(*This article has been excerpted from The Guide to Investigating Business Fraud, available on cpa2biz.com.)

Quite often, however, a fraud investigation reaches business professionals who are not familiar with how investigations are conducted, their role in an investigation and possible outcomes. With frauds such as Enron, WorldCom, Tyco, Parmalat, Adelphia, Société Générale, the Ponzi scheme recently perpetrated by Bernard Madoff and the recent billion dollar fraud at Satyam in India, it has become even more important that business owners, controllers and management understand how a fraud investigation is run. These cases are just a few examples of frauds that have occurred, resulting in devastating effects on their organization, employees and investors. The continued onset of one of the worst global economic downturns in recent history has now created a robust environment for fraud. Based on these painful lessons learned in the past and the current environment, companies, regulators and other key stakeholders are putting more emphasis into addressing their approach to fraud investigations and how they view fraud proactively and reactively.

The Fraud Investigation Framework

Combating business fraud crimes is not an optional exercise. One of the difficult but necessary aspects of business ownership involves planning for potentially fraudulent activities to occur within the business at some point and time. It is shocking to think that even in Fortune 500 businesses, fraud risk management plans can be in disarray. Too often, in both big and small business culture, policy and practicality do not intersect. There is no one correct way of approaching a fraud investigation. It is the primary responsibility of management to take appropriate action when an event involving fraud or alleged fraud is brought to his or her attention. An inadequate response to fraud or an allegation of fraud can result in a protracted investigation that involves rework and wasted time and resources. In such instances, a fraud investigation framework comprises involvement of people who lack credibility or are perceived to lack objectivity relative to the issue, activities or persons involved. Another investigation scenario could involve participants, investigators and advisors who lack sufficient competence in critical areas. Investigators and decision makers stumble into preventable pitfalls. The potential downsides of certain decisions are not understood until after the fact. Poor decision making in the first few hours after an allegation or a fraudulent activity is brought to light can lead to disastrous consequences.

By contrast, a strong, credible and competent response ensures that adequate, relevant and complete information is assembled to support decision making; legal rights and responsibilities are respected; and any applicable legal privileges are preserved.

Basics of Investigations

Unique considerations for each business are on the front end of fraud investigation planning, but the most critical consideration involved in implementing a fraud investigation framework for any business is practicality and timeliness. What is key for any fraud management architecture, regardless of how the framework is structured, is that the architecture is followed consistently over time. The best way to encourage the proliferation of fraudulent activity in a business is to either not follow an investigation framework or to do so inconsistently.

The Guide to Investigating Business Fraud is available on cpa2biz.

Defining Fraud

The American Heritage Dictionary defines fraud as “a deception deliberately practiced in order to secure unfair or unlawful gain,” and the Collins Essential English Dictionary defines an investigation as a “careful search or examination to discover facts.” Although these two definitions provide guidance on what legally constitutes a fraud investigation, they do not address the practical nature of uncovering and remediating a fraud scenario. What is more important is being able to encompass the entirety of not only what the crime is and who has perpetrated it but the effect(s) that the crime and an investigation may have on a company or organization.

In grade school, most of us were introduced to the five “Ws,” which are generally understood to represent fundamental rhetorical questions to be used in scholarly, journalistic and other evidence-based treatises. Although it seems reasonable that arriving at evidence-based conclusions in an investigation need not be mentioned in a field that deals with forensics, it should be.

Types of Fraud

Fraudulent activities in businesses can fall into three main classes of activity: asset misappropriation, financial statement fraud and corruption. Understand that the type of event is a significant factor in determining a proper response. Furthermore, in each class, unique activities (if understood) can help focus an investigation even further.

Asset Misappropriation

• The former CFO, accounting manager and accounts payable supervisor conspired to embezzle over $35 million dollars from PBSJ, an employee-owned engineering and construction firm, in Miami, Florida. The FBI conducted the investigation and revealed that the employees were able to steal the funds by writing unauthorized checks to a private account and also by transferring funds from the medical benefits account into private checking accounts. The money was then shown to be spent on real estate, luxury cars, a yacht, jewelry and gambling activities.
• The accounting manager, who had worked for the company for over 25 years, was sentenced to 63 months in prison and ordered to pay over $10 million in restitution. The CFO was sentenced to 97 months in prison on the embezzlement charges and 24 months on the campaign finance charge, to run concurrently.
• The president and CFO of Continental Express, an Arkansas-based trucking company, worked closely together to transfer funds into personal accounts, only to have the CFO testify against his accomplice at trial. Together, the two men established an insurance company with the same name as that used by Continental Express, but it was incorporated in a different state. They then made payments to the fraudulent insurance company. In addition, they paid themselves multiple salaries. According to the prosecution, it was a sense of entitlement that motivated the former president to scam the money from his employer. The CFO received a reduced sentence for his cooperation in the prosecution.

Financial Statement Fraud

• In August 2007, Dell announced the completion of a year-long internal investigation, overseen by its audit committee, into the accounting practices that led to an overstatement of profits by $50 million. The audit committee investigation was in response to, but conducted separately from, a continuing SEC investigation. Employing outside professional services firms, the investigation required 375 professionals who conducted 233 interviews and reviewed over five million documents. As a result of the investigation, Dell restated financial statements for four years and reported management would continue to report to the audit committee on their actions to correct previous control deficiencies.

Corruption

• Pacific Northwest Financial Services (PNFS), using a name quite similar to the publicly traded and trusted Pacific Financial, sold fake surety bonds to 57 trucking companies. The trucking industry is required to purchase $10,000 bonds from licensed bonding companies. Licensing is obtained through the Federal Motor Carrier Safety Administration (FMCSA). The FMCSA discovered the documents filed with them by PNFS were falsified and notified the Department of Transportation’s Office of the Inspector General. The owner of PNFS, Larry James Jackson, never intended to actually provide the bonding service and spent the money on himself. Jackson was sentenced to 70 months in prison and ordered to pay $236,347 in restitution.
• Kmart conducted an internal investigation into management practices amidst their 2002 bankruptcy and external investigations by both the SEC and FBI. The investigations were triggered by anonymous letters claiming to be from employees who accused Kmart of intentionally violating accounting standards. Kmart’s CEO, who was overseeing the investigation, reported that they uncovered “credible and persuasive evidence demonstrating that certain former managers of Kmart violated their stewardship responsibilities to Kmart, its employees and shareholders.” The investigation included more than 570 interviews and the review of more than 1.5 million pages of documents. In addition, Kmart provided over 620,000 pages of documents for use in the external investigations.

Conclusion

Understand that each fraud case is different and every investigation must be adjusted to the variables encountered by the investigation team. The timeline of the investigation either can be focused and short in duration (a few weeks to a couple months) or wide ranging and last for several months or even years. Although the specific procedures employed to investigate an alleged fraud vary depending on the size of the fraud and its potential scope, each investigation will typically include all of the following steps:

• Occurrence of the event
• Planning and organization
• Information and evidence collecting
• Recommendation and reporting
• Remediation and follow-up steps

These steps align are generally sequential and it is important to understand that all investigations, regardless of scope, should address all of these considerations across time. View sidebar for additional business fraud internal control measures.