Forensic Accounting for Non Accountants

1. Forensic Accounting – How to
Uncover Fraud
Richard C. Hermerding
January 26, 2012

2. Richard C. Hermerding,
MBA, MAIA, MSIS, CMA, CFM, CFE, CFS
• Richard Hermerding serves as Senior Principal – OLIVO CPA in San Jose, CA. He has over 25
years of experience providing accounting and consulting services. He has a broad range of
experience and education in many aspects of accounting, auditing and financial
management. His accounting and consulting experience includes Audit, Controllership, Chief
Financial Officer services, Fraud, Forensic Accounting, and Strategic Planning. Richard has
served as a Expert Witness. Richard’s experience spans numerous industries, including
manufacturing, government, healthcare, nonprofits, and financial services.
• Richard holds a Bachelor of Arts degree (German and Russian), a MBA (Accounting and
Finance), a MA (International Affairs) from Ohio University, and a MS (Information Systems)
from Golden Gate University. He is a Certified Management Accountant (CMA), a Certified
Financial Manager (CFM), a Certified Fraud Examiner (CFE), a Certified Fraud Specialist (CFS)
and a Certified Senior Advisor (CSA). Richard also holds National Association of Security
Dealers - 6, 63, 65, and 7 licenses, Life and Health and Property and Casualty Insurance
licenses, as well as being a California Real Estate Broker.
• Richard speaks regularly at meetings and seminars and is an Instructor for the University of
California – Santa Cruz Extension for Strategic Management.
• Richard is the President of the Silicon Valley Chapter of the Institute of Management
Accountants and Vice President of Education of the Golden West Council of the Institute of
Management Accountants.

3. Contributing Authors and/or Sources
• AICPA, Special Report, Forensic Procedures and Specialists: Useful Tools and Techniques
• Association of Certified Fraud Examiners, Fraud Examiners Manual
• Association of Certified Fraud Examiners, Fraud Magazine March/April, May/June, July/August 2009
• Association of Certified Fraud Examiners, Understanding the Basics of Mortgage Fraud
• Bruce Frey, Statistics Hacks
• CPA Mutual Insurance Company SAS 99 Friend of Foe . Gary D. Zeune, CPA
• G. Jack Bologna/Robert J. Lindquist-Fraud Auditing and Forensic Accounting, Second Edition
• Howard Silverstone/Howard R. Davia, Fraud 101, Techniques and Strategies for Fraud Detection,
• Joseph T. Wells-Corporate Fraud Handbook, Prevention and Detection, Second Edition
• Martin T. Biegelman/Joel T. Barton, Executive Roadmap to Fraud Prevention and Internal Control
• Paul E. Zikmund, CFE, CFD, CFFA, MBA, Forensic Accounting for VLAF Practitioners
• Ralph R. Roberts/Rachel Dollar, Protect Yourself from Real Estate and Mortgage Fraud
• Second Edition
• Rebekah J. Poston/David A. Saltzman/Christopher Richardson, Foreign Corrupt Practices Act in
Review July 2009
• Tracy L. Coenen, Essentials of Corporate Fraud
• W. Steve Albrecht, Fraud Examination

4. Summary
• One survey stated that more than four out of five companies
surveyed (85 percent) have suffered from corporate fraud in the
past three years. These findings also indicated that not only is fraud
widespread, but it is growing, and it is Global.
• You have heard and read the statistics. So what do you do now?
How can Forensic Accounting help? What is Forensic Accounting.
What should be reviewed? What should you look for? What are
some common fraud schemes? What are the warning signs? What
are basic fraud prevention procedures? What is the best way for
management to be involved? Do you need to hire an outside
expert?
• Black’s Law Dictionary defines forensic as “used in or suitable to
courts of law or public debate.”
• Forensic accounting is a specialty field within the broader arena of
accounting.

5. Forensic Investigation
• Disciplines commonly applicable include accounting, auditing,
fraud examination, law, computer and other technologies.
• Generally involves the application of special skills in
accounting, auditing, finance, quantitative methods, certain
areas of law and research, and investigative skills to collect
analyze, evaluate evidential matter and to investigate and
communicate findings.
• Has been defined as … the art & science of investigating
people & money.

6. Seven Forensic Investigative
Techniques
1. Public Document Review and Background Investigation
2. Interviews of Knowledgeable Persons
3. Confidential Sources
4. Laboratory Analysis of Physical and Electronic Evidence
5. Physical and Electronic Surveillance
6. Undercover Operations
7. Analysis of Financial Transactions

7. Forensic Accounting
Economic
Damages
Tax
PI Performance
Auditing
Forensic Accounting
Audit/
Review/
Comp Valuation
Internal Audit
Fraud

8. Seriousness of Fraud
ACFE study in the mid 1990’s
• Over $400 Billion at that time
• That was before Enron, WorldCom, Tyco,
Madoff, etc.
• $9 per day per employee
• 6% of companies Total Revenue
• FBI has labeled it the fastest growing crime
• Every $1 of Fraud reduces Net Income by $1

9. What is Fraud?
• Fraud is a generic term, and embraces all the
multifarious means which human ingenuity can
devise, which are resorted to by one individual, to
get an advantage over another by false
representations. No definite and invariable rule can
be laid down as a general proposition in defining
fraud, as it includes, surprise, trickery, cunning, and
unfair ways by which another is cheated. The only
boundaries defining it are those which limit human
knavery.
• (Webster’s New World Dictionary-College Edition 1964)

10. Who Commits Fraud
• Almost anyone can commit Fraud
• Fraud perpetrators usually cannot be
distinguished from other people by
demographics or psychological characteristics
• Most Fraud perpetrators have profiles that
look like honest people

11. Sarbanes Oxley’s Impact On Fraud
• Audit Committee
• Code of Ethics
• Internal Controls
• Internal Audit
• Common Problem
Segregation of Duties

12. Why People Commit Fraud
The Fraud Triangle
Perceived Opportunity

13. Why People Commit Fraud
• To make the Company’s earnings look better
on paper
• To cover up embezzlement of company funds
• To encourage investment through the sale of
stock
• To demonstrate increased earnings per share
• To cover the inability to generate cash flow
• To dispel negative market perceptions

14. Why People Commit Fraud
• To obtain financing, or to obtain more
favorable terms on existing financing
• To receive higher purchase prices for
acquisitions
• To demonstrate compliance with financing
covenants
• To meet company goals and objectives
• To receive performance based-related
bonuses

15. Why People Commit Fraud
• However; in government contracts, just the
opposite may be true.
• Assets and revenues are understated
• Liabilities and expenses are overstated
Why?
• The entities may rely on understated revenues
or overstated expenses to get more money for
a project or contract

16. Financial Statement Fraud
• Improper Revenue Recognition
Recording fictitious revenues
Recording revenues prematurely
• Overstatement of Assets
Overstating existing assets or recording fictitious
assets
• Understatement of Expenses
Capitalizing assets that should have been
expensed

17. Financial Statement Fraud
Assets most often misstated were:
• Accounts Receivable
• Inventory
• Property, plant and equipment
• Loans/notes receivable
• Cash
• Investments
• Patents
• Natural Resources

18. Who was most often the
perpetrator of the Fraud?
• Chief Executive Officer (72%)
• Chief Financial Officer
• Controller
• Chief Operating Officer
• Vice Presidents
• Members of the Board of Directors
• Lower level personnel
• External auditor (29%)

19. Today’s Objectives
• Provide some insight to “Red Flags”
• Highlight a few common methods to misstate
financial statements and/or commit Fraud
• Demonstrate how forensic accounting can assist in
uncovering Financial Transaction Fraud
• Provide basic methodologies for Financial
Transaction Fraud Detection
• Provide basic tools for Financial Transaction Fraud
Detection

20. General - Red Flags
• Industry has a reputation for corruption
• Company culture
• Excessive Miscellaneous and/or unsupported
expenses
• Incomplete invoices and/or supporting
documentation
• Unusual cash disbursements or excessive use
of petty cash

21. General –Red Flags
• Offshore bank accounts
• Customer Complaints
• Vendor Complaints
• “Special arrangements”
• Override of internal controls, (SOX 404 issues)
• Advance payments, excessive commissions
• Pressure to “make the numbers”

22. General –Red Flags
• Manual Journal Entries and/or those lacking
support
• Financial estimates that require significant
subjective judgment
• Generic and/or un-descriptive account names
and activity.
• Suspense account activity or large un-
reconciled balances.

23. General – Red Flags
• False or incomplete invoice or
mischaracterization of invoices
• Falsified or “mislabeled” records
• Unrecorded “off the books” payments
• Payment to different suppliers with the same
address

24. ABC Historical Balance Sheets
2000 2001 2002 2003 2004 2005 2006
ASSETS
Cash 7,340,853 9,000,141 10,247,037 10,612,505 9,791,278 9,071,235 9,506,321
Accounts
Receivable 3,037,713 3,531,609 3,450,584 4,066,189 5,354,956 4,681,143 4,572,910
Inventory 20,707,347 21,186,365 22,272,693 23,672,161 25,709,465 27,993,935 30,665,649
Other Current
Assets 1,999,511 2,208,786 2,132,999 2,160,575 2,680,688 2,599,862 3,713,573
Total Current
Assets 33,085,424 35,926,901 38,103,313 40,511,430 43,536,387 44,346,175 48,458,453
Fixed Assets 78,479,188 82,986,383 79,502,294 69,918,680 70,554,241 79,566,514 83,028,658
Net Intangible 8,641,354 8,274,062 8,007,702 13,192,621 19,238,106 24,625,266 30,806,473
Other Non
Current Assets 9,604,551 8,448,813 8,920,030 12,707,889 15,107,652 15,732,002 16,053,086
Non-Operating
Assets - - - 7,252,562 7,252,562 7,252,562 7,252,562
Total Assets 129,810,517 135,636,159 134,533,339 143,583,182 155,688,948 171,522,519 185,599,232

25. ABC Historical Balance Sheets
LIABILITIES &
EQUITY 2000 2001 2002 2003 2004 2005 2006
Accounts Payable 11,814,573 10,301,276 11,934,461 13,292,947 11,859,356 14,958,034 17,604,006
Short Term Notes
Payable 5,500,000 4,000,000 2,000,000 3,000,000 7,000,000 10,000,000 12,200,000
Current Portion of LT
Debt 6,721,928 9,503,629 11,767,006 6,037,797 6,220,074 8,049,385 7,791,760
Other Current
Liabilities 9,017,676 13,135,508 15,012,197 12,996,169 16,201,172 17,138,682 18,000,661
Total Current
Liabilities 33,054,177 36,940,413 40,713,664 35,326,913 41,280,602 50,146,101 55,596,427
Long Term Debt 67,002,033 66,935,421 55,527,283 70,863,356 72,528,541 75,292,777 91,310,219
Other Non-Current
Liabilities 6,715,823 7,268,366 7,919,523 8,294,939 8,770,469 8,546,452 8,776,146
Non-Operating
Liabilities - - - -
Total Liabilities 106,772,033 111,144,200 104,160,470 114,485,208 122,579,612 133,985,330 155,682,792
Total Equity 23,038,484 24,491,959 30,372,869 29,097,974 33,109,336 37,537,189 29,916,440
Total Liabilities &
Equity 129,810,517 135,636,159 134,533,339 143,583,182 155,688,948 171,522,519 185,599,232

26. ABC Historical Income Statement
2000 2001 2002 2003 2004 2005 2006
Revenue 282,684,058 316,134,725 323,807,201 341,198,318 361,434,956 375,711,489 423,455,160
Cost of Goods Sold 200,052,646 222,411,651 223,585,996 236,708,393 246,858,110 252,374,610 285,797,507
Gross Profit 82,631,412 93,723,074 100,221,205 104,489,925 114,576,846 123,336,879 137,657,653
Operating Expenses 66,358,848 76,006,290 78,403,789 84,387,118 92,285,289 96,952,085 112,592,318
Officer's
Compensation 804,848 881,452 938,124 839,878 830,235 795,465 521,241
Depreciation/Amor
tization 5,227,725 5,922,793 5,492,676 5,751,120 5,516,684 6,052,032 7,010,348
Interest Expense 7,275,085 7,282,709 6,117,280 5,445,046 8,450,906 9,096,521 12,157,828
Total Operating
Expenses 79,666,506 90,093,244 90,951,869 96,423,162 107,083,114 112,896,103 132,281,735
Operating Profit 2,964,906 3,629,830 9,269,336 8,066,763 7,493,732 10,440,776 5,375,918
Other
Income/(Expense) (1,146,303) (914,014) 187,403 435,827 178,091 (27,316) (1,498,016)
Income Before
Taxes 1,818,603 2,715,816 9,456,739 8,502,590 7,671,823 10,413,460 3,877,902
Income Taxes 563,764 1,020,347 3,281,760 4,390,591 2,251,513 4,133,187 1,120,966
Net Income 1,254,839 1,695,469 6,174,979 4,111,999 5,420,310 6,280,273 2,756,936

27. ABC Historical Cash Flow Statements
2000 2001 2002 2003 2004 2005 2006
Increase/(Decrease in
Cash)
Cash Provided by (Used
for) Operations
Net Income/(Loss) 1,254,839 1,695,469 6,174,979 4,111,999 5,420,310 6,280,273 2,756,936
Total Cash Provided by
(Used for) Operations 5,371,528 9,248,889 12,427,953 (2,502,077) 10,937,989 16,990,295 11,706,653
Cash Provided by (Used
for) Investing Activities
Total Cash Provided by
(Used for) Investing
Activities (15,263,142) (10,062,696) (1,742,227) (1,352,425) (12,197,730) (20,451,465) (16,653,699)
Cash Provided by (Used
for) Financing Activities
Total Cash Provided by
(Used for) Financing
Activities 8,135,899 2,473,095 (9,438,830) 4,219,970 438,514 2,741,127 5,382,132
Total
Increase/(Decrease) in
Cash (1,755,715) 1,659,288 1,246,896 365,468 (821,227) (720,043) 435,086
Cash Balance at Beginning
of Year 9,096,568 7,340,853 9,000,141 10,247,037 10,612,505 9,791,278 9,071,235
Cash Balance at End of
Year 7,340,853 9,000,141 10,247,037 10,612,505 9,791,278 9,071,235 9,506,321

28. A Few Ratios
• Current Ratio = Current Assets/Current Liabilities
• Quick (Acid-Test) Ratio = Cash + Securities + Receivables/ Current
Liabilities
• Receivable Turnover = Net Sales On Account/Average Net Receivables
• Revenue-Accounts Receivable=Revenue/Accounts Receivable
• Collection Ratio=365/Receivable Turnover
• Inventory Turnover= Cost of Goods Sold/Average Inventory
• Average Number of Days Inventory in Stock=365/Inventory Turnover
• Debt to Equity=Total Liabilities/Total Equity
• Profit Margin=Net Income/Net Sales
• Asset Turnover=Net Sales/Average Assets

29. ABC Ratios
Name 2000 2001 2002 2003 2004 2005 2006
Current
Ratio 1.00 0.97 0.94 1.15 1.05 0.88 0.87
Quick Ratio 0.31 0.34 0.34 0.42 0.37 0.27 0.25
Revenue/AR 93.06 89.52 93.84 83.91 67.50 80.26 92.60
Debt to
Equity 4.63 4.54 3.43 3.93 3.70 3.57 5.20
Revenue/
Working
Capital 9046 -311 -124 66 160 -65 -59

30. Example of Fictitious Revenues
In one case, a foreign subsidiary of a U.S. company recorded sales to a
series of companies. They invoiced the sales but did not collect any of the
accounts receivable, which became severely past due.
The manager of the foreign subsidiary arranged for false confirmations of
the AR for audit purposes and even hired actors to pretend to be the
customers during a visit from US management. Background checks on the
customers would have revealed that some of the companies were fictitious
while others were either undisclosed related parties or operated in
industries that would have no need for the goods supposedly supplied.
An investigation revealed that the manager of the foreign subsidiary
directed the scheme to record fictitious revenues to met unrealistic
revenue goals set by the U.S. Management.

31. Red Flags - Revenue
• Fake Journal Entries to record Goods or Services sales
that did not occur
• Sales to Fake or Phantom Customers
• Fake sales to Legitimate Customers
• Altered (higher) invoices to Legitimate Customers
• Sales with Conditions (do not qualify as revenue)

32. Red Flags - Revenue
• Rapid growth or unusual profitability.
• Recurring negative cash flows from operations or
inability to generate cash flows while reporting
profits.
• Significant transactions with related parties or special
purpose entities not in the ordinary course of
business.
• Significant, unusual, or highly complex transactions,
especially close to period end that pose difficult
“substance over form” questions.

33. Red Flags – Revenue
• Unusual growth in days sales in receivables.
• A significant volume of sales to entities whose
substance and ownership is not known.
• An unusual surge in sales by a minority of the
units within a company, or of sales recorded
by corporate headquarters.

34. Red Flags – Asset Valuation
• Inventory Valuation
• Accounts Receivable
• Business Combinations
• Fixed Assets

35. Asset Valuation
Inventory
• Not stated at the Lower of Cost or Market
• Fictitious Physical Inventory counts
• Inflating of Unit costs used to price out inventory
• Failure to release Inventory to Cost of Goods Sold
• Creation of Fake documents
• Capitalizing non-asset costs

36. Misrepresenting Fixed Asset Costs
Enron
In October 2002, the SEC filed a civil enforcement action against former
Enron CFO Andrew S. Fastow, who also faced criminal charges relating to
an alleged self enriching scheme to defraud Enron’s security holders
through the use of off-balance sheet entities. One of the six transactions is
the SEC’s complaint against Andrew Fastow involved Raptor I and Avici.
According to the complaint, Enron and the Fastow controlled partnership
LJM2 engaged in complex transactions with an entity called Raptor I.
Raptor I was used to manipulate Enron’s balance sheet and income
statement and to generate profits for LJM2 and Fastow at Enron’s expense.
In September 2000, Fastow and others used Raptor I to effectuate a
fraudulent hedging transaction and thus avoid a decrease in the value of
Enron’s investment in the stock of a public company called Avici Systems,
Inc. Specially, Fastow and others back dated documents to make it appear
that Enron locked in the value of its investment in Avici in August 2002.
when Avici’s stock was trading at its all time high price.

37. Reds Flags – Improper Asset Valuation
• Assets, liabilities, revenues, or expense based on significant
estimates that involve subjective judgments or uncertainties
• On-financial management’s excessive participation in or
preoccupation with the selection of accounting principals or
determination of significant estimates
• Unusual increase in gross margins or margin in excess of
industry peers
• Unusual growth in the number of days sales in receivables
• Unusual growth in the number of days of purchases in
inventory.

38. Reds Flags – Improper Asset
Valuation
• Allowances for bad debts, excess or obsolete inventory, etc.
that is shrinking in percentage terms or are other wise out of
line with industry peers
• Unusual change in the relationship between fixed assets and
depreciation
• Adding to assets while competitors are reducing capital tied
up in assets

39. Red Flags – Concealed Liabilities and
Expenses
Three common methods
• Liability/Expense Omissions
• Capitalized Expenses
• Failure to Disclose Warranty Costs and
Liabilities

40. Omission of Liabilities
In July 2002, the SEC filed suit in the US District Court for the Southern
District of New York, charging major cable television producer Adelphia
Communications; its founder John J. Rigas, his three sons, Timothy J.
Rigas, Michael J. Rigas, and James P. Rigas, and two senior executives at
Adelphia, James R. Brown and Michaels C. Mulcahey, in one of the most
extensive financial frauds ever to take place at a public company. The SEC
charged that Adelphia, at the direction of the individual defendants (1)
fraudulently excluded over $2.3 billion in liabilities from its consolidated
financial statements by hiding them in off-balance sheet affiliates; (2)
falsified operations statistics and inflated Adelphia’s earnings to meet Wall
Street expectations; and (3) concealed rampant self dealing by the Rigas
family, including the undisclosed use of corporate funds for Rigas stock
purchase and the acquisition of luxury condominiums in New York and
elsewhere.

41. Three Elementary Fraud Types
• Duplicate Payment Fraud
• Multiple Payment Fraud
• Shell Fraud

42. Duplicate Payment Fraud
• The issue of two more identical checks to pay
the same debt
• Employee of the paying entity initiates
procedure to issue a second check and
intercepts the second check
• Payee’s name is usually no problem
• Unless the Auditor’s are specifically looking for
it, it is difficult to uncover

43. Duplicate Payment Fraud
If the Auditor’s are specifically looking for it, it is
relatively easy to discover.
• Small business – scan Accounts Payable manually
• Larger business – use a automated computer search
program using data mining software to display
identical payment amounts to same payee

44. Multiple Payee Fraud
Involves two or more payments to different payees for the
same item or service
• One of the payments will be to a legitimate payee, the other
will be fraudulent
• The underlying documentation is switched to support the
bogus transaction
• A bogus vendor name, PO Box can be used to control the
payment receipt
• More difficult to uncover than Duplicate Payment fraud.

45. Shell Fraud
Probably got the name from the old carnival game
• Shell frauds are like the object under the shells, the item that
was purchased and paid for did not exist and never existed
• Perpetrator conceives of a fictional purchase and prepares
paperwork and accounting entries, forging whatever
signatures are needed
• Perpetrator submits a bogus invoice at the proper time

46. Statement on Auditing Standards 99
• 1. All frauds are material because they
signal that management lacks integrity.
Further, materiality isn’t just an amount
• 2. Malpractice cases are litigated with
20/20 hindsight, with all the facts out for
the world to see.

47. SAS 99
• 3. SAS 99 requires that you significantly
change your relationship with clients. You no longer can
assume that your clients are honest just because they have
been in the past.
• 4. The cost of audits is on the rise. Clients may attempt to
save money by either terminating their current accountants or
asking for a compilation or review rather than an audit. You
should consider adding, in large, bold print, the wording,
“NOT AN AUDIT OPINION” at the top of compilation and
review opinions.

48. SAS 99
• 5. SAS 99 is an admission that risk-based auditing doesn’t
work.
This is because no matter how good the controls are,
management can always override them.
• 6. Don’t wait until you have identified a risk of material fraud
to perform appropriate procedures. That’s backwards.
Perform the procedures to identify the risk.

49. How a Company Can Reduce
Fraud
The risk of fraud can be reduced through a combination of
prevention, deterrence and detection measures.
However, fraud often is difficult to detect because it often
involves concealment through falsification of documents or
collusion. Therefore, it is important to place a strong emphasis
on fraud prevention, which may reduce opportunities for
fraud to take place, and fraud deterrence, which could
persuade individuals that they should not commit fraud
because of the likelihood of detection and punishment.
Moreover, prevention and deterrence measures are much less
costly than the time and expense required for fraud detection
and investigation.

50. Create and maintain a culture of
honesty and high ethics.
The ethical culture needs to be set by management through
their daily words, but more importantly, their actions.
Therefore, the organizations value system requires not so
much a written code of conduct (which is important as well)
but a daily, consistent adherence to these values.
Companies should also clearly communicate their ethical
values, decision-making processes and codes of conduct to all
employees so they may be empowered to make appropriate
ethical decisions even when they are far from headquarters or
confronted with a new dilemma.

51. Evaluate the risks of fraud, and
implement risk mitigation
Fraud risk assessment should be part of a more enterprise-
wide risk monitoring process but can also be done separately.
A collection of fraud risk factors are included in SAS 99 and
are segregated into the areas of fraudulent financial reporting
and asset misappropriation. Based on the assessed risks, a
response is developed which may include preventative
controls (reducing the opportunity to commit fraud),
mitigation controls (reducing the impact of the potential
fraud), or transference (selecting appropriate fraud insurance
such as a fidelity insurance policy).

52. Develop an appropriate oversight
process.
Internal and external parties need to oversee the risk of and
responses to fraudulent financial reporting.
Although the entire management team shares the
responsibility for implementing and monitoring these
activities, the entity’s CEO should initiate and support such
measures.
In addition, the entire organization should adopt a level of
fraud awareness similar to a neighborhood watch
program. Employees should have a means to communicate
wrongdoing without fear of retribution as tips from
employees are still the number one way fraud is uncovered.

53. Develop an appropriate oversight
process.
Further, independent verifications by internal and external
auditors help to ensure controls are operating effectively.
Such reviews should be reported directly to the audit
committee.
Coupled with follow-up work to suspected wrongdoing, these
reviews send a strong deterrent message throughout the
organization.
Oversight needs to take a tiered approach so that override at
any given layer, including the CEO, may be identified and
properly handled. The top layer of this oversight process is
reserved for the audit committee who must ensure top
management upholds its responsibilities to the organization.

54. Questions??