Book ’em, Accountants

The term “forensic accounting” conjures up visions of latex-gloved, 10-key-toting wonks examining the minutia of company ledgers under microscopes.

But the number-crunching branch of forensics isn’t all cloak, dagger and CSI Miami. It’s really about being able to prove a financial theory and back it up in a court of law.

The American Institute of Certified Public Accountants doesn’t even define the term as yet, but other trade associations sum it up roughly as using accounting, auditing and investigative skills to assist in legal matters.

Essentially, forensic accounting is used to help combat fraud — an estimated $660 billion annual black hole in the United States — as well as prove or disprove economic damages in civil suits, and even help decide who gets what in a nasty divorce case.

There were a total of four embezzlement arrests in Arkansas in 2003 and six in 2004, according to the Arkansas Crime Information Center in Little Rock. There were 14,919 fraud arrests in 2003, which includes all manner of activities as well as hot check-writing, and a total of 4,998 in 2004.

The gap in fraud cases from year to year is due to a concerted statewide push to prosecute hot check-writers in 2003.

James Dunn, partner with law firm Warner Smith & Harris LLC in Fort Smith, frequently uses forensic accountants as expert witnesses or to determine the degree of damages in a dispute. Sometimes work performed by an accountant can encourage the other side to settle or even back off completely, he said.

In the last six months, Dunn has used three different accounting firms in everything from commercial litigation to insurance defense and property disputes.

Three of the larger firms in the state — BKD LLP and Moore Stephens Frost, both based in Little Rock, and Beall Barclay & Co. PLC of Fort Smith — each have a single person they look to for their respective forensic practices.

Fraud Findings

One element of the forensic practice, and probably the most well known, is fraud investigation. Some certified public accountants pursue a designation of certified fraud examiner (CFE) through the Association of Certified Fraud Examiners. But a CPA does not need a certification to practice fraud examining or to be a forensic accountant.

The ACFE is an Austin, Texas-based international organization that fights fraud and white-collar crime.

The organization came up with the $660 billion a year loss to the

U.S. economy in a study called the “2004 Report to the Nation on Occupational Fraud and Abuse.” The number is up from an estimated $400 billion a year in 1996 (see story, p. 19).

Eight of the nine key personnel listed with the Arkansas Division of Legislative Audit, the entity that helps ensure proper accountability of public funds in the state, are CFEs.

Both Wal-Mart Stores Inc. of Bentonville and Tyson Foods Inc. of Springdale also have CFEs listed with the ACFE.

Gettin’ Proactive

Sue Talkington, a CPA and CFE with Beall Barclay & Co., earned her CFE in 2000 and her background is in auditing. But she said her practice in the fraud field is slower than she’d like.

Her goal is to help businesses proactively guard against fraud and embezzlement, she said, but it’s a hard sell to most companies.

“I see the need, but I can’t get it across to [business owners],” Talkington said.

She said most fraud is committed by people who are highly trusted within an organization, so it’s sometimes hard for the top brass to wrap their minds around prevention.

But a recent ACFE study claims the average organization loses 6 percent of its annual revenue to occupational fraud.

Talkington has worked on fraud cases worth anywhere from $9,000 to $1.6 million, she said, and it’s an even split between male and female perpetrators.

The best insurance an organization can have against fraud is setting up a series of self-protective internal controls, Talkington said. By setting up a series of controls, a business can close the holes a motivated person uses to commit fraud.

The controls can be as simple as making sure to sign every check, or by requiring that the monthly bank statement shows up unopened.

But even with those, some people manage to steal.

“There’re clever people out there,” she said.

The idea is to make the loopholes smaller and smaller within an organization to reduce the number of opportunities.

“Pay me now or pay me later, but you’re going to lose more if you pay me later,” she said.

Computer Forensics

Steven Haenchen is a CPA and CFE with the BKD firm. His specialty is in computer-assisted accounting forensics, and he has a list of Microsoft certifications as long as a proverbial slide rule.

Haenchen has performed services for the FBI and has already spent four weeks this year working in the United Kingdom on a case.

Very little of what he does involves fraud, Haenchen said. Instead, most of the time his services are hired on by a lawyer who needs help determining economic damages, or to disprove an opposing side’s claim to damages.

“Fraud may be 2 or 3 percent of what I do,” Haenchen said. “The idea is you work with attorneys and help them determine damages before you know if the person is guilty or not.”

He writes customized computing code as needed to look for pieces of information in any one case.

One case Haenchen worked on involved a telephone broker who signed up long distance services with hotels. The more hotels the broker signed up, the slimmer his margin became.

The broker and the phone company hired Haenchen (then with another firm) to investigate and compute damages.

The broker felt he was due between $2 million and $5 million in commissions from underpayment. The phone company disagreed.

Haenchen sifted through 13 million call records from the phone company and compared them with the 10,000 pages of information the broker provided. He matched about 2,000 calls and showed the phone company owed the broker between $15,000 and $45,000 in lost commissions.

The broker balked, and Haenchen’s firm was eventually taken off the case. But the research service billed for about $100,000 and took more than three months to compile, Haenchen said.

That was a cheap price for the phone company, whose $50,000 investment saved up to $5 million, and it was a risk for the broker, who would’ve lost money if he’d agreed to Haenchen’s findings.

Since he was taken off the case, he’s not sure how the long-distance broker finally fared against the phone company.

Another case involved trade secrets between two landscape nurseries. When one firm that was started by employees of another became successful, the original firm sued for damages and insinuated that the new firm had stolen clientele.

The plaintiff came up with “outrageous damages” worth more than the defendant’s annual revenue. Haenchen said.

Haenchen went through five years of sales records, sometimes reconstructing byte-by-byte information from one of the firm’s annual back-up tapes into a legible form.

Through that information, he was able to identify a customer base and segment it, and he looked at the marginal profit of the new firm.

“The expert report said ‘this is what the other guy did wrong, and this is what we did right,'” Haenchen said.

The parties settled out of court for a sum much less than the original asking price, he said.

“It’s extremely rare you go to court because most cases settle,” he said.

Litigation Investigation

But Cheryl Shuffield, a CPA and an accredited business valuations specialist with Moore Stephens Frost’s Little Rock office, had what she called an unusually busy May. She went to court five times that month.

Shuffield’s practice is mostly in the litigation field, she said, which means she is willing and ready to go to court to defend what she finds in her investigations. Her accounting background is in taxes, she said.

She spends a lot of her time working out of the Rogers office and recently spent two days in Bentonville tied up in testimony and depositions, she said.

Shuffield originally thought about going to law school, but forensic accounting gave her the opportunity to work in both areas, she said.

“It is challenging and rewarding work,” Shuffield said, “although it is not for the faint of heart because your work is constantly subject to scrutiny from opposing experts, attorneys, judges and juries.”

She also said fraud is on the lower end of billings for her firm. Last year forensic work accounted for about 10 percent of billings, but she said it is the single fastest growing segment for MSF, growing at about 15 to 20 percent annually.

The Enron scandals have brought more attention to fraud, she said, but her services are used more to prove economic damages and make sure they don’t get out of hand, and to maybe keep a case from going to court.

Attorneys may ask her firm to look for financial irregularities, to see if an opposing side’s principal is under financial stress or if there is evidence of check kiting.

In a recent insurance defense case, she said the insurance company knew a fire claim was arson but wanted to prove the suspect did it. She was engaged to help look for a motive to find culpability.

She examined the suspect’s finances over three years and saw that his net worth declined from $400,000 to nothing just before the fire. Her firm found drafts from a casino, which showed he probably had a gambling problem.

Her services are used in a lot of divorce cases too, Shuffield said, because most of the time one person is more knowledgeable than the other about the family’s assets and sometimes that person hides assets.

It’s frequently her job to show what would be a fair division between spouses, according to Arkansas law, she said.

Facing Fraud Facts

According to the “2004 Report to the Nation on Occupational Fraud and Abuse” compiled by the Association of Certified Fraud Examiners, small organizations, those with 100 or fewer employees, suffer disproportionately large losses due to occupational fraud.

Other findings on the cost of fraud include:

• Total estimated U.S. loss from fraud has grown from about $400 billion in 1996 to about $660 billion in 2004.

• About 46 percent of fraud happened in small organizations.

• The median loss to small companies was $98,000.

• The typical organization loses 6 percent of its annual revenue to occupational fraud.

Of the 471 cases the ACFE reviewed, more than 90 percent of occupational fraud involved the misappropriation of assets, and the most frequently targeted asset was cash, though 22 percent of the cases involved the misappropriation of non-cash assets.

Sue Talkington, a CPA and CFE with Beall Barclay & Co. in Fort Smith, said fraud is a triangle of opportunity, motivation and rationalization. The idea behind fraud prevention from the accounting standpoint is to reduce or eliminate the opportunity, Talkington said.

She recommends businesses be proactive rather than reactive and the best way to do that is to work with an accountant to set up controls.

For fraud prevention tips, see related story here or visit the ACFE’s Web site at www.cfenet.com.