbo-esque investigative style. "We don't wear special windbreakers that say 'forensic accountant.' "
Finally, says Seliskar, "there is research that suggests that the willingness of the company to prosecute and to make a criminal referral, even when the cost of the fraud is modest, acts as an incredibly strong deterrent." In the ACFE study, 75 percent of respondents indicated that the victim organization they worked for referred its case to law enforcement. When the other 25 percent were asked why their client did not make a criminal referral, the top reasons were fear of bad publicity, the fact that the parties reached a private settlement, the desire for closure and the company's attitude that internal discipline was sufficient.
As CFOs shore up internal defenses against fraud, they need to keep in mind all the benefits of external assistance. Criminal referrals can send a message to employees about the stiff consequences of committing fraud at the same time they take a bite out of wrongdoing.
During one of Ernst & Young's forensic assignments, the victim organization's top finance executive was terminated. Seliskar's team later determined that the exec had instituted a sophisticated scheme that enabled him to embezzle several million dollars. In the two months between his dismissal and his former company's filing of criminal charges against him, the executive had landed a new job, implemented the same plot there and bilked his new company for more than $100,000. After Ernst & Young referred the evidence to prosecutors, the fraudster's work-of-art scheme came crashing to a halt.
Is Crime-Fighting In Your Future?
Some fraud experts believe that forensic techniques will become a regular component of both external and internal auditing processes. "Because of all this bad accounting press, even the external auditors are going to have to introduce forensic techniques into their activities," says Larry Crumbley, Ph.D., KPMG-endowed professor at Louisiana State University in Baton Rouge. He also notes that internal auditors, once hailed as quasi-management consultants because of their prime position for spotting weakness in business processes throughout the organization, "have not been too worried about fraud" in the past several years.
"I definitely agree that greater amounts of forensic accounting should become part of the internal audit process," says Gary Zeune, Columbus, Ohio-based founder of The Pros & the Cons, a speakers' bureau for white-collar criminals, and author of "The CEO's Complete Guide to Committing Fraud" (Securities Press, 1994). Zeune reports that there are sound arguments both for and against infusing traditional external audits with forensic techniques. If external audits expand to include forensics, he says, the new procedures should be handled by forensic experts, "people who know what they're looking for, rather than staff who are two or three years out of college and wouldn't know fraud if it walked up to them and shook their hand."
Although some accounting firms, like KPMG, have exposed their auditors to training by forensic auditors, many question the viability of adding forensic techniques to the auditing process. "In terms of the sheer labor, the magnitude of effort, time and expense required to do a single, very focused investigation -- as contrasted to auditing a set of the financial statements -- the difference is incredible," says Stephen Seliskar, Cleveland-based national leader of Ernst & Young's fraud, forensic and investigation service. "So one can't really go and conduct a generic fraud investigation of an entire company. It would be a physical impossibility."
Author - Eric Krell
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