From Yizhou HuangTo Professor BoyerSubject FRAUD INVESTIGATI.docx

From Yizhou Huang
To: Professor Boyer
Subject: FRAUD INVESTIGATION: MOUNTAIN SPORTING
GOODS
10/16/2017
Fraud refers to deliberate efforts by a party to conceal
information to other parties for his/her benefits to the
detriment/loss of the party to whom the information is being
hidden. Not many organizations’ management will readily
accept fraud has occurred. As a result, not may fraud cases will
be detected especially by outsiders.
At onset, I am aware that Mountain Sporting Goods, and I
particular Pawn shop will not be an exception to the above. As
such, my findings may not be conclusive of all the fraud which
has occurred in Pawn Shop or Mountain Sporting Goods.
It is the duty of the management to come up with plans and
programs which will safeguard the organizations assets, deter
and detect fraud, and ensure the integrity of its accounting
records. In the Pawn shop scenario, I am aware that this may be
a red flag to check in my investigations. Since the members of
the company were of the opinion that the business was not
going well, I decided to approach the engagement with a free
mind but cognizant of the fact that it is possible they are right.
No organization is safe from fraud regardless of its size.
Therefore, an organization should create a fraud risk assessment
plan and ensure that proper internal controls are in place.
Mountain Sporting Goods were supposed to have one. For this
to work, the owners or management must fully understand the
business and the environment in which it is working in.
However, when the proprietor, JD, the family did not
understand the business and eventually entrusted their friend
TW to manage and run the business.
Pawn shop management was expected to put in place controls to

provide reasonable assurance regarding the achievement of the
objective, effectiveness and efficiency of operations reliability
of financial reports.
Phase I: red flags, fraud hypothesis:
1. Misappropriation and misuse of company assets. This may
include assets such as cash, data and property. This may include
theft of resources and assets.
2. Financial fraud schemes.
3. Corruption. This is done through bribery in order to ensure a
person with information does not disclose it, extortion by a
person with influence over another and conflict of interest.
Red flags:
1. Tw is not a owner manage business: college student, not
efficiency
2. sales are increasing each year, but NI is going down
significantly, not making projection. Company has the ability to
generate revenue, but NI decrease
3. Pawn shop sales for the year is really small- not the growth
area, failure of the business
4. Inventory for the Pawn shop is not on the book (ending
inventory that was not redeemed should recorded)- inflating
sales, purchases , sales will not recorded on the book(pawn),
inventory not on the book, loan repayment by cash—workman
can take home some cash, inventory… no traces on sales, cash,
inventory
Loan(pawn) GAAP
Purchase 100 Inventory 100
Cash 100 Cash 100
Redemption
Cash 120 Cash 120
Sales 120 Inventory
5. Workman’s bonus percentage is too small, could be a red flag
6. Non-independent CPA in the audit! Not able to sign off
7. Long-time employee left after previous owner death
Hypothesis

1. Running personal expenses in to the business
2. Inflated revenue, manipulate expenses
The main causes reasons why fraud is committed are:
1. Pressure due to economic factors: unsustainable lifestyle
within employees means,
2. Opportunity. Access to assets and ability to conceal that
abuse: Pawn loans, major employees leaving, lacking
segregation of duties, independence, inventory method
switching.
3. Rationalization. Employees trying to justify their decision to
commit fraud because they are unhappy or unjustly
compensated.
Phase II: financial statement analysis and journal entry testing.
I started my investigation by analyzing the financial statements
where I found that:
Income statement summary
• Profit margins surprising are worrying and need explanations
. Recording of interest from pawn loans
• No specific knowledge on total pawn loans made – would
guess small
• Whether all income being reported
• Trends seem misplaced
• Leases
-offices expense increase, travel expense increase
-Gross margin is about 35%, but Mountain state is only half of
it, when the sales increase, the GM goes down
-Payroll tax payable is going up, JD have larger salary goes up,
Sue left, Payable should goes down instead of increasing
sales are increasing each year, but NI is going down
significantly (2008 compare to 2006), under projection growth,
why so far off?

7.2 Product categories, guns/ammo-highest gross margin- big
part of business,
Pawn shop sales for the year is really small- not the growth
area, failure of the business
Pawn shop- sell revenue, interest revenue
Review of balance sheet
• What was purchased $40k in 2008 which took IRC 179
• Whether money could have been used as down payment on
building
• Why account balance for payroll tax payable seems high
• What comprises note balances?
• How payday loans (receivable) accounted for on balance sheet
• If cash on hand for loans included in cash balance
• Inventory value supporting documentation
• Where forfeited pawn items are recorded
-no interest income/expense
Review of Cash Flow Analysis
• Difference between implied cash balance and reported cash
balance of $33,227 in 2006, and 15,488 in 2007
Valuation Report Dec 31, 2006
• Who did the valuation - $35,0000 and where it is
• Hand over during staff changes
• Who and for what purpose was 2006 review requested
• Effects of misstatements or errors in review could result in
erroneous value – no specialized training in valuation.
• If understatement of assets would impact valuation
Evaluation of JE and their impacts
Check for $45,000 on Dec 23, 2006 – initially recorded as
employee loan; reclassified (adj) to reduce sales ($45,000);
$20k came from company LOC(reducing LOC) – coded as
payroll tax payable –makes no sense, payroll liability will never
pay back
Adjustment to travel expense- seems moving expenses items in
FS

Checks to Cash – Charged to COGS
Checks to cash substantially exceeded total pawn sales and
interest as reported
Cash on hand was only $3,126 v. $10k
Cash deposits were less than checks for cash
Checks (3) drawn on Company LOC -- Payable to TW --
totaling $25,000; Not recorded on books; entry to reduce sales
and increase debt
Checks payable to Classic Construction – 5 in ’07 totaling $5k
($1k each) and 2 in’08 totaling $8k ($3k and $5k) –
disbursements initially coded as outside labor; adjusted to
reduce outside labor and increase insurance
Checks payable to Ford Leasing - $6,000 per year in ’07 and
‘08– initially classified as auto lease; adjustment entry made to
reclassify to COGS.
Checks payable to AMX (personal credit card) – 10 checks in
’07 totaling $13,212 and 12 checks in ’08 totaling $21,409 –
payments initially coded as travel – adjusted to advertising,
$12,500 and $20,000 respectively:
Check payable to TW May 3, 2008 - $40,000 – initially
recorded as loan to employee; adjustment
Dec 31 ‘08 to furniture and fixtures
Checks (3) payable to Fidelity Investment in ’08 ($3,000 each)
– recorded as COGS.
On interviewing former and current staff, I found the following:
I. Sue Bryant. former accountant Loan to payment – bonus
45,000 as promises to workman
(was it approved by shareholders?), LOC went to workman’s
summer home
Reviews of work not done. Tax returns are done by HR. Though
this may appear as a segregation of duty, knowledge and
expertise is doubtful.
Cash receipts, recording and banking not reconciled and not
transparent.
No knowledge of overall business and no knowledge of how

pawn shop operates.
TW used his position to influence and award himself a bonus
without informing owners.
She was unhappy for her payment and benefits were not agreed
upon.
TW became a bank signatory and therefore no accounting
controls to countercheck him. He later forced Sue to resign.
II. Anita
Salary determined by Hess. Could not do against his will
Did some book keeping at home. No pay for this work.
Hess negotiated Lease agreement. Could have overpriced it and
benefited from proceeds.
She didn’t understand the inventory and accounting software
fully. This created a loophole for fraud by TW and Hess.
She had not seen annual accounts. Not aware whether they
reflected true position as she knew it.
Had no working schedule but had a constant salary. Misuse
of company resources.
She was not sure how inventory was done.
III. Hess
Had no letter of engagement to the company. Scope of work was
not clear.
Does accounting work for landlord thereby leading to conflict
of interest? He was the one who negotiated the lease.
He doesn’t understand the business though he attends BOD
meetings and presents accounts.
He doesn’t know the duties and responsibilities of TW yet he is
the one who recruited him.
Does shoddy work for he relies on Anita and Mia. These two
rely on TW who in turn rely on Hess for advice on treatment of
entries.
He doesn’t do analysis. Assumes all transactions are recorded.
He does not know what is in the accounts yet he presents them
to BOD.
IV. TW
Believes he is underpaid.

Does not know how Hess bills the company
Hess does his personal work at no charges. Conflict of interest
He has invested with Hess on beach home. This is conflict of
interest.
Believes he has a right to benefit the way JD was benefiting for
he does what JD was doing.
All the above facts point to Hess, TW and probably Anita
knowingly misrepresenting the truth in order to conceal material
facts. This is dishonesty calculated for advancement of gains to
the perpetrators causing material loss to the Victims (JD
family).
Cash Flow
2003
2004
2005
2006
2007
2008
Beginning Cash
72,963
60,540
65,057
38,220
54,162
82,803
Operating

Net Income
97,696
75,660
37,109
71,846
34,789
27,621
Expense
5,407
5,824
11,648
5,860
6,588
6,534
Change in Inventory
-35,007
-10,014
-22,635
-27,894
-16,572
15,629
Change in Current Liabilities
2,959
1,979
10,540
15,693
21,770
4,437

Investing
Change in Equipment
-3,128
-2,611
-14,907
-15,476
-3,380
-40,000
Financing
Change in Long-Term Debt
-20,496
-22,634
-42,522
9,907
10,000
-1,862
Dividends
-59,744
-43,490

-6,069
-10,767
-9,066
Net Cash Flow
-12,313
4,714
-26,837
49,169
44,129
-18,899
Implied Ending Cash
60,650
65,254
38,220

87,389
98,291
63,904
Reported Ending Cash
60,540
65,057
38,220
54,162
82,803
63,904
Difference
-110
-197
0
-33,227
-15,488
0
By year how much does workman took? -45,000
Factored Interest calculation in to the analysis
Not properly, suspect distribute to workman
Figure out what the interest should have been(not recorded in
the company )
Have chart that list improper transactions with numbers
Sheet1Mountain State Sporting Goods, IncCash Flow Statement
WorksheetYear Ending 2008Beginning End Assetsof
YearIncreaseDecreaseof YearCurrent Assets:Cash$ 82,803$
63,904Inventory$ 281,147$ 296,776 Total CA$ 363,950$
360,680Equipment$ 83,498$ 123,498Accum Dep$ (66,824)$

(73,358) Net FA$ 16,674$ 50,140Other Assets$ 1,253$
1,253Total Assets$ 381,877$ 412,073Liabilities and
EquityCurrent LiabilitiesPayroll taxes payable$ 49,169$
51,789Sales tax payable$ 16,593$ 18,410 Total CL$
65,762$ 70,199LT debt$ 44,441$ 42,579 Total
Liabilities$ 110,203$ 112,778EquityCommon Stock$ 1,000$
1,000Retained earnings$ 270,674$ 298,295 Total Equity$
271,674$ 299,295Total Liab and Equity$ 381,877$
412,073Statement of Cash FlowsYear ended 2008Cash Flows
from Operations:Net incomeNon cash expense- depChange in
working capital accounts: Inventory Payroll taxes payable
Sales tax payableCash Flows from operationsCash Flows from
Investing ActivitiesPPE additionsCash Flows from Investing
ActivitiesCash Flows from Financing Activities: Long term
debt DividendsCash Flows from Financing ActivitiesChange in
cashCash at beginning of yearCash at end of year
Chapter 7: Conducting a Fraud Investigation
©2015 Pearson Education, Inc. All rights reserved
1
Fraud Investigation: Introduction
Objective is to gather evidence of a suspected fraud
Forensic accountants might be engaged as:
Agent of law enforcement

Member of an audit team
Private accountant engaged by victim or victim’s counsel
Private accountant engaged by accused or accused’s counsel
2
Cautions and Reminders
In conducting a fraud investigation, the following cautions and
reminders are presented:
Unique and has its own cast of characters, facts, and
circumstances
Initiated after the fact
Forensic accountants should operate in a state of disbelief or
suspended belief
The scientific process is most effective and efficient approach
Gather and analyze both documentary evidence and interactive
evidence
The purpose of this chapter is to employ the many concepts,
tools, and techniques to the challenge of conducting a fraud
investigation.
In preparation for this challenge, the following cautions and
reminders are presented:
Every fraud investigation is unique and has its own cast of

characters, facts, and circumstances.
Fraud investigations are initiated after the fact—that is, in
response to an allegation or suspicion of fraud. In other words,
once an allegation of fraud is received or a suspicion identified,
the company (that is, the victim) is faced with the decision of
whether to pursue an investigation. Another necessary decision
is who should conduct the investigation—in-house personnel,
law enforcement, an external audit team, or a private outside
firm.
Although the initial suspicion of fraud might help frame your
case and develop your working hypothesis, it is imperative to
remain objective. Forensic accountants should operate in a state
of disbelief or suspended belief, where information and
representations are evaluated in a rational, curious, objective,
and systematic manner.
The scientific process is the most effective and efficient
approach to conducting a fraud investigation. Remember, a
hypothesis is not a statement of fact; it is simply a tentative
explanation based on preliminary observations or suspicions
that must be tested. Without a working hypothesis, a fraud
investigation is only random data collection.
Evidence is something that tends to prove or disprove the
existence of an alleged fact. Forensic accountants gather and
analyze both documentary evidence, such as financial data and
other business records, and interactive evidence, such as
interviews and observations.
3
Cautions and Reminders
Financial statements analysis: Most valuable evidence-gathering
technique
Interview: Another widely used investigation tool
Fraud is a crime of intent
Cressey’s fraud triangle suggests that fraud results from
convergence of three conditions:

Need (pressure)
Opportunity
Rationalization
Fraud: Not an accounting problem, rather a social phenomenon
One of the most valuable evidence-gathering techniques
forensic accountants use is financial statements analysis.
Financial statements rarely reflect economic reality and often
conceal more than they reveal.
Another widely used investigation tool is the interview, which
has two primary advantages: It is a direct means of obtaining
evidence, and it provides immediate results. Interviewing is
much more than just asking questions. It is a systematic process
that requires planning, staging, execution, and active listening.
Fraud is a crime of intent. Absent an admission, circumstantial
evidence is used to establish or infer fraudulent intent. The
reliability of circumstantial evidence for the purpose of
establishing intent depends on two key factors: alternative
explanations and degree of impact. Because the results of your
investigation cannot provide certainty, you should avoid
conclusions of guilt or innocence.
Cressey’s fraud triangle suggests that fraud results from the
convergence of three conditions: need (pressure), opportunity,
and rationalization. Research has identified many red flags, or
indicators of fraud, that support Cressey’s framework.
Identifying red flags helps to evaluate the reasonableness of
suspicions and allegations of fraud.
Fraud is not an accounting problem—it is a social phenomenon.
Forensic accounting is rooted in law and economics, not
psychology or criminology. Thus, our interest in “why” people
commit fraud, especially when conducting a fraud investigation,

is explanatory (cause and effect), not predictive. Applying
traditional economic theory, we propose that people commit
fraud when the perceived reward ($) is greater than the probable
loss—the calculus of fraud. Because fraud investigators are
called in after a suspicion of fraud has been identified, the focus
is who, when, how, and how much—not why.
4
Mountain State Sporting Goods: A Case of Fraud
In 2009, brothers Robert and Nathaniel Smith contacted a
former federal prosecutor, Dwane Peoples, to discuss their
suspicions of fraudulent activity
Sparked by observations of general manager’s lavish lifestyle
Your role:
Consulting expert to assist in evaluating fraud
Employees are told routine financial review
Will use phased approach- Phases 1-6
Period from 12/31/06 ( JD’s death) to 12/31/08
On March 18, 2009, Mountain State Sporting Goods, Inc., held
its annual meeting of directors and shareholders.
The company’s general manager Thomas Workman and CPA
Charles Hess presented the company’s financial report and
responded to questions regarding the company’s failure to meet
projections and its current financial instability.
Other issues for discussion included a request by the general
manager to increase the company’s line of credit and enhance
employee benefits.
Immediately following the annual meeting, the company’s two
shareholders, brothers Robert and Nathaniel Smith, contacted

attorney Dwane Peoples, a former federal prosecutor, to discuss
their suspicions of fraudulent activity within the company.
The shareholders’ suspicions were sparked by observations of
the general manager’s lavish lifestyle.
Fraud Investigation – applying the scientific approach
5
Organization and Ownership
Mountain State Sporting Goods was organized by J.D. Smith in
1993. One store until March 2006.
Following his death, management was assigned to Thomas A.
Workman, the assistant manager
Ownership inherited equally by J.D.’s two children—Robert and
Nathaniel, full-time college students
Workman responsible to facilitate preparation of financial
statement
Background information
Mountain State Sporting Goods is a Kentucky corporation
organized by J.D. Smith in 1993. Following J.D.’s death on
December 15, 2006, day-to-day management was assigned (via
an employment contract, effective January 1, 2007) to Thomas
A. Workman, a long-term employee and assistant manager under
J.D.
Ownership of the company’s stock was inherited equally (50/50)
by J.D.’s two children—Robert and Nathaniel, both full-time
college students (ages 18 and 19, respectively).
Pursuant to the terms of his employment contract with the

company, Workman is required to facilitate the preparation of
annual (audited) financial reports with supporting schedules and
footnotes.
Red Flags- 1) inexperienced owners
2) GM facilitates prep of financial statement- audit
required but not done
-lack of segregation of duties- why
not have BOD be in charge of this?
-it appears that annual financial
reporting is done annually- no interim
6
Table 7-1—Gross Revenues: Projected Versus Actual
According to J.D.’s projections, the new location ( March 2006)
and pawn shop activity would complement the company’s
existing offerings and result in revenue growth of 10% in 2006,
15% in 2007, and 10% in each of the following three years.
J.D.’s projections attributed 50% of the increased revenue
directly to the pawn component. Importantly, any increase in
profits was to be accumulated in a sinking fund to fund a 20%
down payment on the building upon exercise of the purchase
option. J.D.’s projections and actual results are presented in the
table.

How was profitability?
Year Net Income
$67k
$35k
$28k
Increasing sales decreasing net income RED FLAG
7
Table 7-2—Product Categories
According to the valuation report, the company’s various
product categories were grouped into the five general categories
presented in the table.
Anyone know how a pawn shop operates? As illustrated, during
the 2006 calendar year, the smallest component of the
company’s revenues was pawn loans. The company offers 30-
day renewable loans at a periodic interest rate of 20%. ( 240%
annually? – is this an unregulated industry?) Borrowers pledge
a variety of items as loan collateral, including firearms, tools,
and electronics.
Red Flag- pawn shop is smallest category for 2006 but it is
new. JD thought it would drive 50% of increase in sales. For
2006 total pawn sales are .0073 x $2,210,000= $16,133 Why so

low?
8
Pawn Shop Marketplace
10,000 pawn shops in US, 85% small businesses
Business centered on pawn loans
Pawn loans are quick and easy way to borrow without a credit
check. Loans are based on value of collateral, not your credit
rating.
Loan term typically 30 days plus a 30 day grace period
Interest rates of 12% to 240% based on state regs
9
Table 7-3—Pawn Items
The character of items pawned is summarized in the table. If
interest charges are not paid within seven days of the end of
each thirty-day period, the collateral is seized and placed in
inventory for resale. The company’s annual physical inventory
does not include forfeited pawn items. Advances (pawn loans)

are recorded as non-inventoried purchases (vs. receivables), and
redemptions are recorded as sales (vs. collections). These
practices are not in conformity with GAAP, which requires the
initial recording of a pawn loan receivable and a subsequent
movement of the receivable to inventory when a pawn item is
not redeemed.
RED FLAGS
Mostly firearms, easily resalable, probably high demand
Pawn items not included in inventory
Advances (loans) recorded as purchases Dr Purchase 100
Cr Cash 100
Redemptions recorded as sales Dr Cash 100
Cr Sales 100
Loan amounts calculated by Workman
Loans must be repaid in cash-WHY? Keep interest off the
books?
Interest at 20%- where is this recorded in the ledger?
Big portion of accounting kept off the books
10
Management
Co-managed by Sue Bryant and Workman till 2007; after Sue’s
retirement, managed by Workman
Robert and Nathaniel do not actively participate in management
Management
The company was co-managed by Sue Bryant and Workman

following J.D.’s death (December 15, 2006) until her retirement
on January 6, 2007. Since that time, the company has been
managed by Workman pursuant to the terms of his employment
contract. RED FLAG Bryant retires less than 1 month after JD
dies- potential problem with transition?
RED FLAG Robert and Nathaniel do not actively participate in
management but attend annual BOD meetings to review
financial reports, which are prepared and presented by the
company’s auditor, Charles Hess, CPA.
11
Compensation
Officers’ Compensation
Workman’s compensation determined by his employment
contract
Base salary of $50,000 plus 1% of all sales exceeding
projections
To date, company has failed to meet projections
Key Employees, Compensation, and Benefits
Average of eight employees
Including Workman’s spouse, Anita, and his daughter, Mia
Anita and Mia share in-house accounting duties and
responsibilities
Officers’ Compensation
According to Workman, his compensation is determined by his
employment contract, which specifies a base salary of $50,000
plus 1% of all sales exceeding projections.

To date, the company has failed to meet these projections.
RED FLAG- Workman may feel entitled to a bonus even though
plan would say he did not earn it.
Key Employees, Compensation, and Benefits
The company has an average of eight employees, including
Workman’s spouse, Anita, and his 17-year-old daughter, Mia.
Anita and Mia share in-house accounting duties and
responsibilities.
Before J.D.’s death, these duties were performed by Sue Bryant,
who retired shortly thereafter. Now handled by Workman
RED FLAG- segregation of duties issues
12
Significant Accounting Policies
Accrual method of accounting
Following J.D.’s death, the company abandoned perpetual
system and converted to periodic inventory method
Current practice was to conduct physical inventory at the end of
each year, adjusting cost of goods sold and ending inventory
accordingly
Company’s auditor did not object and, in fact, encouraged the
change
Significant Accounting Policies followed by Mountain State
Sporting Goods
Method of accounting
The company employs the accrual method of accounting. Under
the accrual method, income is accounted for (recognized) when
earned. It is not the actual receipt, but rather the right to
receive, that governs. Expenses are recognized as incurred—that

is, when all events have occurred that fix the amount of the item
and determine the liability to pay.
As explained by Hess, the IRS requires taxpayers that maintain
inventories to employ the accrual method of accounting.
Inventory accounting
Inventory is usually the largest current asset of a business, and
its proper measurement is necessary to ensure accurate financial
statements. If inventory is not properly measured, expenses and
revenues cannot be properly matched. When ending inventory is
incorrect, the following balances on the balance sheet are also
incorrect as a result: inventory, total assets, and owners’ equity.
When ending inventory is incorrect, the cost of merchandise
sold and net income on the income statement are also incorrect.
The two most common inventory systems are the periodic and
perpetual systems.
Following J.D.’s death in December 2006, the company
abandoned its perpetual system and converted to a periodic
inventory method. Under this method, a purchases account is
used, and the beginning inventory is unchanged during the
period (month, quarter, or year).
At the end of an accounting period, the inventory account is
adjusted by closing out the beginning inventory and recording
the ending inventory, as determined by a physical inventory.
The company’s current practice is to conduct a physical
inventory at the end of each year, adjusting cost of goods sold
(COGS) and ending inventory accordingly.
As presented by Workman, the perpetual system maintained by
J.D. before his death was too complex, too time-consuming, and
simply not cost justified. Moreover, the company’s auditor did
not object and, in fact, encouraged the change.
RED FLAGS- inventory is 70% of total assets so why change?
Is CPA independent of Workman?
13
Significant Accounting Policies
Company employed FIFO cost flow assumption to value ending

inventory
Physical inventory: All items on premises (or in transit) for
which it has legal title, with the exception of forfeited pawn
items
Lower of cost or market method
Unsellable items due to obsolescence or condition valued at
bona fide selling prices, determined by Workman
All accounting functions processed by Anita and Mia,
supervised by Workman
Method of Valuing Ending Inventory
The valuation of inventory can be a complex process that
requires the determination of:
(a) the physical goods to be included;
(b) the costs to be included;
(c) the cost flow assumption to be adopted (that is, cost or
lower of cost or market); and
(d) the accounting cost flow assumption to be adopted (specific
identification, LIFO, FIFO, or moving-average).
The company employs the FIFO cost flow assumption.
The company includes in its physical inventory all items on
premises (or in transit) for which it has legal title, with the
exception of forfeited pawn items.
The company employs the lower of cost or market method in
valuing its ending inventory, and items identified as unsellable
due to obsolescence or condition are valued at bona fide selling
prices, as determined by Workman. Subjective estimates??
Accounting Functions; Segregation of duties issues?
Effective January 1, 2007, all accounting functions and day-to-
day accounting activities have been processed by the company’s
in-house personnel, Anita and Mia, and supervised by

Workman, as the company’s manager.
Annual financial reports and related income tax returns are
prepared by Hess.
14
Phase I of Investigation
Phase I(a): Confirm the reasonableness of the suspicions of
fraud
Review case profile presented previously
Identify ten conditions (red flags) that either confirm or fail to
confirm the reasonableness of Smith’s suspicions
Employ the fraud triangle
Phase I(b): Create a fraud hypothesis
Hypothesis: An educated guess about how something works or
an explanation for an event
Exercise critical thinking and reasoning skills
Phase I(a): Confirm the Reasonableness of the Suspicions of
Fraud
Review the case profile presented previously, and identify ten
conditions (red flags) that either confirm or fail to confirm the
reasonableness of the Smith’s suspicions of fraud.
To this end, employ the fraud triangle (need, opportunity, and
rationalization) and professional skepticism.
Phase I(b): Create a Fraud Hypothesis
Having confirmed the reasonableness of the Smith’s suspicions
of fraud, you must now develop a fraud hypothesis.
A hypothesis is not a statement of fact—it is simply an educated
guess about how something works or an explanation for an
event.
In this phase, you will exercise your critical thinking and

reasoning skills.
Brainstorming can also be used.
Look at hypothesis in text: Workman has systematically eroded
the company’s internal controls and oversight functions to
facilitate fraud
Consider another hypothesis: Workman’s lifestyle creates
incentive to commit fraud
15
The Fraud Triangle
Cressey’s research suggests that violations of trust (fraud) occur
when the position of trust (opportunity) is viewed by the trusted
person as a rational means (solution) to solve a nonshareable
problem (pressure).
This research is the foundation for the fraud triangle, which
proposes that three factors—pressure (or need), opportunity,
and rationalization— constitute the conditions under which
fraud occurs. The implication, of course, is that influencing any
one of these conditions can impact the likelihood that fraud will
occur.
Walk through the student suggestions for hypotheses
Look at hypotheses in book-
Workman has systematically eroded the company’s internal
controls and oversight function to facilitate fraudulent schemes
16

Phase II(a) of Investigation
Phase II(a): Test hypothesis via financial statements analysis
Examination of financial statements for the purpose of
acquiring additional information
This analysis may reveal unexpected relationships or the
absence of expected relationships
Use various analytical techniques
Consider the implications of your findings
Phase II(a): Test Your Hypothesis via Financial Statements
Analysis
Financial statements analysis is the examination of financial
statements for the purpose of acquiring additional information
about the activities of a business.
This analysis may reveal unexpected relationships or the
absence of expected relationships.
Your next challenge is to use various analytical techniques,
such as
Trend analysis,
Common-size analysis,
Ratio analysis, and
Cash flow analysis, to analyze the company’s financial
statements
Walk through financial statement findings
Refine hypotheses
17

The Cash Cycle
Concerns about controls over cash
Are all corporate collections and disbursements recorded?
Authorization and review controls
Calculating the cash flow statement
Resolving differences in ending cash balance
Phases II(b) of Investigation
Phase II(b): Test hypothesis via journal entry testing
Can potentially undermine the validity of financial statements
and the financial reporting process
Objective is to identify and assess any inappropriate or unusual
activity
Important when there is ineffective system of internal controls
and management has ability to override the journal entry
process
Consider characteristics of fraudulent journal entries
PhaseII(b): Test Your Hypothesis via Journal Entry Testing
Journal entries (JEs) can potentially undermine the validity of
financial statements and the financial reporting process.

Thus, the importance of JE testing cannot be overstated.
The objective of this testing is to identify and assess any
inappropriate or unusual activity.
This is especially important when, as in this case, there is an
ineffective system of internal controls and management has the
ability to override the JE process.
As outlined in SAS No. 99, fraudulent JEs have several common
characteristics:
JEs made to unrelated, unusual, or seldom-used accounts
JEs recorded at the end of the period or as post-closing entries
with little or no explanation
JEs containing round numbers or a consistent ending number
JEs applied to intercompany or related parties
19
Phase III of Investigation
Phase III: Refine and confirm hypothesis via interviews
At this stage, you should have:
Developed a working knowledge of the business
Developed a working knowledge of company’s accounting
system
Identified any questionable financial statement reporting issues
Identified the key players to be interviewed and the information
sought
Follow the interview sequence
Phase III: Refine and Confirm Your Hypothesis via Interviews
An interview is a primary tool used by forensic accountants to
gather information and make assessments.

At this phase of your investigation, you should have:
1. Developed a working knowledge of the business (including
the pawn shop operation).
2. Developed a working knowledge of the company’s accounting
system, especially the internal controls (or lack thereof).
3. Identified any questionable financial statement (tax return)
reporting issues (for example, no pawn receivables, no interest
expense, and questionable JEs).
4. Identified the key players to be interviewed and the
information sought.
Who should be interviewed? In what order? Should the
interviews be formal or informal? To assist you in this phase,
we propose the following interview sequence:
1. Neutral third parties (Sue Bryant)
2. Corroborative witnesses and possible co-conspirators (Anita
Workman)
3. Suspected co-conspirators (Charles Hess)
4. Target (Thomas Workman)
20
Assignment for Next Class
Phase 4- draw conclusions and communicate results
Determination of amount misappropriated
Discussion of specific schemes employed
Loss components
Specific transactions
Unreported pawn loan interest ( from Exhibit 7I)
Unreported forfeited pawn sales (from Exhibit 7I)
Add statutory interest at 7.5%

Phase 5: Present a discussion of Mr. Hess’s roles, duties and
responsibilities
Evidences indicate that Mr. Hess may be a co- conspirator and
may have violated the AICPA ethical and professional standards
in his service
Address these concerns in a discussion
Phase 6: Present recommendations for resolution and
remediation
Consider the following:
Strength of the evidence
Alternative explanations , if any
Eligibility for criminal complaint
Eligibility for civil complaint
Consideration for alternative dispute resolution

From Yizhou HuangTo Professor BoyerSubject FRAUD INVESTIGATI.docx

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