Journal of Forensic & Investigative Accounting
Senior Editor:  D. Larry Crumbley
Editor: Tanweer Hasan
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Journal of Forensic & Investigative Accounting

Senior Editor
D. Larry Crumbley

Louisiana State University
Department of Accounting
3106A Patrick Taylor Hall
Baton Rouge, LA 70803
Phone: 225-578-6231
Fax: 225-578-6201

Tanweer Hasan

Roosevelt University
430 S. Michigan Avenue
Chicago, IL 60605
Phone: 847-619-4886
Fax: 847-619-4852

Volume 2: No. 2, July-December, 2010

Table of Contents

+ Corporate Governance Factors Associated with Financial Fraud
    • Mohammad J. Abdolmohammadi
    • William J. Read
    • Kwadwo Asare
Abstract: We identify a sample of 36 publicly-held companies with financial fraud in their 2003 financial statements. We use industry-specific summary corporate governance ratings (CGQ-Y) from RiskMetrics Group (formerly Institutional Investor Services), to select a sample of control firms with governance ratings similar to the fraud firms. We trace changes in CGQ-Y ratings as well as numerous governance mechanisms over the period of 2003-2006 to identify those with significant differences between the fraud firms and control firms. Specifically, we identify two corporate governance mechanisms with theoretical justification for their effects on differences due to fraud. The first is the extent of non-audit services, as proxied by the dollar magnitude of “audit-related” and “other” non-audit fees, provided by incumbent auditors. We hypothesize and find that significantly fewer fraud firms received substantial non-audit services compared to the control sample. The second governance variable is board election, where we hypothesize and find that fraud companies elect all directors annually, more often than control firms, which have more staggered terms for their directors.

We used the Compustat data base to codify a number of control variables identified from prior literature as impacting governance and investigated differences by fraud and control firms. We do not find significant differences between fraud and control firms with respect to return on assets, the proportion of executive ownership of the firm, or firm size. However, we find that fraud firms have significantly more financial need, lower Z-scores, and more audit committee meetings in the fraud year than control firms. Finally, when compared with control firms, we find that fraud firms improve their overall governance rating in the year following the fraud, but revert to lower ratings in the following two years.

Keywords: Corporate governance; financial fraud.

Data Availability: Performance and financial data are available from Compustat. Financial fraud data were obtained from public sources and corporate governance ratings were obtained from RiskMetrics Group.

Abstract: “Forensic accounting,” recently a seldom heard term, has quickly become a hot new area for students, professionals, and researchers. However, given that it is such a new field, there is little existing research in this area, especially in the area of forensic accounting education. Many schools are rushing to offer courses, minors, and even majors in forensic accounting, yet so far there has been little academic research to investigate the demands of the profession. In this study, we examine the professional community’s perceptions of the necessary skills for forensic accountants, as well as the education requirements and the training requirements considered important to the profession. We developed a survey through interviews with practicing professionals and a review of the limited existing literature. The survey was administered to over 150 fraud and forensic accounting professionals.

Keywords: Forensic accounting skills; careers in forensic accounting.

Abstract: For many years, AICPA audit standards offered minimal guidance for risk-based audit planning. While some leading CPA firms developed risk-based audit plans, practitioners did not apply such standards consistently. But by 1980 the AICPA developed auditing standards that provided more structured guidance for auditors’ (1) assessment of identified risks, (2) audit planning with a focus on strengths and weaknesses of an organization’s internal control environment, and (3) plans to respond to risks of error and fraud. These auditing standards evolved into the audit risk assessment standards that require auditors to gain an in-depth understanding of an organization’s control environment, rigorously assess the risk of financial statement misstatement based on that understanding, and specify audit procedures that respond to the assessed risk. The purpose of this paper is to describe the evolution of risk assessment and discuss the possible effect of the current standards on future practice and the profession. Understanding the evolution of risk assessment forms a key part in designing and evaluating audit procedures to control, detect and report on fraudulent activities.

Keywords: Risk assessment standards; audit guidance; expectation gap; internal controls.

Abstract: We use Benoit’s (1995) image restoration typology to analyze the communication strategies computer firms apply to disclose their material weaknesses in Section 404 reports. The results of this study indicate that although the majority of firms report corrective actions, some firms use non-corrective action strategies in response to material weaknesses and these firms experience significant increases in the incidence of mergers, bankruptcy, and regulatory noncompliance. The occurrence rate is nearly double for non-corrective action firms compared to the industry. In addition, firms that use non-correction action strategies appear to have significantly more control environment material weaknesses than firms that use corrective action strategies.

Keywords: SarbOx; Material Weaknesses; Internal Control; Communication Strategies.

Data Availability: Data is available from the authors upon request.

Abstract: It is generally accepted that litigation against firms could result in significant losses to stockholders. In a bid to mitigate investor losses, research is needed to identify factors that could be used in predicting litigation against firms. The purpose of this study is to contribute to the literature by investigating whether there is an association between audit fees and subsequent client litigation. If there is an association, then audit fees may be used as an early warning signal of client litigation. We hypothesize and find a positive association between audit fees and subsequent client litigation. Change in audit fees is also significantly higher for litigation firms. Our findings suggest that audit fees may be used as an early warning signal of subsequent client litigation.

Keywords: Audit Fees; Legal Cost; Litigation; Risk.

Data Availability: Data is publicly available.

+ Internal Control Opinions and Auditor Resignations
    • Abhijit Barua
    • Clark M. Wheatley
    • Yun-Chia Yan
Abstract: SEC registrants have suggested that Section 404 of the Sarbanes-Oxley Act (Section 404) has significantly increased the work associated with an audit and that in the post Sarbanes-Oxley period auditors are much more likely to resign from clients perceived to be risky. This has important implications, from a forensic standpoint, for both current and successor auditors. We examine auditor changes during 2005 for 2,923 non-financial firms that filed their initial Section 404 opinions. We find that there is a significant association between the disclosure of internal control problems and subsequent auditor resignations. This result provides empirical grounding for the controversy surrounding auditor resignations from risky clients in the post Sarbanes-Oxley period.

Keywords: Internal controls; auditor resignations; auditor changes; section 404 disclosures.

Abstract: This study develops a bootstrap procedure applied to digital analysis based on Benford’s Law. It shows that the developed procedure provides accurate diagnoses of fraud as opposed to traditional statistical procedures. The traditional procedures such as the chi-square goodness-of-fit test exhibit the problem of excessive power as the volume of transactions becomes large. This problem may lead auditors to expend unnecessary fraud investigation costs. In contrast, applications of the proposed bootstrap procedure to reported annual earnings of S&P 1500 companies, Federal Election Commission data, and extremely fraudulent data demonstrate the robustness of the proposed procedure over different periods of time and across small or large financial data sets.

Keywords: Benford’s Law; Bootstrap; Confidence Interval; Cosmetic Earnings Management; Digital Analysis; Fraud; Power.

+ Defined Benefit Pension Fraud: A Ticking Time Bomb
    • Stephanie R. Sipe
    • Cheryl T. Metrejean
    • William Donaldson
Abstract: There are many different kinds of pension fraud, but the type most likely to have significant adverse systemic consequences on an already strained national economy involves under-funding by employers of defined benefit pension obligations through two distinct types of fraud: nondisclosure and misrepresentation. This paper seeks to present a primer on the laws that regulate defined benefit plans, the problems presented by the understaffing of the Employee Benefits Security Administration and the under-funding of and lack of oversight by the Pension Benefit Guaranty Corporation, and the potential for escalating pension fraud in today’s troubled corporate environment and depressed financial markets.

Keywords: Defined Benefit Pension Plans; Pension Fraud; Earnings Management.

Abstract: Despite passage of the Private Securities Litigation Reform Act in 1995, litigation against auditors and their clients threatens the viability of many audit firms. Turmoil in the audit profession in the early 2000s resulted not only in the demise of Arthur Andersen and the resulting realignment of audit portfolios, but in increasingly large lawsuits and increased scrutiny of the audit profession. As a result, auditors once more are seeking regulatory and legal relief to protect themselves from damaging lawsuits. While regulatory and legal relief may be achieved at some point, audit firms and their clients likely have been proactive in otherwise reducing exposure to litigation. This study uses three different surrogates for litigation risk—estimated discretionary accruals, relative risk of restatement, and degree of financial distress—to compare the relative riskiness of the largest six audit firms and to evaluate changes in their litigation risk over time. Results indicate that the audit portfolios of five of the six firms likely reduced litigation risk between 2002 and 2005. Results also identify significant differences in litigation risk between the Big 4 and the two non-Big 4 firms examined.

Keywords: Litigation risk; estimated discretionary accruals; relative risk of restatement.

Abstract: Differing internal control perspectives by accountants and lawyers make future internal control research imperative. Attorneys and accountants view the world of internal control very differently. The Sarbanes-Oxley Act (SarbOx) has made internal control part of the legal realm. Now, more than ever, it is important that accountants understand how attorneys view internal control before court battles begin. Attorneys find a lack of research in this area. Attorneys also differ from accountants in how they perceive reasonableness, effectiveness, cost/benefit, and the inherent limitation of internal control. Accountants should not be complacent that their view of internal control will be accepted by courts of law when SarbOx is inevitably tested.

Keywords: Sarbanes Oxley; Internal control; Attorney; Legal Action.

Abstract: Traditional forensics professionals use among other tools, fingerprint, blood splatter and ballistic analysis, DNA typing, and forensic pathology to make their case. Infosec professionals have to develop new tools for collecting, preserving, examining and evaluating electronic evidence in an effort to establish intent, culpability, motive, means, methods and loss, resulting from cyber-based crimes.

Considering the increasing complexity of technology and as a result, the devices which may contain latent and incriminating digital evidence, due to a migration from aged analog devices to state-of-the-art digital multifunctional devices (MFDs), this article discusses these MFDs, their potential legal exposures, their importance/role in IT audit and cyber forensic investigations and the exposure, which they may represent to un- and under- prepared organizations.

Keywords: Multifunction Devices; Cyber Forensics; IT Audit; Internal Control Exposures; Privacy; Common Vulnerabilities and Exposures; Data Loss; Latent Electronic Evidence; Data Security; e-discovery.

+ Bankruptcy and Fraud Analysis: Shorting and Selling Stocks
    • Hugh Grove
    • Tom Cook
    • Eric Streeper
    • Greg Throckmorton
Abstract: We examine the stock price reaction to announcements that firms are being questioned for possible fraudulent financial reporting or manipulating earnings, using the firms cited by the Securities Exchange Commission (SEC) in its comment letters issued after August 1, 2004 through the end of 2006. These SEC letters concerning financial reporting issues were issued to public companies filing with the SEC. The final sample was 300 companies which included all the major SIC industries. To assess these reporting issues, six well established models and ratios were used: quality of earnings, quality of revenues, Sloan’s accrual measure, Altman’s bankruptcy model, Beneish’s fraud model, and the Dechow et al. fraud model. After adjusting for general price movements in the stock market, companies that had four or more of these six possible red flags for financial reporting had stock price declines of 40% to 80% over the two years following the release of these SEC comment letters. Forensic accountants, auditors, investment managers, and short sellers can use these six models to identify financial factors for assessing earnings management and fraud possibilities and related investment decisions.

Keywords: Earnings manipulation; Fraudulent financial reporting; Detection models; Stock market reactions.

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Books Received

Fraud in the Markets: Why it Happens and How to Fight it
Peter D. Goldmann, 2010, $39.95, 272 pp.
John Wiley & Sons
111 River Street
Hoboken, N.J. 07030-5774

Fraud and corruption have always been components of American culture. However, as statistics and the personal experiences of many Americans confirm, fraud, corruption, and ethical misconduct was not as prevalent in the 1970s and early 1980s as it is now. From the fraud-driven destruction of a $100 billion company like Enron and the theft of $65 billion through a one-man Ponzi scheme, to the demise of a Wall Street icon like Bear Stearns at the hands of two rogue hedge fund managers, these earth-shattering incidents were practically unheard of until the late 1980s.

Goldmann provides a dramatic look at fraud’s role in the financial markets, and how readers can protect themselves. The book looks back at the late 1970s and early 1980s as the early stages of what would become the perfect storm of the 2000s. It was the period of unmitigated financial abuse by a contingent of moral misfits who abused deregulation of the S&L industry to steal $150 billion of depositor and investor funds. A period of corporate raiding, dismantling, dissolving, and divesting. Not illegal or particularly unethical, but fuel for the demise of Wall Street decorum and the ascent of personal avarice that some would say culminated in the financial crisis of 2007-2008.

Written from an insider’s perspective, this new book reveals the critical role fraud played in the global financial crisis. Shedding light on the reckless conduct of the former senior executives at major Wall Street firms such as Lehman Brothers, Bear Stearns, Merrill Lynch and others just before their collapse. This book shows how the culture of “anything goes” on Wall Street fueled the innovation of exotic but deadly asset-backed securities. Looking back at the most dramatic economic and business headlines in recent memory, readers will find revealing discussion of:

  • The fraudulent lending practices that engulfed the U.S. mortgage industry
  • The deceptive marketing of asset-backed securities
  • The fraud culture and the untold secrets of flagrant lawlessness in the executive suites of major financial institutions
  • Reform, re-regulation, and the persistence of fraud
  • The real estate bubble and bust
  • The markings of a melt down
  • A road map to prevent similar disasters from recurring
Online Newsgathering Research and Reporting for Journalism
Stephen Quinn and Stephen Lamble, 2008, 197 pp.
Sheri D. Allen

This book exists to help mono-media journalists and students in journalism programs around the world move into realms of multimedia reporting. A forensic accountant will find these chapters informative:

  • How the Internet is changing Journalism.
  • Generating Ideas and Finding Experts.
  • Blogs as a newsgathering and reporting tool.
  • Beyond Google: Finding trustworthy Info online.
  • Evaluating Information quality.
  • Using CAR [computer-assisted reporting]
  • Websites and links
  • Advanced CAR
Forensic & Investigative Accounting
D.L. Crumbley, L.E. Heitger, G.S. Smith
Commerce Clearing House, 2009, 4th Edition
4025 W. Peterson Avenue
Chicago, IL – 60646-6085

This readily teachable textbook provides in-depth, clear explanations of the concepts, substantive issues, and practices associated with forensic accounting. Pedagogical features peppered throughout enhance the text materials--Chapter Objectives, numerous illustrative Examples, Figures, Tables, and Special information sidebars engage students and keep the presentations lively and interesting. End of Chapter Problems test student understanding and reinforce the key concepts and practices discussed. There is a companion Instructor’s Guide and Test Bank available to adopters that will greatly assist your instruction.

Major divisions of the text examine: 1) Discipline and Practice of Forensic Accounting (two chapters); 2) Uncovering Accounting Fraud (four chapters); 3) Courtroom Procedures and Litigation Support (four chapters); 4) Cybercrime (three chapters); 5) Business Valuations (one chapter).

The introductory chapters provide a historical overview of forensic accounting and discussion of forensic specialties, career opportunities, associations and certifications. Next, the methods accountants employ to uncover crime, financial fraud, and misappropriation of assets are presented, and important topics related to money laundering and transnational financial flows are examined. The text logically progresses to an in-depth review of courtroom procedures, litigation, evidence and damages. The latter chapters cover the most modern of topics, cybercrime, where loss valuations for web sites, legal issues and criminal profiling are studied. Students are also introduced to Business Valuations.
Encyclopedia of Victimology and Crime Prevention
Bonnie S. Fisher and S.P. Lab, editors
Sage Publications, 2010, $315.0
2455 Teller Road
Newbury Park, CA 91320

A massive, two volume encyclopedia with 28 general topical categories, such as Business Prevention Actions, Civil Justice System, Courts: Alternative Remedies, Courts: Law and Justice, and Crime Prevention. The index is 60 pages long, including entries to Cyber and Internet offenses, disputes resolution, evidence, forensic evidence, theft by employees, corporate crime against, expert testimony, fraud, fraudsters, internet fraud, and white collar crime. An excellent resource for a forensic accounting office.

Trap Doors and Trojan Horses: An Auditing Action Adventure
D.L. Crumbley, M. Smith, L.D. Delaune
Carolina Academic Press, 2009, $25, 228pp.
700 Kent Street
Durham N.C. 27701
Fax 919-493-5668

In this educational novel, the famous forensic accountant, Lenny Cramer, has joined the accounting faculty at Georgia State University. In addition to his professional duties, he is conducting an operational audit for the international soft drink company, Coca-Cola. Espionage and fraud place Lenny’s life on the line as he uncovers a scheme to steal Coke’s secret formula. The story features a variety of settings, from Washington, D.C. to Poland.

As an expert in his field, Professor Cramer uses his forensic auditing knowledge to assist the Coca-Cola Company, his students, the U.S. Congress, and the legal system as an expert witness. With his assistant, Slam Duncan, an accounting Ph.D. student, he puts state-of-the-art technology to work solving audit problems in the real world.

The novel may be used near the end of an auditing or beginning of a data processing course. It would be ideal for an MBA program that has a light coverage of accounting or used in CPA firm’s in-house training programs.

This educational novel illustrates the difference between a regular audit and the investigation required by forensic accountants to uncover computer fraud. Every business executive should read it, because just as termites never sleep, fraud never sleeps. And just like termites, fraud can destroy the foundation of an entity.
Forensic Accounting
W.S. Hopwood, et al., 1st edition
McGraw-Hill Irwin, 2008, 512 pp.

The authors include a vast range of civil and criminal accounting fraud and related activities, from false business valuations and employer fraud to information security and counter-terrorism. Coverage of the criminal justice system as it relates to accounting is extensive, touching on areas such as forensic science, organized crime, litigation support, and expert testimony.

The book includes coverage of accounting information systems and auditing, making the material more accessible to accounting non-majors. The book’s pedagogy includes chapter learning objectives and glossaries of key terms. Most chapters are extensively illustrated with figures and artwork. The end-of-chapter material consists of review questions, discuss questions, and both short and long cases.
The Audit Committee Handbook
L. Braiotta, Jr et al., 2010, 5th Edition, $95.0, 388 pp.
John Wiley
Hoboken, New Jersey

More than ever before, audit committees are accountable for their company’s financials, especially amidst the uncertainties arising from the changing statutory, regulatory, legal, and risk environment for corporations, directors, and officers, as well as the accounting and auditing substance of audit committee’s jobs.

Completely updated to help a person operate in this ever-changing environment, the handbook fills the need for an up-to-date reference that helps busy professionals perform their oversight responsibilities.

This edition features:

  • Updates from the latest regulatory changes.
  • New chapters covering internal and external audit planning and oversight.
  • New coverage of fraud risk.
  • Broader international coverage.
  • Advice on complying with myriad regulations while managing costs and maintaining a business focus --- rather than one of compliance.
  • Discussion of current trends and development that maximize the effectiveness of audit committees.
Foreign Corrupt Practices Act Compliance Guidebook: Protecting Your Organization from Bribery and Corruption
M.T. and D.R. Biegelman, 2010, 384 pp.
John Wiley & Sons

One of the fastest growing areas of law and corporate compliance is the Foreign Corrupt Practices Act (FCPA). This growth is due to the globalization of business and today’s greater focus on anti-corruption compliance. The FCPA makes it a crime for U.S.-listed companies, their employees, or their agents to obtain business by bribery of a government official of another country. The global nature of companies with subsidiaries, affiliates, and vendors all over the world provide great opportunity but also great risk. U.S. law reaches all around the world and covers the actions of U.S. corporations and their employees no matter where they are. Illegal actions relating to the FCPA can have major implications.

This guide provides invaluable compliance guidance on the business risks associated with bribery, corruption, and the FCPA. Included is rich content and practical information for both U.S. and foreign companies. For anyone that needs to learn about the past, present, and future of the FCPA, the constant threat of bribery, and how to design and manage an anti-corruption compliance program, this book is a must-read.

There are harsh penalties for those who violate the anti-bribery provision of the Foreign Corrupt Practices Act. Third party liability is another major concern as companies are liable for the actions of the people they hire, be they direct employees or agents. The solution is a strong compliance program to ensure everyone knows what the rules are and to keep track of who’s doing what. The authors show readers how the FCPA is critically important to any U.S. company that does business in a global environment, as well as foreign companies that supply or have agency agreements with U.S. companies. It provides an overview of the business risks and guidance on spotting potential FCPA red flags. This book provides business professionals with practical guidance on managing FCPA requirements as part of an overall compliance program.