Category Archives: Client Relations

Reaching Behind the Curtain

Not too long ago a close friend of one of our Chapter members paid a substantial sum of money to a relative, the owner of a closely held corporation, in exchange for a piece of the relative’s real estate to which, it turns out,  the relative/owner did not have clear title.  The relative apparently used a substantial portion of the funds to immediately clear debts of his corporation of which he and his wife are the sole officers and shareholders.  He now claims that, since he used the sale proceeds for corporate purposes, the refund of the purchase price he owes our Chapter member’s friend is a debt of the corporation and not of his personally.   Our Chapter’s friend has engaged an attorney at the suggestion of our certified Chapter member.

Our legal system recognizes that corporations have a separate existence from their shareholders/owners and are treated as ‘individuals’ under the law. There are two ways for a wrong-doer to use the existence of a corporation to avoid efforts to recover a money damage judgment from him or her:

–As in this case, the scammer argues that the corporation and not the shareholder/owner committed the offense, and therefore the shareholder’s personal assets and property should not be used to satisfy any judgment for the offense.

–Argues that the wrongdoer/shareholder’s property is held in the name of the corporation, and therefore s/he has no personal assets that can be used to satisfy a judgment against him  or her.

The first reflects the classic doctrine that shareholder/owners are not liable for the debts or liabilities of the corporation. Of course, if the shareholder/owner also controls the corporation and personally acted wrongfully, s/he may still be liable for her misconduct, and the corporation may simply be jointly and severally liable together with her. Whether the wrongful conduct was that of the corporation or that of an individual shareholder usually is a question of fact to be decided by the jury.

The second reflects the corporation’s ability, as a separate legal entity, to own its own property. If the corporation owns the property, then the individual shareholder does not.  Since both pre-judgement attachment writs and writs of execution can only reach a defendant’s interest in leviable assets, a wrongdoer can appear without assets and judgment proof – and your client can be unable to satisfy a money judgment against her- if the wrongdoer/shareholder has transferred title in her personal assets to the corporation. This does not apply to a non-money judgment to recover specific money or property which can reach proceeds or property in the hands of the wrongdoer or of third persons. Of course, if the wrongdoer’s transfer of assets to the corporation was to defraud creditors, the injured party can seek to have the transfers set aside.

However, even where a corporation apparently shields the defendant or his or her property, the wrongdoer and her leviable property can still be reached if the court can be convinced to disregard the corporation or to regard it merely as her alter ego. The court may do so if it can be proved that the corporation is merely a sham whose sole purpose is to help the wrongdoer fraudulently avoid liability for her conduct. This is sometimes called piercing the corporate veil.

If the corporation is found to be the alter ego of the shareholder, then either or both of the following consequences apply, depending on the goal in piercing the corporate veil:

–The wrongdoer is no longer shielded from liability for the corporation’s misconduct because the wrongdoer and the corporation are viewed by the court as one and the same.

–Corporate property can be reached to satisfy a judgment against the wrongdoer because the property is now regarded, properly, as the wrongdoer/shareholder’s property.

One of the factors to consider in attempting to pierce the corporate veil is whether the corporation is closely held; i.e. owned or directed by one or by a small or limited number of shareholders, officers, and directors (often all the members of the same family). Obviously, the larger the number of shareholders, and the more broadly the corporation’s directing positions are distributed, the less likely it is to be a sham or alter ego for one person. However, given the lawful goals and purposes of incorporation, even a small, closely held corporation may be legitimate. Conversely, the existence of other shareholders or other directors and officers may not mean that the corporation is not a sham.

The ACFE tells us that there is no hard and fast test to determine whether a corporation is a sham. Instead, courts will look at a variety of factors to determine whether to pierce the corporate veil. These factors include:

–As in this case, does the wrongdoer exercise sole or ultimate control over the activities of the corporation?

–Does the corporation’s charter describe the approved activities of the corporation with some specificity, or is it left largely to the discretion of the wrongdoer?

–Does the corporation fail to hold director’s and shareholder’s meetings, record minutes of those meetings, and otherwise observe the formalities of corporate existence?

–Is the corporation so undercapitalized as to raise questions about its viability as a separate entity?

–Are the corporation’s finances so intertwined or identifiable with those of the wrongdoer as to raise questions about its separate existence?

–Does the corporation own property which does not seem to reasonably relate to its activities, particularly as described in its charter?

–Does the wrongdoer use the corporation’s property as if they were her own, personal assets, including but not limited to whether she uses them for purposes not within the corporation’s approved activities?

These and similar or related facts can indicate that the corporation is a sham and has no true, separate existence from the wrongdoer/shareholder. In that case, the court would be justified in ruling that the corporation should be regarded as an alter ego of the wrongdoer and that the corporation and the wrongdoer be considered as one and the same ‘person’ for purposes of determining liability or levying on assets to satisfy a money judgment.

Many thanks to our member for bringing this case to our attention!

Another Sold Out Event!

 

 

 

 

Our Chapter wants to extend its formal thanks to our partners, national ACFE and the Virginia State Police, but especially to our event attendees who made this year’s May training event a resounding, sold-out success! As the rave attendee evaluations revealed, How to Testify, was one of our best received sessions ever!

Our presenter, Hugo Holland, CFE, JDD, brought his vast courtroom experience as a prosecutor and nationally recognized litigator to bear in communicating every aspect of a complex practice area in a down-to-earth comprehensible manner with no sacrifice of vital detail.

As Hugo made clear, there are two basic kinds of testimony. The first is lay testimony (sometimes called factual testimony), where witnesses testify about what they have experienced firsthand and their factual observations. The second kind is expert testimony, where a person who, by reason of education, training, skill, or experience, is qualified to render an expert opinion regarding certain issues at hand. Typically, a fraud examiner who worked on a case will be capable of providing both lay, and potentially, expert testimony based on observations made during the investigation.

Certified Fraud Examiners (CFEs) and forensic accountants serve two primary roles as experts in forensic matters: expert consultants and expert witnesses. The fraud investigator must always be prepared to serve as an expert witness in court and learning how best to do so is critical for the training of the rounded professional. The expert consultant is an independent fraud examiner/accounting contractor who provides expert opinions in a wide array of cases, such as those relating to fraud investigations, divorces, mergers and acquisitions, employee-employer disputes, insurance disputes, and so on. In a fraud case, the CFE could identify and document all fraudulent transactions. This in turn could lead to reaching a plea bargain with a guilty employee. Therefore, the CFE helps solve a problem before any expert trial testimony is needed.

In addition, CFEs and forensic accountants are called upon to provide expert consultation services involving testimony in such areas as:

• Fraud investigations and management.
• Business valuation calculations.
• Economic damage calculations.
• Lost profits and wages.
• Disability income analysis.
• Economic analyses and valuations in matrimonial (prenuptial, postnuptial, and divorce) accounting.
• Adequacy of life insurance.
• Analysis of contract proposals.

Hugo emphasized that the most important considerations at trial for experts are credibility, demeanor, understandability, and accuracy. Credibility is not something that can be controlled in and of itself but is a result of the factors that are under the control of the expert witness. Hugo expounded in greater detail on these and other general guidelines:

• The answering of questions in plain language. Judges, juries, arbitrators, and others tend to believe expert testimony more when they truly understand what the expert says. It is best, therefore, to reduce complicated, technical arguments to plain language.

• The answering of only what is asked. Expert witnesses should not volunteer more than what is asked even when not volunteering more testimony could suggest that the expert’s testimony is giving the wrong impression. It is up to employing counsel to clear up any misimpressions through follow-up questions. That is, it is up to counsel to “rehabilitate” his or her expert witness who appears to have been impeached. That said, however, experienced expert witnesses sometimes volunteer information to protect their testimony from being twisted. Experience is needed to know when and how to do this and Hugo supplied it. Our presenter emphasized repeatedly that the best thing for an inexperienced expert witness to do is to work with experienced employing attorneys who know how to rehabilitate witnesses.

• The maintenance of a steady demeanor. It is important for the expert witness to maintain a steady, smooth demeanor regardless of which questions are asked and which side’s attorney asks them. It is especially undesirable to do something such as assume defensive body language when being questioned by the opposing side.

• Attendees learned how to be friendly and smile at appropriate times. Judges and juries are just people, and it helps to appear as relaxed but professional.

• To remain silent when there is an objection by one of the attorneys. Continue speaking only when instructed to do so.

• Attendees learned how best to state the facts. The expert witness should tell the truth plainly and simply. Attendees learned how the expert’s testimony should not become more complicated or strained when it appears to be harmful to the client the expert represents. The expert witness should not try to answer questions to which s/he does not know the answer but should simply say that s/he does not know or does not have enough information to form an opinion.

• Attendees learned to control the pace. The opposing attorney can sometimes attempt to crush a witness by rapid fire questions. The expert witness should avoid firing back answers at the same pace. This can avoid giving the appearance that s/he is arguing with the examining attorney. It also helps prevent her from being rushed and overwhelmed to the point of making mistakes.

• Most importantly, Hugo imparted invaluable techniques to survive cross examination. Attendees learned how to testify effectively on both direct and cross examination, basic courtroom procedures, and tricks for general survival on the witness stand. Attendees were told how to improve their techniques on how to offer testimony about damages and restitution while learning to know when to draw the line between aggressive testimony and improper advocacy. All our attendees walked away with more effective report writing and presentation skills as well as benefiting from a solid exploration of the different types of evidence and related legal remedies.

Again, thanks to all, attendees and partners, for making our May 2019 training event such a resounding success!

The Man in the Mirror

I readily confess I would not have won any awards for effective delegation during my early years as a fraud examiner/information systems audit professional. To my mind the buck stopped with the guy in the mirror I saw shaving every morning. I prided myself on being personally capable of performing every routine task of every assignment involved in whatever function I was managing at the time. What finally weaned me from the practice of doing it all myself was the threat of burn-out and the seemingly ever-increasing demands of a typical work week of seventy hours.

The demands of managing in an assurance environment featuring risk assessments, regulatory compliance, fraud investigations, corporate governance, and engagement quality control can be crushing for any new (or not so new) manager but especially so for those unwilling or who simply lack the skills to adequately delegate; those skills usually only come with experience.

While some new to assurance or investigative management may think delegating simply means passing off work to subordinates, the lines of delegation also can occur laterally to peers and upward to superiors. The distinction is important, because in delegating to subordinates, one of the goals is to achieve long term investigative team development. This goal comes with a shift in emphasis from managing to leading. Managing is about getting the work done, whereas leading fosters learning, growth, and a greater sense of responsibility among individual members of the your team.

According to the ACFE, the first step to successful delegation within examination work is recognizing when to let go rather than trying to do too much. For CFEs new to leadership responsibilities, a willingness to delegate can be challenging. CFEs typically advance to management positions as a result of their individual achievements and performance. This advancement fosters a sense that the person best suited to accomplish a given task is the one whose already done it satisfactorily, but that is not the way leaders should think. Even though an assurance professional has advanced to a management position based on past accomplishments, he or she needs to take a broader view of what is in the long term interest of her function group and/or organization. A conscious commitment to delegation can enable the individual manager to not only increase their personal productivity but also (and here I speak from personal experience) gain better control of their lives and, hence, prevent burnout.

An honest self-examination is a precursor to delegation. CFEs and other assurance professionals in a management position need to understand their capabilities and role(s) within the organization. One way to do this is by considering their vision for and the needs of the organization. Then, what are the assurance function’s immediate and long-term goals, including capabilities and developmental needs? Realizing that trusting others, not just one self, to do a high quality job is a personal decision and there can be many barriers to it. What is the nature of your own personal career goals and your priorities for work-life balance? A periodic, wholly candid assessment of these and similar issues can give any manager a better perspective on his or her motives in relation to delegating.

Delegating is more than just shoving work on someone who possesses the skill set to fit the task. Rather, delegating is an opportunity to cultivate members of the investigative team by increasing the number of people who are capable of taking on a bigger role, which can help strengthen the team and create a succession plan in the event of unexpected personnel turnover. How often have we all been witness to the chaos which can ensure when a key staff member leaves and no-one has been groomed to fill her place?

To the extent possible, an new staff CFE should be matched strategically with an assignment that is a bit above his or her head as a way of providing a positive learning experience. Delegating with career development in mind means managers will need to resist playing the role of lifeguard. Subordinates will struggle at times, but managers shouldn’t be too quick to act as helicopter parents and come to the rescue. Instead, managers should remain confident in the basic capabilities of their staff and allow reasonable time for learning and growth, which enables the team to gain experience and add more value to the organization.

Knowing whether a particular assignment is within an examiner’s potential capabilities and can enable him or her to grow professionally, however, is often not an easy task. As managers delegate assignments, they should consider not limiting assignments only to those areas in which an investigator has had prior experience. Also, managers need to avoid the tendency toward primarily delegating interesting or important assignments to the most favored team members; managers should groom everyone on the team not just the superstars; it’s the superstars who are, let’s face it, the most desirable targets for external recruiters. The same is true for undesirable assignments; managers also should spread those among the whole team, which can demonstrate that everyone is treated fairly. A thoughtful delegating process helps keep the assurance team challenged and motivated, thereby reducing the likelihood of losing promising but insufficiently challenged staff members.

Initial parameters need to be established to prevent misunderstandings, deficient productivity, or delays in the timely completion of examinations. All parties involved should have a clear understanding of the delegated assignment and of expectations. However, managers should refrain from giving excessively detailed instructions. Successful delegating does not mean micromanaging anyone. Instead, managers should consider focusing on discussing the objectives, scope, and outcomes of the assignment. When examiners are allowed the flexibility and freedom to perform their work, they not only learn more but also may show considerable ingenuity. Managing CFEs can foster an environment of participative management by encouraging input from subordinates toward refining the plans, expectations, and deadlines, as well as emphasize how the present investigation fits into the larger scheme. When a team member sees the whole process rather than only a part, he or she is less likely to miss a critical matter and may become more motivated to deliver a quality product.

The ACFE recommends that the CFE engagement manager should give his or her subordinates authority to operationally pursue their assignment and to make decisions as they see fit. Delegating the authority is no less important than assigning the responsibility for a task. In the absence of conferring an appropriate level of authority, the team member’s performance could be undercut. Also, examination managers should keep an open mind by welcoming new ideas, innovative suggestions, and alternative proposals from others. Nothing is more motivating for a subordinate than to realize that he or she has a significant ownership stake in the results. This is another reason why managers should delegate as much of an entire assignment, rather than a small portion, as possible. Doing so can help instill a sense of importance and self-esteem for the staff investigator no matter what the number of years of their experience.

Communication is an essential element of successful delegating, and regular updates about progress, results, and deadlines should occur weekly, or sometimes daily, depending on the staff member’s level of experience and the type of assignment. Meetings can be conducted face-to-face, by phone, or through videoconferencing and do not always have to be long to be effective.

As managers check on progress, they should be supportive rather than intrusive and avoid putting a subordinate on the defensive by being too critical. Managers also should allow for communication flexibility by encouraging more immediate contact between progress meetings in the event a matter requiring urgent attention unexpectedly develops.

Any significant delegated assignment should culminate with a constructive evaluation of the subordinate’s performance. Often, there is a tendency to view the simple act of delegation itself as work done. As an old colleague of mine used to say, “A task delegated is a task completed.” Even in a case where the smaller scope of a subordinate’s assignment does not merit an exit session, it is still a boost for team morale to give recognition and show gratitude for the work done.

I have never met an experienced (and successful) CFE investigation team leader who did not embrace the role and significance of delegating. However, the ability to delegate depends on trust, communication, and encouragement. When delegating, assurance managers need to accept the risk that mistakes can and will occur and remember that professionals can learn from their mistakes. Not only is valuable experience gained by the investigative team, but the manager’s time also is freed up for more critical tasks and projects. In the long run, a commitment to delegation serves to strengthen any team of investigators as well as benefit our client organization, whatever and wherever that might be.

Expert Witness or Consultant

One of our newer Chapter members submitted a comment on-line two weeks ago requesting information about the pitfalls involved in the CFE choosing to act as a consultant to a client attorney rather than as an expert witness. This is an important topic for CFEs in individual practice as well as for those serving as examiners on the staffs of private or public entities. The ACFE tells us that CFEs typically act as experts in the legal process by assisting attorneys with the financial details of a suit and testifying about these practices at trial. They analyze documents and transactions, showing how the fraud was accomplished and, when possible, who the most likely perpetrators were. The CFE is a guide and adviser for the attorney in assembling the case, and a major participant in explaining the details of a fraud scenario to a judge and jury.

In general, expert witnesses are typically brought in when required by law, as in malpractice suits where a member of a given profession must explain the infraction against professional by-laws or principles; when key points are deemed sufficiently technical or complex, such as in cooking-the-books schemes involving intricate accounting manipulations, or to assist a jury in making its decision. Federal Rule of Evidence 702 says that an expert witness with appropriate knowledge and credentials may testify in any proceeding where scientific, technical, or specialized knowledge will shed light on the dispute. Even in cases that don’t go to trial, experts may still be involved in mediation, arbitration, settlement conferences, or summary judgment motions.

Experts contribute to the trial process in numerous ways. They provide background information to guide and frame a case; during the discovery process they investigate, run tests, advise on depositions, prepare other witnesses, make exhibits, and respond to the opposition’s discovery requests; they file written opinions, which are entered as evidence into the court record; and they testify in actual proceedings should the case make it to a courtroom.

Once they accept a case, many experts immediately start assembling a narrative version of the events. This detailed summary of the facts of the case serves as the raw material for rendering an official opinion. As we’ve pointed out many times, it’s important that the text be written with care and professionalism because the text may (and probably will) have to be produced during discovery. Additionally, a well-written narrative helps the client attorney in preparing and executing the case at trial.

According to our most experienced members, perhaps the thorniest challenge for CFEs, once they’re engaged to work on a case, is setting a value on the specific business losses due to a fraud. Depending on the facts, there may be several methods for evaluating net worth/net loss, each rendering a different number at the end. And regardless of the numbers, there’s always the human element. Calculating business loss is a challenging task in a complex case because the examiner has to consider the amount of business being done, try to reconstruct the market conditions, think about competitors, and then calculate the amount of direct personal benefit; all of these factors being intertwined. In such cases, the examiner must consider a variety of points, prepare an estimate of loss, and then, most often, try to work out a compromise.

Article V. of the Association of Certified Fraud Examiners Code of Professional Ethics states:

A fraud examiner, in conducting examinations, will obtain evidence or other documentation to establish a reasonable basis for any opinion rendered. No opinion shall be expressed regarding the guilt or innocence of any person or party.

The rule that prohibits opinions regarding the guilt or innocence of any person or party is a rule of prudence. Clearly, it’s prudent for a Certified Fraud Examiner to refrain from usurping the role of jury. In a courtroom, no good attorney would ask a CFE for such a conclusion, and no alert judge would allow such testimony.  The fraud examiner’s job is to present the evidence in his or her report. Such evidence might constitute a convincing case pointing to the guilt or innocence of a person. But a clear line should be drawn between a report that essentially says, “Here is the evidence” and one that steps over the line and says “S/he is the guilty (innocent) person.” Nevertheless, there is a fine line between recommending action, forwarding the evidence to a law enforcement agency or filing a complaint or lawsuit, and giving an opinion on guilt or innocence. CFEs may make such recommendations because they think the evidence is strong enough to support a case. They might even have a conclusion about whether the suspect committed a crime. The rule does not prohibit the CFE, under the proper circumstances, from accusing the person under investigation. However, the ultimate decision of whether a person is “guilty” or “innocent” is for a jury to determine. The CFE is free to report the facts and the conclusions that can be drawn from those facts, but the decision as to whether a person is guilty of a crime is a decision for the judge or jury.

Caution is the by-word for every expert witnesses at every step of the legal process. According to discovery rules governing expert testimony, everything the expert says or writes about the case after being hired is subject to discovery by opposing counsel. That means everything: narrative versions of the case, comments to the press or law enforcement, hypothetical reconstructions, even notes can be demanded and used by the opposing party. A shrewd attorney can use an expert’s preliminary notes containing drafts of an opinion and other purely deliberative information to call the witness’s testimony into question. The only exception is when the expert is hired by the attorney purely on a consulting basis. An expert witness has no privilege. The principle of privilege exists to protect certain core societal relationships (attorney-client, husband-wife), but the expert witness’s relationship with clients is not among those protected. If the expert’s opinions will be presented in court, everything related to the expert’s opinion is discoverable by the defense.

There is an exception. The CFE expert may consult on the client attorney’s work product, i.e., materials the attorney prepares as background for a case. While performing background work, the expert is said to be working as an associate of the attorney, so the exchange is protected; they are two professionals conferring. However, once the expert is hired as a witness, and begins entering opinions as part of the attorney’s case, there is no privilege for any contribution the expert makes. The distinction is something like this: when acting as “witnesses,” experts are bringing official information to the court, and so must disclose any contact with the case; when experts act as “consultants” or “associates” for attorneys or law enforcement, they are only assisting the attorney, and do not have to disclose their involvement in the case. However, if a testifying expert reviews the work of the consultant expert, then the work of the consultant expert will be discoverable. Remember this; if a CFE is hired to testify at trial, anything he or s/he used to form his or her opinion will be subject to review by the opposing party. This includes notes from other experts, documents received from the plaintiff or defendant, and any documents or notes from the attorney. CFEs should be sure to consult with the client attorney before reviewing anything. If the attorney has not given the document to you, then ask before you read. Otherwise, you may inadvertently destroy the confidentiality or privilege of the material.

In summary, the best way to protect the confidentiality of information is to keep good files. Any materials which serve as the basis for an expert’s opinion must be in the file. Notes, documents, or tests that serve as background, or that represent unfruitful lines of investigation, don’t have to be included, and probably shouldn’t be. The attorney trying the case doesn’t want an expert having to answer about investigative dead ends or exploratory side lines; a shrewd cross-examiner can turn a hastily scribbled hypothetical into reasonable doubt, just enough to avert a conviction. So, in the best-case scenario, an expert presents to the court an opinion and its basis, nothing more nothing less.

The Client Requested Recommendation

We fraud examiners must be very circumspect about drawing conclusions. But who among us has not found him or herself in a discussion with a corporate counsel who wants a recommendation from us about how best to prevent the occurrence of a fraud in the future?  In most situations, the conclusions from a well conducted examination should be self-evident and should not need to be pointed out in the report. If the conclusions are not obvious, the report might need to be clarified. Our job as fraud examiners is to obtain sufficient relevant and reliable evidence to determine the facts with a reasonable degree of forensic certainty. Assuming facts without obtaining sufficient relevant and reliable evidence is generally inappropriate.

Opinions regarding technical matters, however, are permitted if the fraud examiner is qualified as an expert in the matter being considered (many fraud examiners are certified not only as CFE’s but also as CPA’s, CIA’s or CISA’s).  For example, a permissible expert opinion, and accompanying client requested recommendation, might address the relative adequacy of an entity’s internal controls. Another opinion (and accompanying follow-on recommendation) might discuss whether financial transactions conform to generally accepted accounting principles. So, recommended remedial measures to prevent future occurrences of similar frauds are also essentially opinions, but are acceptable in fraud examination reports.

Given that examiners should always be cautious in complying with client examination related requests for recommendations regarding future fraud prevention, there is no question that such well-considered recommendations can greatly strengthen any client’s fraud prevention program.  But requested recommendations can also become a point of contention with management, as they may suggest additional procedures for staff or offend members of management if not presented sensitively and correctly. Therefore, examiners should take care to consider ways of follow-on communication with the various effected stakeholders as to how their recommendations will help fix gaps in fraud prevention and mitigate fraud risks.  Management and the stakeholders themselves will have to evaluate whether the CFE’s recommendations being provided are worth the investment of time and resources required to implement them (cost vs. benefit).

Broadly, an examination recommendation (where included in the final report or not) is either a suggestion to fix an unacceptable scenario or a suggestion for improvement regarding a business process.  At management’s request, fraud examination reports can provide recommendations to fix unacceptable fraud vulnerabilities because they are easy to identify and are less likely to be disputed by the business process owner. However, recommendations to fix gaps in a process only take the process to where it is expected to be and not where it ideally could be. The value of the fraud examiner’s solicited recommendation can lie not only in providing solutions to existing vulnerability issues but in instigating thought-provoking discussions.  Recommendations also can include suggestions that can move the process, or the department being examined to the next level of anti-fraud efficiency.  When recommendations aimed at future prevention improvements are included, examination reports can become an additional tool in shaping the strategic fraud prevention direction of the client being examined.

An examiner can shape requested recommendations for fraud prevention improvement using sources both inside and outside the client organization. Internal sources of recommendations require a tactful approach as process owners may not be inclined to share unbiased opinions with a contracted CFE, but here, corporate counsel can often smooth the way with a well-timed request for cooperation. External sources include research libraries maintained by the ACFE, AICPA and other professional organizations.

It’s a good practice, if you expect to receive a request for improvement recommendations from management, to jot down fraud prevention recommendation ideas as soon as they come to mind, even though they may or may not find a place in the final report. Even if examination testing does not result in a specific finding, the CFE may still recommend improvements to the general fraud prevention process.

If requested, the examiner should spend sufficient time brainstorming potential recommendations and choosing their wording carefully to ensure their audience has complete understanding. Client requested recommendations should be written simply and should:

–Address the root cause if a control deficiency is the basis of the fraud vulnerability;
–Address the business process rather than a specific person;
–Include bullets or numbering if describing a process fraud vulnerability that has several steps;
–Include more than one way of resolving an issue identified in the observation, if possible. For example, sometimes a short-term manual control is suggested as an immediate fix in addition to a recommended automated control that will involve considerable time to implement;
–Position the most important observation or fraud risk first and the rest in descending order of risk;
–Indicate a suggested priority of implementation based on the risk and the ease of implementation;
–Explain how the recommendation will mitigate the fraud risk or vulnerability in question;
–List any recommendations separately that do not link directly to an examination finding but seek to improve anti-fraud processes, policies, or systems.

The ACFE warns that recommendations, even if originally requested by client management, will go nowhere if they turn out to be unvalued by that management. Therefore, the process of obtaining management feedback on proposed anti-fraud recommendations is critical to make them practical. Ultimately, process owners may agree with a recommendation, agree with part of the recommendation, and agree in principle, but technological or personnel resource constraints won’t allow them to implement it.  They also may choose to revisit the recommendation at a future date as the risk is not imminent or disagree with the recommendation because of varying perceptions of risk or mitigating controls.

It’s my experience that management in the public sector can be averse to recommendations because of public exposure of their reports. Therefore, CFEs should clearly state in their reports if their recommendations do not correspond to any examination findings but are simply suggested improvements. More proposed fraud prevention recommendations do not necessarily mean there are more faults with the process, and this should be communicated clearly to the process owners.

Management responses should be added to the recommendations with identified action items and implementation timelines whenever possible. Whatever management’s response, a recommendation should not be changed if the response tends to dilute the examiner’s objectivity and independence and becomes representative of management’s opinions and concerns. It is the examiner’s prerogative to provide recommendations that the client has requested, regardless of whether management agrees with them. Persuasive and open-minded discussions with the appropriate levels of client management are important to achieving agreeable and implementable requested fraud prevention recommendations.

The journey from a client request for a fraud prevention recommendation to a final recommendation (whether included in the examination report or not) is complex and can be influenced by every stakeholder and constraint in the examination process, be it the overall posture of the organization toward change in general, its philosophy regarding fraud prevention, the scope of the individual fraud examination itself, views  of the effected business process owner, experience and exposure of the examination staff, or available technology. However, CFEs understand that every thought may add value to the client’s fraud prevention program and deserves consideration by the examination team. The questions at the end of every examination should be, did this examination align with the organization’s anti-fraud strategy and direction? How does our examination compare with the quality of practice as seen elsewhere? And finally, to what degree have the fraud prevention recommendations we were asked to make added value?

Tailoring Difficult Conversations

We CFE’s and forensic accountants, like other investigative professionals, are often called upon to be the bearers of bad news; it just goes with the territory.  CFE’s and forensic accountants are somewhat unique, however, in that, since fraud is ubiquitous, we’re called upon to communicate negative messages to such a diverse range of client types; today the chairman of an audit committee, tomorrow a corporate counsel, the day after that an estranged wife whose spouse has run off after looting the family business.

If there is anything worse than getting bad news, it may be delivering it. No one relishes the awkward, difficult, anxiety-producing exercise of relaying messages that may hurt, humiliate, or upset someone with whom the deliverer has a professional relationship. And, what’s more,  it often proves a thankless task. This was recognized in a Greek proverb almost 2,500 years ago, “Nobody loves the messenger who brings bad news.”

Physicians, who are sometimes required to deliver worse news than most CFE’s ever will, often engage in many hours of classwork and practical experience studying and role-playing how to have difficult conversations with patients and their families They know that the message itself, may be devastating but how they deliver it can help the patient and his or her family begin to process even the most painful facts.   CFE’s are in the fortunate position of typically not having to deliver news that is quite so shattering.  Nevertheless, there is no question that certain investigative results can be extremely difficult to convey and to receive.  The ACFE tells us that learning how to prepare for and deliver such messages can create not only a a better investigator but facilitate a better investigative outcome.

Preparation to deliver difficult investigative results should begin well in advance, even before there is such a result to deliver. If the first time an investigator has a genuine interaction with the client is to confirm the existence of a fraud, that fact in itself constitutes a problem.  On the other hand, if the investigator has invested time in building a relationship before that difficult meeting takes place, the intent and motivations of both parties to the interaction are much better mutually understood. Continuous communication via weekly updates to clients from the moment irregularities are noted by examination is vital.

However, despite best efforts in building relationships and staying in regular contact with clients, some meetings will involve conveying difficult news. In those cases, preparation is critical to accomplishing objectives while dealing with any resultant fallout.  In such cases, the ACFE recommends focusing on investigative process as well as on content. Process is professionally performing the work, self-preparation for delivering the message, explaining the conclusions in meaningful and realistic ways, and for anticipating the consequences and possible response of the person receiving the message. Content is having the right data and valid conclusions so  the message is correct and complete.

Self-preparation involves considering the type of person who is receiving the difficult message and in determining the best approach for communicating it. Some people want to hear the bottom line first and the supporting information after that; others want to see a methodical building of the case item by item, with the conclusion at the end. Some are best appealed to via logic; others need a more empathetic delivery. Discussions guided by the appropriate approach are more likely to be productive. Put as much effort as possible into getting to know your client since personality tends to drive how he or she wants to receive information, interact with others, and, in turn, values things and people. When there is critical investigative information that has to be understood and accepted, seasoned examiners consider delivery tailored specifically to the client to be paramount.

Once the ground work has been laid, it’s time to have the discussion. It’s important, regarding the identified fraud, to remember to …

–Seek opportunities to balance the discussion by recognizing the client’s processes that are working well as well as those that have apparently failed;

–Offer to help or ask how you can help to address the specific issues raised in the discussion;

–Make it clear that you understand the client’s challenges. Be precise and factual in describing the causes of the identified irregularity;

–Maintain open body language. Avoid crossing your arms, don’t place your hands over your mouth or on your face, and keep your palms facing each other or slightly upwards instead of downwards. Don’t lean forward as this appears extra aggressive. Breathe deeply and evenly. If possible, mimic the body language of the message recipient, if the recipient is remaining calm. If the recipient begins to show signs of defensiveness or strong aggression, and your efforts to calm
the situation are not successful, you might suggest a follow-up meeting after both of you have digested what was said and to consider mutually acceptable options to move forward.

–Present the bottom-line message three times in different ways so your listener has time to absorb it.

–Let the client vent if he or she wishes. The ACFE warns against a tendency to interrupt the client’s remarks of explanation or sometimes of denial; “we don’t hire people who would do something like that!” Allowing the client time to vent frees him or her to get down to business moving afterward.

–Focus on problems with the process as well as on the actions of the suspect(s) to build context for the fraud scenario.

–Always demonstrate empathy. Take time to think about what’s going through your hearer’s mind and help him or her think through the alleged scenario and how it occurred, what’s going to happen next with the investigation, and how the range of issues raised by the investigation might be resolved.

Delivering difficult information is a minefield, and there are ample opportunities to take a wrong step and see explosive results. Emotional intelligence, understanding how to read people and relate to them, is vital in delivering difficult messages effectively. This is not an innate trait for many people, and it is a difficult one to learn, as are many of the other so-called soft skills. Yet they can be critical to the successful practice of fraud examination. Examiners rarely get in trouble over their technical skills because such skills are generally easier for them to master.  Examiners tend to get in trouble over insufficient soft skills. College degrees and professional certifications are all aimed at the technical skills. Sadly, very little is done on the front end to help examiners with the equally critical soft skills which only arise after the experience of actual practice.  For that reason, watching a mentor deliver difficult messages or deal with emotional people is also an effective way to absorb good practices. ACFE training utilizes the role-playing of potentially troublesome presentations to a friendly group (say, the investigative staff) as another way to exercise one’s skills.

Delivering bad news is largely a matter of practice and experience, and it’s not something CFEs and forensic accountants have the choice to avoid. At the end of the day, examiners need to deliver our news verbally and in writing and to facilitate our clients understanding of it. The underlying objective is to ensure that the fact of the alleged fraud is adequately identified, reported and addressed, and that the associated risk is understood and effectively mitigated.

Beyond the Sniff Test

Many years ago, I worked with a senior auditor colleague (who was also an attorney) who was always talking about applying what he called “the sniff test” to any financial transaction that might represent an ethical challenge.   Philosophical theories provide the bases for useful practical decision approaches and aids like my friend’s sniff test, although we can expect that most of the executives and professional accountants we work with as CFEs are unaware of exactly how and why this is so. Most seasoned directors, executives, and professional accountants, however, have developed tests and commonly used rules of thumb that can be used to assess the ethicality of decisions on a preliminary basis. To their minds, if these preliminary tests give rise to concerns, a more thorough analysis should be performed using any number of defined approaches and techniques.

After having heard him use the term several times, I asked my friend him if he could define it.  He thought about it that morning and later, over lunch, he boiled it down to a series of questions he would ask himself:

–Would I be comfortable as a professional if this action or decision of my client were to appear on the front page of a national newspaper tomorrow morning?
–Will my client be proud of this decision tomorrow?
–Would my client’s mother be proud of this decision?
–Is this action or decision in accord with the client corporation’s mission and code?
–Does this whole thing, in all its apparent aspects and ramifications, feel right to me?

Unfortunately, for their application in actual practice, although sniff tests and commonly used rules are based on ethical principles and are often preliminarily useful, they rarely, by themselves, represent a sufficiently comprehensive examination of the decision in question and so can leave the individuals and client corporations involved vulnerable to making unethical decisions.  For this reason, more comprehensive techniques involving the impact on client stakeholders should be employed whenever a proposed decision is questionable or likely to have significant consequences.

The ACFE tells us that many individual decision makers still don’t recognized the importance of stakeholder’s expectations of rightful conduct. If they did, the decisions made by corporate executives and by accountants and lawyers involved in the Enron, Arthur Andersen, WorldCom, Tyco, Adephia, and a whole host of others right up to the present day, might have avoided the personal and organizational tragedies that occurred. Some executives were motivated by greed rather than by enlightened self-interest focused on the good of all. Others went along with unethical decisions because they did not recognize that they were expected to behave differently and had a duty to do so. Some reasoned that because everyone else was doing something similar, how could it be wrong? The point is that they forgot to consider sufficiently the ethical practice (and duties) they were expected to demonstrate. Where a fiduciary duty was owed to future shareholders and other stakeholders, the public and personal virtues expected (character traits such as integrity, professionalism, courage, and so on), were not sufficiently considered. In retrospect, it would have been wise to include the assessment of ethical expectations as a separate step in any Enterprise Risk Management (ERM) process to strengthen governance and risk management systems and guard against unethical, short-sighted decisions.

It’s also evident that employees who continually make decisions for the wrong reasons, even if the right consequences result, can represent a high governance risk.  Many examples exist where executives motivated solely by greed have slipped into unethical practices, and others have been misled by faulty incentive systems. Sears Auto Center managers were selling repair services that customers did not need to raise their personal commission remuneration, and ultimately caused the company to lose reputation and future revenue.  Many of the classic financial scandals of recent memory were caused by executives who sought to manipulate company profits to support or inflate the company’s share price to boost their own stock option gains. Motivation based too narrowly on self-interest can result in unethical decisions when proper self-guidance and/or external monitoring is lacking. Because external monitoring is unlikely to capture all decisions before implementation, it is important for all employees to clearly understand the broad motivation that will lead to their own and their organization’s best interest from a stakeholder perspective.

Consequently, decision makers should take motivations and behavior expected by stakeholders into account specifically in any comprehensive ERM approach, and organizations should require accountability by employees for those expectations through governance mechanisms. Several aspects of ethical behavior have been identified as being indicative of mens rea (a guilty mind).  If personal or corporate behavior does not meet shareholder ethical expectations, there will probably be a negative impact on reputation and the ability to reach strategic objectives on a sustained basis in the medium and long term.

The stakeholder impact assessment broadens the criteria of the preliminary sniff test by offering an opportunity to assess the motivations that underlie the proposed decision or action. Although it is unlikely that an observer will be able to know with precision the real motivations that go through a decision maker’s mind, it is quite possible to project the perceptions that stakeholders will have of the action. In the minds of stakeholders, perceptions will determine reputational impacts whether those perceptions are correct or not. Moreover, it is possible to infer from remuneration and other motivational systems in place whether the decision maker’s motivation is likely to be ethical or not. To ensure a comprehensive ERM approach, in addition to projecting perceptions and evaluating motivational systems, the decisions or actions should be challenged by asking such questions as:

Does the decision or action involve and exhibit the integrity, fairness, and courage expected? Alternatively, does the decision or action involve and exhibit the motivation, virtues, and character expected?

Beyond the simple sniff test, stakeholder impact analysis offers a formal way of bringing into a decision the needs of an organization and its individual constituents (society). Trade-offs are difficult to make, and can benefit from such advances in technique. It is important not to lose sight of the fact that the concepts of stakeholder impact analysis need to be applied together as a set, not as stand-alone techniques. Only then will a comprehensive analysis be achieved and an ethical decision made.

Depending on the nature of the decision to be faced, and the range of stakeholders to be affected, a proper analysis could be based on any of the historical approaches to ethical decision making as elaborated by ACFE training and discussed so often in this blog.  A professional CFE can use stakeholder analysis in making decisions about financial fraud investigations, fraud related accounting issues, auditing procedures, and general practice matters, and should be ready to prepare or assist in such analyses for employers or clients just as is currently the case in other areas of fraud examination. Although many hard-numbers-oriented executives and accountants will be wary of becoming involved with the “soft” subjective analysis that typifies stakeholder and ethical expectations analysis, they should bear in mind that the world is changing to put a much higher value on non-numerical information. They should be wary of placing too much weight on numerical analysis lest they fall into the trap of the economist, who, as Oscar Wilde put it: “knew the price of everything and the value of nothing.”

The CFE, Management & Cybersecurity

Strategic decisions affect the ultimate success or failure of any organization. Thus, they are usually evaluated and made by the top executives. Risk management contributes meaningfully and consistently to the organization’s success as defined at the highest levels. To achieve this objective, top executives first must believe there is substantial value to be gained by embracing risk management. The best way for CFEs and other risk management professionals to engage these executives is to align fraud risk management with achievement (or non-achievement) of the organization’s vital performance targets, and use it to drive better decisions and outcomes with a higher degree of certainty.

Next, top management must trust its internal risk management professional as a peer who provides valuable perspective. Every risk assurance professional must earn trust and respect by consistently exhibiting insightful risk and performance management competence, and by evincing a deep understanding of the business and its strategic vision, objectives, and initiatives. He or she must simplify fraud risk discussions by focusing on uncertainty relative to strategic objectives and by categorizing these risks in a meaningful way. Moreover, the risk professional must always be willing to take a contrarian position, relying on objective evidence where readily available, rather than simply deferring to the subjective. Because CFEs share many of these same traits, the CFE can help internal risk executives gain that trust and respect within their client organizations.

In the past, many organizations integrated fraud risk into the evaluation of other controls. Today, per COSO guidance, the adequacy of anti-fraud controls is specifically assessed as part of the evaluation of the control activities related to identified fraud risks. Managements that identify a gap related to the fraud risk assessments performed by CFEs and work to implement a robust assessment take away an increased focus on potential fraud scenarios specific to their organizations. Many such managements have implemented new processes, including CFE facilitated sessions with operating management, that allow executives to consider fraud in new ways. The fraud risk assessment can also raise management’s awareness of opportunities for fraud outside its areas of responsibility.

The blurred line of responsibility between an entity’s internal control system and those of outsourced providers creates a need for more rigorous controls over communication between parties. Previously, many companies looked to contracts, service-level agreements, and service organization reports as their approach to managing service organizations. Today, there is a need to go further. Specifically, there is a need for focus on the service providers’ internal processes and tone at the top. Implementing these additional areas of fraud risk assessment focus can increase visibility into the vendor’s performance, fraud prevention and general internal control structure.

Most people view risk as something that should be avoided or reduced. However, CFEs and other risk professionals realize that risk is valued when it can help achieve a competitive advantage. ACFE studies show that investors and other stakeholders place a premium on management’s ability to limit the uncertainty surrounding their performance projections, especially regarding fraud risk. With Information Technology budgets shrinking and more being asked from IT, outsourcing key components of IT or critical business processes to third-party cloud based providers is now common. Management should obtain a report on all the enterprise’s critical business applications and the related data that is managed by such providers. Top management should make sure that the organization has appropriate agreements in place with all service providers and that an appropriate audit of the provider’s operations, such as Service Organization Controls (SOC) 1 and SOC 2 assurance reports, is performed regularly by an independent party.

It’s also imperative that client management understand the safe harbor clauses in data breach laws for the countries and U.S. states where the organization does business.  In the United States, almost every state has enacted laws requiring organizations to notify the state in case of a data breach. The criteria defining what constitutes a data breach are similar in each state, with slight variations.

CFE vulnerability assessments should strive to impress on IT management that it should strive to make upper management aware of all major breach attempts, not just actual incidents, made against the organization. To see the importance of this it’s necessary only to open a newspaper and read about the serious data breaches occurring around the world on almost a daily basis. The definition of major may, of course, differ, depending on the organization’s industry and whether the organization is global, national, or local.  Additionally, top management and the board should plan to meet with the organization’s chief information security officer (CISO) at least once a year. This meeting should supplement the CFE’s annual update of the fraud risk assessment by helping management understand the state of cybersecurity within the organization and enabling top managers and directors to discuss key cybersecurity topics. It’s also important that the CISO is reporting to the appropriate levels within the organization. Keep in mind that although many CISOs continue to report within the IT organization, sometimes the chief information officer’s agenda conflicts with the CISO’s agenda. As such, the ACFE reports that a better reporting arrangement to promote independence is to migrate reporting lines to other officers such as the general counsel, chief operating officer, chief risk officer (CRO), or even the CEO, depending on the industry and the organization’s degree of dependence on technology.

As a matter of routine, every organization should establish relationships with the appropriate national and local authorities who have responsibility for cybersecurity or cybercrime response. For example, boards of U.S. companies should verify that management has protocols in place to guide contact with the Federal Bureau of Investigation (FBI) in case of a breech; the FBI has established its Key Partnership Engagement Unit, a targeted outreach program to senior executives of major private-sector corporations.

If there is a Chief Risk Officer (CRO) or equivalent, upper management and the board should, as with the CISO, meet with him or her quarterly or, at the least, annually and review all the fraud related risks that were either avoided or accepted. There are times when a business unit will identify a technology need that its executive is convinced is the right solution for the organization, even though the technology solution may have potential security risks. The CRO should report to the board about those decisions by business-unit executives that have the potential to expose the organization to additional security risks.

And don’t forget that management should be made to verify that the organization’s cyber insurance coverage is sufficient to address potential cyber risks. To understand the total potential impact of a major data breach, the board should always ask management to provide the cost per record of a data breach.

No business can totally mitigate every fraud related cyber risk it faces, but every business must focus on the vulnerabilities that present the greatest exposure. Cyber risk management is a multifaceted function that manages acceptance and avoidance of risk against the necessary actions to operate the business for success and growth, and to meet strategic objectives. Every business needs to regard risk management as an ongoing conversation between its management and supporting professionals, a conversation whose importance requires participation by an organization’s audit committee and other board members, with the CFE and the CISO serving increasingly important roles.

Team Work is Hard Work

From reading posts and comments posted to LinkedIn, it seems that a number of our Chapter members and guests from time to time find themselves involved in internal fraud investigations either as members of internal or external audit units or as sole practitioners.  As CFE’s we know that we can make significant contributions to a financial crime investigation, if we can work effectively, as team members, with the victim company’s internal and external auditors, as well as with other constituents involved in resolving allegations or suspicions of internal fraud. In addition to a thorough knowledge of accounting and auditing, CFE’s bring to bear a variety of skills, including interviewing, data mining and analysis.  We also know that some auditors assume that simply auditing more transactions, with the use of standard procedures, increases the likelihood that fraud will be found. While this can prove to be true in some cases, when there is suspicion of actual fraud, the introduction of competent forensic accounting investigators may be more likely to resolve the issue and bring it to a successful conclusion.

Within the boundaries of an investigation, we CFE’s typically deal with numerous constituencies, each with a different interest and each viewing the situation from a different perspective. These parties to the investigation may well attempt to influence the investigative process, favor their individual concerns, and react to events and findings in terms of personal biases. CFE’s thus often have the task of conveying to all constituencies that the results of the investigation will be more reliable if all participants and interested parties work together as a team and contribute their specific expertise or insight with objectivity. In the highly-charged environment created by a financial crime investigation, the forensic accounting investigator can make a huge contribution just by displaying and encouraging the balance and level headedness which comes from his or her detailed familiarity with the mechanics of the standard types of financial fraud.

The ACFE recommends that all parties with a stake in the process, management, audit committee, auditors, and legal counsel, should always consider including forensic accounting investigators in the front-end process of decision making about an investigation. One of the key initial decisions is, usually, the degree to which the forensic accounting investigators can work with and rely on the work of others, specifically, the internal and external auditors. Another common front-end decision is whether CFE’s—with their knowledge of accounting systems, controls, and typical fraud schemes, may be added to the team that eventually evaluates the organization’s business processes to strengthen the controls that allowed the fraud to occur. Management may at first be inclined to push for a quick result because it feels the company will be further damaged if it continues to operate under a shadow.

Senior executives may be unable or in some cases unwilling to see the full scope of issues and may attempt to limit the investigation, sometimes as a matter of self-protection, or they may seek to persuade the CFE that the issues at hand are immaterial. Whatever happened, it happened on their watch, and they may understandably be very sensitive to the CFE’s intrusion into their domain. Any defensiveness on the part of management should be defused as quickly and as thoroughly as possible, usually through empathy and consideration on the part of the forensic accounting investigator. The party or entity engaging the forensic accounting investigator, for example, the audit committee, management, or counsel, should be committed to a thorough investigation of all issues and is ultimately responsible for the investigation. The committee may engage CFE’s and forensic accounting investigators directly and look to them for guidance, or it may ask outside counsel to engage the CFE, who usually will work at counsel’s direction in fulfilling counsel’s responsibilities to the audit committee.

Every CFE should strive to bring independence and objectivity to the investigation and strive to assist each of the interested parties to achieve their unique but related objectives. As to the CFE’s  objectives, those are determined by the scope of work and the desire to meet the goals of whoever retained their services. Regardless of the differing interests of the various constituencies, forensic accounting investigators must typically answer the following questions:

  • Who is involved?
  • Could there be coconspirators?
  • Was the perpetrator instructed by a higher supervisor not currently a target of the investigation?
  • How much is at issue or what is the total impact on the financial statements?
  • Over what period did this occur?
  • Have we identified all material schemes?
  • How did this happen?
  • How was it identified, and could it have been detected earlier?
  • What can be done to deter a recurrence?

CFE’s should always keep in mind that they are primarily fact finders and not typically engaged to reach or provide conclusions, or, more formally, opinions. This differs from the financial auditor’s role. The financial auditor is presented with the books and records to be audited and determines the nature, extent, and timing of audit procedures. On one hand, the financial statements are management’s responsibility, and an auditor confirms they have been prepared in accordance with generally accepted accounting principles after completing these procedures and assessing the results. The CFE or forensic accounting investigator, on the other hand, commands a different set of skills and works at the direction of an employer that may be management, the audit committee, counsel, or an auditing firm itself.

Teaming with all concerned parties together with the internal and external auditors, the forensic accounting investigator should strive to bring independence and objectivity to the investigation and strive to assist each of the interested parties to achieve each team member’s unique but related objectives; management understandably may be eager to bring the investigation to a quick conclusion. The chief financial officer may be defensive over the fact that his or her organization allowed this to happen;   the board of directors, through the independent members of its audit committee, is likely to focus on conducting a thorough and complete investigation, but its members may lack the experience needed to assess the effort. In addition, they may be concerned about their personal reputations and liability. The board is likely to look to legal counsel and in some cases, to forensic accounting investigators to define the parameters of the project;  as to counsel, in most investigations in which counsel is involved, they are responsible for the overall conduct of the investigation and will assign and allocate resources accordingly; the internal auditor may have a variety of objectives, including not alienating management, staying on schedule to complete the annual audit plan, and not opening the internal audit team to criticism. The internal audit team may also feel embarrassed, angry, and defensive that it did not detect the wrongdoing; the external auditor may have several concerns, including whether the investigative team will conduct an investigation of adequate scope, whether the situation suggests retaining forensic accountants from the auditors’ firm, whether forensic accountants should be added to the audit team, and even whether the investigation will implicate the quality of past audits.

In summary, team work is complex, hard work.  While fraud is not an everyday occurrence at most companies, boards and auditing firms should anticipate the need to conduct a financial fraud investigation at some time in the future.  CFE’s can be an integral part of the planning for such investigations and can be of great help in designing the pre-planned team work protocols that ensure that, if a fraud exists, there is a high probability that it will be identified completely and dealt with in a timely and appropriate manner.

Inside and Out

college-studentsI had quite a good time a little over a month ago, addressing a senior auditing class at the University of Richmond on the topic of how fraud examiners and forensic accountants can work jointly together, primarily with a client’s internal auditors and, secondarily with its external auditors, to substantially strengthen any fraud investigation assignment.

Internal and external auditors each play an important role in the governance structure of their client organizations. Like CFEs, both groups have mutual interests regarding the effectiveness of internal financial controls, and both adhere to ethical codes and professional standards set by their respective professional bodies. Additionally, as I told the very lively class, both types of auditors operate independently of the activities they audit, and they’re expected to have extensive knowledge about the business, industry, and strategic risks faced by the organizations they serve. Yet, with all their similarities, internal auditing and external auditing are two distinct functions that have numerous differences. The Institute of Internal Auditors (IAA) defines internal auditing as “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.” Internal auditors in the public sector (where I spent most of my audit career as a CIA) place an additional emphasis on providing assurance on performance and compliance with policies and procedures. Concerned with all aspects of the organization – both financial and non-financial – the internal auditors focus on future events because of their continuous review and evaluation of controls and processes.

In contrast, external auditing provides an independent opinion of a company’s financial statements and fair presentation. This type of auditing encompasses whether the statements conform with Generally Accepted Accounting Principles, whether they fairly present the financial position of the organization, whether the results of operations for a given period are represented accurately, and whether the financial statements have been affected materially (i.e., whether they include a misstatement that is likely to influence the economic decisions of financial statement users). External auditing’s approach is mainly historical in nature, although some forward-looking improvements may be suggested in the auditors’ recommendations to management based on the analysis of controls during a financial statement audit.

I emphasized to the students that these definitions alone pinpoint the key distinctions that separate the two audit approaches. However, internal auditing is much broader and more encompassing than external auditing. Its value resides in the function’s ability to look at the underlying operations that drive the financial numbers before those numbers hit the books. For instance, when considering “sales” as a line item in a set of financial statements, the external audit focuses primarily on the existence, completeness, accuracy, classification, timing, posting and summarization of sales numbers. The internal audit goes beyond these assertions and looks at sales operations in a much broader context by asking questions regarding the target market, sales plan, organizational structure of the sales department, qualifications of sales personnel, effectiveness of sales operations, measurement of sales performance, and compliance with sales policies.

These types of questions probe the very core of sales operations and can greatly impact the sales numbers recorded in financial statements. For example, assuming a sales number of $6 million, the external auditor has merely to render an opinion regarding the validity of that number. The internal auditor, however, can ask whether the number could  have really been $12 million, if only the right market had been targeted, and if operations had been effective in the first place. It’s this emersion in detail and the overall knowledge of operations that makes the internal auditor such a strong partner for the fraud examiner in any joint investigation.

Internal auditors represent an integral part of the organization – their primary clients are management and the board. Although historically internal auditors reported to the chief financial officer or other senior management staff, for the last two decades internal auditing has reported directly to the audit committee of the board of directors, which helps strengthen auditor independence and objectivity. Today, internal audit functions, for the most part, follow this reporting relationship, which is consistent with the IIA’s Standard on Organizational Independence.

The chief audit executive’s (CAE’s) appointment is normally meant to be permanent, unless he or she resigns or is dismissed. In some quasi and intergovernmental organizations, CAEs are given tenured positions – five-year appointments, for example – to enhance independence.  Conversely, external auditors are not part of the organization, but are engaged by it. Their objectives are set primarily by statute and by their main client, the board of directors. External auditors are appointed by the board, and they submit an annual report to the company’s shareholders. The appointment is meant to extend for a specified time – external auditors can be re-appointed at the company’s annual general meeting. In some jurisdictions, there are limits on an external auditor’s length of service, often five or seven years.

In general, internal audit functions are not mandatory for organizations. Instead, their installment is left up to individual organizations’ discretion but internal auditing is mandatory in some cases. Companies listed on the New York Stock Exchange must have an internal audit function, whether in-house or outsourced.  An external audit is legally required for many companies, particularly those listed on a public exchange. External audits of some government agencies are also legislated, requiring government auditors to submit the audit report to their respective legislature.

The necessary qualifications for an internal auditor rest solely on the judgment of the employer. Although internal auditors are often qualified as accountants, some are qualified engineers, sales personnel, production engineers, and management personnel who have moved through the ranks of the organization with a sound knowledge of its operations and have garnered experience that makes them abundantly qualified to perform internal auditing. Annually, more and more internal auditors hold the IIA’s Certified Internal Auditor designation, which demonstrates competency and professionalism in the field of internal auditing. Because of their continuous investigation into all the organization’s operating systems, internal auditors who remain in the same organization for many years constitute a unique resource to the CFE of comprehensive and current knowledge of the organization and its operations.

External auditors are required to understand errors and irregularities, assess risk of occurrence, design audits to provide reasonable assurance of material detection, and report on such findings. In most countries, auditors of public companies must be members of a body of professional accountants recognized by law – for example, the Institute of Chartered Accountants in England and Wales, American Institute of Certified Public Accountants, or Canadian Institute of Chartered Accountants.  Because external auditors’ scope of work is narrowly focused on financial statement auditing, and they come into the organization only once or twice a year, their knowledge of the organization’s operations is unlikely to be as extensive as that of the internal auditors.

Those entering the CFE profession need to realize that patterns of business growth, globalization, and corporate scandals have changed the thrust of the internal audit profession in recent years. In its early years, internal auditing focused on protection oriented objectives and emphasized compliance with accounting and operational procedures, verification of calculation accuracy, fraud detection and protection of assets. Gradually, new dimensions were added that ranged from an evaluation of financial and compliance risks to an assessment of business risks, ethics and corporate governance. These changes have only increased the gap between the disciplines of internal and external auditing. Yet, despite their differences, internal auditing and external auditing no longer work in competition, as was the case before the U.S. Sarbanes-Oxley Act was enacted, when a company’s external auditors would sometimes compete with in-house audit departments for internal audit work. Regulations like Sarbanes-Oxley prohibited the external auditor from providing both external and internal audit services to the same company. Today all CFEs can benefit from the complementary skills, areas of expertise, and perspectives of both the external and the internal auditors.  The ACFE recommends that to strengthen the fraud prevention program they should meet periodically to discuss common interests (like the fraud prevention program), strive to understand each other’s scope of work and methods, discuss audit coverage and scheduling to minimize redundancies, jointly assess areas of fraud risk, and provide access to each other’s reports, programs, and work papers.

In summary, fulfilling its oversight responsibilities for assurance, the board also should require internal and external auditors to coordinate their audit work to increase the economy, efficiency, and effectiveness of the overall audit process. Despite some similarities, a world of difference exists between internal auditing and external auditing. Nonetheless, both audit types, and the respective services they provide, are essential to maintaining an effective governance structure. With a greater understanding of the unique perspective of each, CFEs can maximize the aggregate contribution or each to our joint investigations and thereby ensure organizational success.