INVESTIGATING FRAUD:
FINDING THE SAWDUST TRAIL
R. Ed Hancock, CPA, CFE, CFF
Surety & Construction Consultants, Inc.
Surety Claims Institute
June 25 - 27, 2014
{SCI Paper_Fraud Examination_E Hancockv. (.)}
R. Ed Hancock, CPA, CFE, CFF
Surety & Construction Consultants, Inc.
R. Ed Hancock is the President of Surety & Construction Consultants, Inc. in Tampa, FL.
Mr. Hancock is a forensic accountant handling surety claims, fidelity claims, credit insurance
claims and testifies as an expert witness in the areas of surety and forensic accounting. Mr.
Hancock received a Bachelor of Arts degree in Criminology from the University of South
Florida. Mr. Hancock earned his Masters of Business Administration with a concentration in
Accounting from the University of Phoenix. He is a Certified Public Accountant licensed in the
state of Florida. Mr. Hancock has earned the professional designations of Certified Fraud
Examiner and Certified in Financial Forensics.
{SCI Paper_Fraud Examination_E Hancockv. (.)}
TABLE OF CONTENTS
I.
Introduction ......................................................................................................................... 1
II.
Types of Fraus..................................................................................................................... 1
III.
IV.
A.
Financial Statement Fraud .......................................................................................1
B.
Asset Misappropriation ............................................................................................3
C.
Financial Institution Fraud .......................................................................................3
D.
Tax Fraud .................................................................................................................3
E.
Bankruptcy Fraud.....................................................................................................4
Planning and Conducting a Fraud Examination ................................................................. 5
A.
Fraud Examination Methodology ............................................................................5
B.
Obtaining Documentary Evidence ...........................................................................6
C.
Source of Information ..............................................................................................6
D.
Data Analysis ...........................................................................................................6
Conclusion .......................................................................................................................... 7
{SCI Paper_Fraud Examination_E Hancockv. (.)}
i
INVESTIGATING FRAUD: FINDING THE SAWDUST TRAIL
I.
Introduction
In the late 19th century the northwest part of the United States was home to a vibrant
lumber industry. Men would hike into the dense forest without maps or guides that would ensure
their return home. These men would carry on their backs large bags of sawdust to spread on the
ground as they traveled. A lumberman lost in the woods knew that he only had to find the
sawdust trail, and he could easily return home. We often have this same view of evidence
related to investigating fraud. That in every case there exists sufficient evidence to clearly mark
the path so that anyone who sees what we are seeing, will agree that fraud exists. In this paper
we will examine the elements of fraud as well as the different types of fraud and the evidence
needed to support conclusions of fraud. Hopefully we too will find the sawdust trail.
As we explore the different definitions of fraud and how to plan and conduct an
investigation, we need to keep in mind there are two elements to fraud. The first element, which
is objective, is the definition of fraud. Florida statute 817(3)(d) defines Scheme to Defraud as “a
systematic, ongoing course of conduct with intent to defraud one or more persons, or with intent
to obtain property from one or more persons by false or fraudulent pretenses, representations, or
promises or willful misrepresentations of a future act.”1 The words used to define fraud in this
case, or a scheme to defraud, are common in most definitions of fraud. Therefore, we have the
objection definition of fraud and the elements required to meet the definition.
However, there is always a second element, which is the subjective element of fraud. In
the definition above the word “intent” appears. What is meant by intent? Even if we can agree
there is intent what evidence is required to support our conclusion? Is the evidence we acquire
going to meet the requirement? What one person may see as sufficient evidence to support a
conclusion of fraud may be different for another person and this is especially true when
presenting evidence to a trier of fact. Knowing that there is uncertainty in the objective, the
remainder of the paper will identify the various types of fraud as well as the investigative
techniques we use to gather the evidence needed to support our conclusions. Hopefully we can
overcome the objective by conducting a comprehensive and methodical investigation.
II.
A.
Types of Fraud
FINANCIAL STATEMENT FRAUD
Financial Statement Fraud is the deliberate misrepresentation of an enterprise’s financial
condition. This is accomplished through the omission of amounts, intentional misstatements, or
improper disclosures in the financial statements with the intent of deceiving financial statement
users.2 Again, we are dealing with the issue of intent. Is it possible to make an error on a set of
financial statements? Yes, and that error may cause a loss but the issue comes down to intent.
1
“The 2012 Florida Statutes,” last updated April 29, 2014, accessed April 29, 2014,
http://www.leg.state.fl.us/Statutes/index.cfm?App_mode=Display_Statute&URL=08000899/0817/0817ContentsIndex.html
2
Association of Certified Fraud Examiners, Fraud Examiners Manual: 2014 Edition, (Austin, TX: Association of
Certified Fraud Examiners, 2014), 1.203.
{SCI Paper_Fraud Examination_E Hancockv. (.)}
R. Ed Hancock, CPA, CFE, CFF:
Investigating Fraud: Finding The Sawdust Trail
One difference that sets financial statement fraud apart from other types of fraud is there may be
no intent to cause a loss. A company may be looking to buy a little time to obtain a much needed
bridge loan to keep a business up and running until things get better. A CEO or CFO may want
to avoid conflict with the Board of Directors and Shareholders, knowing that with a little more
time they can turn things around. But many times financial statement fraud is committed
knowing that there will be a loss.
In the areas of surety and fidelity, we see financial statement fraud used to obtain a bond
line or to keep an existing bond line in place. The most common form of financial statement
fraud involves overstating the asset side (cash, land, equipment, receivables, revenues, and
profits) or understating the liability side (notes due, payables, expenses). Underwriters often
place a great deal of importance on financial statements and the effects of financial statement
fraud can greatly complicate the claims process in addition to causing the loss. So when we talk
about financial statements, it is important to address the three different levels of assurance
provided by accountants when preparing financial statements.
Financial statements can be compiled, reviewed, or audited. Compiled financial
statements present the assertions of management without providing any assurance regarding the
form or accuracy of the information. No inquiries or analytical procedures are performed and the
accountant does not assess internal control, fraud risk, or otherwise perform any audit
procedures.3 Compiled financial statements are nothing more than the assertions of management
put into the proper form based on the requirements of the intended users. Additional procedures
may need to be performed by the underwriters, in-house accountants, or outside accountants in
order to verify the information presented in the financial statements.
Reviewed financial statements provide limited assurance that no material modifications
need to be made for fair presentation. The accountant is required to perform analytical
procedures in order to compare recorded amounts with the accountant’s expectations. If the
accountant identifies inconsistencies in the information, he or she is required to make an inquiry
of management. Once management responds, the accountant has no further responsibility to
corroborate or verify management’s responses.4 Reviewed financial statements provide a level
of assurance greater than that of compiled financial statements, but less than audited financial
statements. Compiled and reviewed financial statements are compared with audited financial
statements, the objective of which is to “express and opinion on the fairness, in all material
respects, with which the financial statements present financial position, results of operations, and
cash flows in conformity with generally accepted accounting principles.”5 Altogether, there are
ten general, fieldwork, and reporting standards that auditors must comply with for each audit, the
objective of which is to provide reasonable assurance the financial statements are free of material
misstatements. Therefore, when relying on financial statements, we would prefer to have audited
financials as opposed to reviewed or compiled.
3
Steven M. Bragg, Practitioner’s Guide to GAAS 2011, (Hoboken, New Jersey: John Wiley & Sons, 2011), 766.
Id. at 774-775.
5
Steven M. Bragg, Practitioner’s Guide to GAAS 2011, (Hoboken, New Jersey: John Wiley & Sons, 2011), 2.
4
2
R. Ed Hancock, CPA, CFE, CFF:
Investigating Fraud: Finding The Sawdust Trail
B.
ASSET MISAPPROPRIATION
The most common form of occupational fraud is asset misappropriations, and the most
common form of asset misappropriation is the theft of cash. Anyone who has conducted forensic
accounting investigations related to surety or fidelity claims has most likely encountered missing
cash. Theft of cash falls into two general categories. The first is larceny, which is the theft of
cash already recorded on the books and the second is skimming, which is defined as the theft of
cash before it is recorded.6 However, anything of value that can be easily converted to cash is at
risk. From construction sites we have seen the theft of appliances, wiring, aluminum, electrical
and mechanical equipment. All of these items are easily sold, with much of it being sold for
scrap.
C.
FINANCIAL INSTITUTION FRAUD
Financial Institution Fraud includes any type of external or internal fraud where the
financial institution is the victim. Financial institutions include credit unions, savings and loans,
banks, and other federally insured repositories.7 We will refer to these institutions using the
generic term banks and the theft of money as bank fraud. When we think of external bank fraud,
we often think of check fraud, loan fraud, and credit card fraud. These external frauds can have
an internal component as since, someone from outside the bank can be in collusion with someone
who works inside the bank to help facilitate the theft of money.
Someone inside the bank, working alone or in collusion with another employee, can
commit bank fraud. There are many ways an employee or employees can steal from a bank. The
different methods are limited only by the imagination. However, the various methods do fall
into some general categories. Employees can make false accounting entries to cover
unauthorized withdraws from customer accounts and/or deposits into their own accounts.
Employees can pay personal expenses from bank funds or commit outright theft of bank assets.
All banks should regularly monitor dormant or inactive accounts, since these accounts are an
easy target and customers are not likely to notice the missing funds. Directors, officers, or
employees can steal, sell, or use collateral or repossessed property for themselves or create loans
for themselves by falsifying loan documents. There are an unlimited number of variations and
combinations when using the different methods and involving those inside and outside the bank,
acting alone or in collusion with someone outside or inside the bank.
D.
TAX FRAUD
Tax Fraud is an act of intentional wrongdoing, and not the same as tax avoidance. Tax
fraud is:
…the actual intentional wrongdoing, and the intent required…to evade a tax
believed to be owing. Fraud implies bad faith, intentional wrongdoing, and
6
Association of Certified Fraud Examiners, Fraud Examiners Manual: 2014 Edition, (Austin, TX: Association of
Certified Fraud Examiners, 2014), 1.301.
7
Association of Certified Fraud Examiners, Fraud Examiners Manual: 2014 Edition, (Austin, TX: Association of
Certified Fraud Examiners, 2014), 1.801
3
R. Ed Hancock, CPA, CFE, CFF:
Investigating Fraud: Finding The Sawdust Trail
a sinister motive. It is never imputed or presumed and the courts will not
sustain findings of fraud upon circumstances which at most create only
suspicion.8
Tax fraud is addressed due to the impact on the handling of surety and fidelity claims.
The Internal Revenue Service has a great deal of power and can move with great speed at times
to take control of assets in cases of suspected tax fraud. For the surety claims handler, this may
mean a freeze on a principal’s bank accounts, which may contain bonded contract receipts. This
will restrict operating cash, may impede the progress of bonded work, and necessitate additional
legal expense. For the fidelity claims handler, the IRS may seize the assets of a principal, which
would hinder the ability to recover for a loss covered by a fidelity bond or financial institution
bond.
E.
BANKRUPTCY FRAUD
Bankruptcy is a complex subject and beyond the scope of this paper to identify the
various parties and chapters that govern the bankruptcy process. There are many good resources
both within and outside the surety and fidelity industry, and I would recommend those resources
for an exhaustive review of bankruptcy law. Title 18, U.S. Code, Section 152 is the most
comprehensive criminal statute concerning bankruptcy fraud. There are nine items listed in
Section 152 that define various offenses under the bankruptcy code and what follows is a brief
overview of the nine offenses.
The first item on the list, concealment of property, is always an area of concern for
sureties. Assets, records, and anything of value is considered property of the estate and
knowingly and fraudulently concealing the property from an officer of the court or a United
States Trustee is a crime.9 The second and third items are false oaths on account and false
declarations. False oaths apply to oral statements and false declarations concern written
documents filed with the court.10 The fourth item is filing a false claim, which is when a person
knowing and fraudulently presents a proof of claim against the debtor’s estate.11 A person is
guilty of violating Section 152 if they knowingly receive property, of a material amount, with the
intent of defeating the provisions of Title 11, which is item five.12 The sixth item deals with
extortion and bribery, which is also covered in Title 18, Section 210 and Section 1503. Extortion
and bribery consists of giving or offering anything of value, or a promise thereof, for acting or
forbearing to act in any case under Title 11.13
If a person knowingly and fraudulently transfers or conceals his property or the property
of another person or corporation and does that in the capacity of, or as an agent of, or officer of,
any person or corporation in contemplation of or to defeat the provisions of Title 11, the have
8
14 Mertens, Law of Federal Taxation, sec. 55.21, page 64, (1991 Rev); Ross Glove Co. v. Commissioner, 60 TC
569 (1973).
9
Association of Certified Fraud Examiners, Fraud Examiners Manual: 2014 Edition, (Austin, TX: Association of
Certified Fraud Examiners, 2014), 2.416.
10
Id.
11
Id.
12
Id. at 2.417.
13
Id.
4
R. Ed Hancock, CPA, CFE, CFF:
Investigating Fraud: Finding The Sawdust Trail
committed a criminal act.14 This is the seventh item. The last two items, item eight and item
nine, are somewhat related. Item 8 states a crime is committed if a person knowingly and
fraudulently conceals, destroys, falsifies, or mutilates the property or record of a debtor. Item 9
states that knowingly and fraudulently withholding a document or record related to the financial
affairs of a debtor is a crime as well.15 There are other criminal offenses related to bankruptcy
but the nine listed above provide a general overview of what as an investigator we are likely to
encounter.
III.
Planning and Conducting a Fraud Examination
The decision to begin a fraud examination should be one that entails significant
discussions. While some examinations can be started and completed in a short period of time,
many are time consuming and can be expensive to conduct. To minimize time and achieve the
desired outcome, an investigative plan should be used. The plan should include the nature of the
fraud, the depth of the examination, types of documents or evidence needed or expected, time
frame, reporting requirements, and possible testimony. A plan, accompanied by a budget, helps
to establish a framework so that expectations are understood and communication is facilitated.
A.
FRAUD EXAMINATION METHODOLOGY
Once the decision has been made to begin a fraud examination, and for the purposes of
this paper we will consider forensic accounting to be included in the definition of fraud
examination, a proper methodology should be used. Proper fraud methodology should begin
with the assumption that litigation will follow. The word forensic means, “pertaining to,
connected with, or used in courts of law or public discussion and debate.”16 We always operate
from the assumption that our work will one day be a part of litigation. As fraud examiners, we
want to act on predication, which is the belief that a fraud has, is, and/or will occur.17 As fraud
examiners or forensic investigators, we must seek to prove a fraud has occurred and seek to
prove a fraud has not occurred. By approaching a fraud examination from these two different
perspectives, we are establishing a fraud did occur and there is not another explanation other than
guilt.18
The investigation itself requires that we use a Fraud Theory Approach. The Fraud
Theory Approach requires that we make a hypothesis, or theory, and then acquire evidence to
support our theory. If after testing our hypothesis we determine the hypothesis is not provable,
then we revise our hypothesis and re-test. We continue this process until the theory is provable,
or until we conclude the hypothesis is not provable and therefore a fraud cannot be proven.19
The process of proving our theory or hypothesis requires that we move from the general to the
14
Id.
Id. at 2.418
16
forensic. Dictionary.com. Collins English Dictionary - Complete & Unabridged 10th Edition. HarperCollins
Publishers. http://dictionary.reference.com/browse/forensic(accessed: May 06, 2014).
17
Association of Certified Fraud Examiners, Fraud Examiners Manual: 2014 Edition, (Austin, TX: Association of
Certified Fraud Examiners, 2014), 3.104.
18
Id.
19
Id.
15
5
R. Ed Hancock, CPA, CFE, CFF:
Investigating Fraud: Finding The Sawdust Trail
specific. In other words, we start with general information that is known, and work towards
more specific details.20
B.
OBTAINING DOCUMENTARY EVIDENCE
The heart of any fraud examination is documentary evidence, and that evidence may be
obtained in a number of ways. First, we may obtain documentary evidence directly from the
source. As an example, when conducting a claim of employee embezzlement, the insured may
provide copies of checks or fraudulent invoices. We may obtain documentary evidence from
third parties such as banks and government offices. We may need to have certified copies of
deeds or judgments or we may want to obtain bank statements directly from the banks. Last, we
may generate documentary evidence ourselves in the form of spreadsheets, schedules, and/or
diagrams. Regardless of the origin, we want categorize, classify, and properly organize
documentary evidence to support the conclusions of our investigation.
C.
SOURCES OF INFORMATION
Since documentary evidence is extremely important, what are the sources we can use to
obtain the information? There are two general sources, internal and external. Internal sources
will provide a large percentage of the documentary evidence needed to complete our
investigation. External sources have their place in forensic investigations as well. Fraud
examiners should consider accessing public and non-public records, commercial databases, the
Internet, media records, social media sites, and third-party sources. These sources can be used
locate missing assets, locate and verify corporate records, locate witnesses, research financial
condition, and obtain other types of documentation to provide additional support for our
conclusions or later interviews.21
D.
DATA ANALYSIS
In the last section of this paper, I would like to take some time to address data analysis.
More than ever before, data is being stored electronically, and not just small amounts of data
either. An electronic check register may have thousands of entries going back years. Our
techniques for analysis will depend on whether the data is structured or un-structured but many
of the steps are the same. The first step in any data analysis is preparation. We must identify the
relevant data, obtain the data, verify the data, and then cleanse and normalize the data. Once the
preparation phase is completed, we can then begin the process of data analysis. While data
analysis itself may not be used as trial evidence, the results will provide the fraud examiner with
a trail to follow.22
20
Id.
Id. at 3.601.
22
Association of Certified Fraud Examiners, Fraud Examiners Manual: 2014 Edition, (Austin, TX: Association of
Certified Fraud Examiners, 2014), 3.706-3.713.
21
6
R. Ed Hancock, CPA, CFE, CFF:
Investigating Fraud: Finding The Sawdust Trail
IV.
Conclusion
As we think about the process of getting from the consideration of fraud to proving fraud.
Not just meeting the objective elements of fraud but also overcoming the subjective, we look for
that sawdust trail, that clear path to the finish. Our best hope of finding that path lies in
identifying the proper type of fraud, retaining the right forensic expert, proper planning, and a
well-planned and thorough examination and analysis.
7