Chapter 7 in Forensic Accounting Book. Conducting a fraud investigation.

Outline Proposal to Answer Case #1: 'Mountain State Sporting Goods: A Case of Fraud' - Conducting a Fraud Investigation Investigative Phases This outline follows the step-by-step investigative structure set forth in the chapter, \"The Investigation\". The following outline for answering the case is suggested. Phase I (a) - Confirm the reasonableness of the suspicions of fraud. Phase I (b) - Create a fraud hypothesis. Phase II (a) - Test your hypothesis via financial statements analysis. Phase II (b) - Test your hypothesis via journal entry testing. Phase III - Revise and confirm your hypothesis via interviews. Phase IV-Draw your conclusion(s), and communicate your results. Phase V - Present a discussion of Mr. Hess's roles, duties, and responsibilities. Phase VI - Present recommendations for resolution and remediation. Appendix A: Operations Analysis - Component Percentage Appendix B: Balance Sheet Analysis - Component Percentage Appendix C: Operations Analysis - Trend Appendix D: Selected Ratio Analysis Appendix E: Cash Flow Statement 1 CHAPTER 7: CONDUCTING A FRAUD INVESTIGATION Learning Objectives 1. 2. 3. 4. 5. Evaluate the reasonableness of a suspicion of fraud Create a preliminary fraud hypothesis Test and refine the fraud hypothesis through financial statements analysis and journal entry testing Test and refine the fraud hypothesis by conducting interviews Identify specific schemes used to perpetrate the fraudulent activity Learning Objectives 6. 7. Determine the economic loss resulting from the fraudulent activity In response to a finding of fraud, identify potential recommendations for resolution 1 Fraud Investigation: Introduction Objective is to gather evidence of a suspected fraud Forensic accountants might be engaged as: Agent of law enforcement of an audit team Private accountant engaged by victim or victim's counsel Private accountant engaged by accused or accused's counsel Member 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 Cautions and Reminders Financial statements analysis: Most valuable evidencegathering 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: n Need (pressure) n Opportunity n Rationalization Fraud: Not an accounting problem, rather a social phenomenon 2 Case #1: Mountain State Sporting Goods: A Case of Fraud In 2009, brothers Robert and Nathaniel Smith contacted a former federal prosecutor, to discuss their suspicions of fraudulent activity Sparked by observations of general manager's lavish lifestyle Organization and Ownership Mountain State Sporting Goods was organized by J.D. Smith in 1993 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 Table 7-1Gross Revenues: Projected Versus Actual 3 Table 7-2Product Categories Table 7-3Pawn Items 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 4 Compensation Officers' Compensation Workman's compensation determined by his employment contract n Base salary of $50,000 plus 1% of all sales exceeding projections n To date, company has failed to meet projections Key Employees, Compensation, and Benefits Average of eight employees n Including Workman's spouse, Anita, and his daughter, Mia and Mia share in-house accounting duties and responsibilities n Anita 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 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 5 Phase I of Investigation Phase I(a): Confirm the reasonableness of the suspicions of fraud Review case profile presented previously ten conditions (red flags) that either confirm or fail to confirm the reasonableness of Smith's suspicions Employ the fraud triangle Identify 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 The Fraud Triangle 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 6 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 Phase III of Investigation Phase III: Refine and confirm hypothesis via interviews At this stage, you should have: n Developed n Developed a working knowledge of the business a working knowledge of company's accounting system n Identified any questionable financial statement reporting issues n Identified the key players to be interviewed and the information sought Follow the interview sequence Phase IV of Investigation Phase IV: Draw conclusions and communicate results Determination of the amount misappropriated discussion of specific schemes employed Loss components Related n Specific transactions pawn loan interest n Unreported forfeited pawn sales n Statutory interest at 7.5% n Unreported 7 Common Fraud Schemes Skimming Cash larceny Register disbursement Less cash scheme False credits / discounts Diversion of loan proceeds False entries Unauthorized disbursements Billing scheme Check tampering Others Phase V of Investigation Phase V: Present a discussion of Mr. Hess's roles, duties, and responsibilities Evidences indicate that Mr. Hess may be a coconspirator and may have violated the AICPA's ethical and professional standards in his service Address these concerns with a meaningful discussion Phase VI of Investigation Phase VI: Present recommendations for resolution and remediation Present your recommendations for resolution and remediation Consider the following n Strength of the evidence explanations, if any n Eligibility for criminal complaint n Eligibility for civil complaint n Consideration for alternative dispute resolution n Alternative 8