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Investigating assets: The CPA's role in detecting and preventing fraud.

Fraud and abuse cost U.S. employers an average of $9 a day per employee, totaling in excess of $400 billion in fraud loss to domestic organizations. Median losses committed by executives represent 16 times more damage than those committed by their employees, and the most costly abuses occur in companies with fewer than 100 employees.(1) These statistics confirm what law enforcement authorities have known for years - companies lose billions of dollars to fraud annually, much of it perpetrated against corporate America. During the past decade, however, those in the financial community, particularly within the accounting profession, viewed this information with both interest and dismay. In fact, the level of fraud and, perhaps more important, public outcry compelled certified public accountants (CPAs) to alter the way they conduct business and make the search for fraud a specific requirement in each audit engagement. These changes present new opportunities for law enforcement to work with the accounting community in detecting, preventing, and investigating a myriad of financial crimes long before companies report such frauds for criminal investigation, if they report them at all.


Historically, auditors mainly have reviewed financial statements to form an opinion concerning the accuracy of a company's represented financial position. In order to render this opinion, auditors constructed an audit plan to conduct tests of company records and transactions. In the past, this plan outlined procedures used to search for possible errors and irregularities that materially impacted a company's financial statements-the auditors never specifically addressed the issue of fraud. Most audits resulted in a clean opinion of the veracity of the client's financial report. If auditors detected material problems and corporate management refused to take proper action, the CPA firm simply withdrew from the assignment. Subsequently, the company passed the job to another firm that either did not conduct as diligent an audit or employed a "more creative" approach.

The failure of the Penn square Bank of Oklahoma City in 1982 marked a new era in financial institution fraud. The severity of this failure forever influenced the accounting profession and the way in which auditors conduct financial reviews. As greedy bank officers used the banks they controlled as their own treasure troves for personal enrichment at the public's expense, over 1,000 financial institutions failed in the United States. The savings and loan crisis rocked the United States and cost taxpayers over $200 billion, more than the amount spent on the Vietnam war.(2)

After the dust cleared, the fingers of disgruntled investors, stockholders, and industry experts pointed directly at CPAs across the nation and deemed them derelict in their duties to both their clients and the public. How could failed institutions have received clean bills of health just months prior to financial collapse? CPA firms across the country found themselves in civil court defending their reputations on charges of negligence. The typical large firm spent over 12 percent of its revenues on defense litigation.(3) The Big Six(4) accounting firms began dropping clients at a rate of 50 to 100 per year. Despite implementing lower risk strategies, the accounting profession, as a whole, understood that for every firm that dropped a client, 20 more firms stood ready to step in and replace that one. CPAs became inundated with a barrage of lawsuits claiming negligent conduct and oversight. The industry began to look for ways to reduce risk and enhance law enforcement cooperation.


Due to this unpredictable and litigious economic climate, the American Institute of Certified Public Accountants (AICPA) began reviewing the changing role of the CPA. In 1989, the AICPA addressed the client's expectations regarding the auditor's responsibility to detect fraud during an audit(5) but only provided illusory assurance and offered little guidance as to the exact requirements of the CPA or how to detect errors or irregularities. In 1997, after consulting with various law enforcement and investigative agencies, the AICPA deleted the phrase "errors and irregularities" from its auditing standards and finally used the term "fraud." As a result, CPA firms now must plan their audits to detect and report material fraud to company management.

Since the enactment of this statement on auditing standards, CPAs have discovered new client/service opportunities, and many larger firms have established investigative services divisions. These organizations often employ retired law enforcement personnel, assist clients in preventing fraud, and weigh options at the discovery of an embezzlement. Additionally, several of the Big Six accounting firms conduct periodic fraud surveys to determine the current white-collar crime climate and future potential for fraud throughout various industries. Of note, 75 percent of all U.S. companies surveyed incur at least one incident of fraud each year, and nearly half sustain five or more occurrences. The average fraud totals over $200,000 in losses to the victim company. Interestingly, although 76 percent of managers believe that fraud has become a major problem in society today, only 38 percent believe that fraud represents a significant problem for their companies.(6)

In a recent international fraud survey, 28 corporate respondents indicated that they each had lost over $25 million to fraud during the last 5 years with 50 percent of that amount lost in the previous twelve months. Additionally, the report revealed that employees committed 84 percent of the most significant frauds. Almost half of those employees had been with the company for over 5 years. Discouragingly, only 13 percent of all fraud losses were recovered, including insurance recoveries.(7) Regarding cyberfraud, fewer than 25 percent of responding companies included a computer fraud vulnerability assessment in their year 2000 strategic plans. Only 1 in 10 respondents believed adequate internal controls were in place to prevent computer hacking.(8)

Fraud presents a daunting challenge to today's business executives. A bigger problem remains persuading corporate America to report instances of fraud for criminal investigation. Senior executives cite the two chief reasons for failing to refer fraud discoveries to law enforcement as fear of embarrassment and disclosure of events to competitors.(9) Since law enforcement often relies on criminal referrals to initiate these types of investigations, both sectors should seek to bridge the gap toward mutual cooperation.


Traditionally, where the auditor's job concluded in cases of corporate criminal activity, the law enforcement officer's work began. Infrequent communication existed between the two professions except when officers obtained accounting records through subpoena or called accounting personnel to testify. Previously, only corporate management, pursuant to engaging an independent auditor to perform a specified fraud audit, made referrals to law enforcement agencies concerning material criminal misconduct. Today, however, companies should establish investigative guidelines for the handling and reporting of fraud allegations.

Many groups view the law enforcement and accounting professions as mutually exclusive when, in fact, they often have convergent missions. CPA firms, particularly those with established investigative services divisions, seek to identify existing frauds and establish prevention programs to insulate companies from incurring future losses. In some ways, these goals overlap efforts of law enforcement agencies striving to bring criminal charges against individuals committing fraud. The key to success remains cooperation between the professions, and the first step is to gain a better understanding of how each operates. Many CPAs would not consider working with law enforcement authorities on a suspected fraud matter, not just because of client confidentiality issues, but rather because they are unsure of how to proceed. The criminal investigator usually initiates liaison with local accountants to establish rapport and areas of commonality where both professions can benefit. For instance, although CPAs rarely refer suspected fraud to law enforcement without client consent, officers can encourage them to recommend this course of action to their clients based on the likelihood of success, improved chances of recovering funds, and greater deterrence factors. In turn, law enforcement offers assistance with training public and private accountants in fraud detection techniques, current crime trends, and frauds to which certain industry segments remain particularly susceptible.

As criminals concoct more sophisticated financial schemes, they challenge both CPAs and law enforcement officers to develop techniques to combat this country's ever-expanding fraud problem. In an effort to narrow the gap between CPA and police department cooperation, the FBI's Financial Crimes Section published a report on CPA and law enforcement liaison and approached the AICPA in an effort to improve relations and promote a better exchange of information.(10) Shortly after that meeting, a major national newspaper ran the headline "FBI: Accountants Should Turn in Crooked Clients."(11) Although the headline was not completely accurate, the FBI did recommend that CPAs strongly encourage their clients to refer suspected frauds for criminal investigation. Except in rare instances, corporate management should make criminal referrals to law enforcement concerning fraud. Two situations exist where an auditor should make a direct referral to a law enforcement agency: 1) when a client's primary or subsidiary business operation is fraudulent in its entirety (e.g., illegal telemarketing operations, money-laundering front businesses) and 2) when significant criminal fraud occurs within the highest levels of corporate management, and an audit review committee appears unlikely to internally address or rectify such fraudulent activity.(12)

Many savings and loan collapses fall into this second category. These criminal activities may extend beyond isolated incidents and signify problems within an entire industry. Presently, besides the nation's financial institutions, the insurance, health care, and government-contracting industries remain particularly vulnerable to such frauds.


"A Meeting of Minds"

During 1995, the commissioner of the City of London Police (COLP) approached the FBI director about the possibility of producing a joint fraud prevention video. The concept came to fruition in 1997 with an unprecedented joint collaboration between COLP, the FBI, and a major private accounting firm. Filmed in London, New York, and Bridgeport, Connecticut, "A Meeting of Minds" traces the downfall of a British investment firm involved in an international "bust out" scheme orchestrated by the security officer of a major New York financial institution.(13)

The video enlightens business executives around the world concerning the daily pitfalls their associates encounter when dealing with fraud. It also focuses on factors leading to fraud, such as knowing company employees, controlling access to vital systems, realizing the importance of establishing anti-fraud and contingency plans, and, most important, reporting suspected frauds for criminal investigation.(14)

Law enforcement agencies and accounting firms worldwide use "A Meeting of Minds," in addition to presenters' notes and handout materials, to educate both the public and private sectors about the prevalence of this problem. By assisting current and potential clients in dealing with various fraud issues and underscoring their exposure to significant loss, the film conveys a significant message - this problem could happen to anyone.

Successful Scenarios

Law enforcement agencies and the private sector continue to search for comfortable common ground in reporting criminal wrongdoing. The following examples epitomize successes that investigators and CPAs can enjoy when working together.

The Case of the Missing Fish

During their 1989 annual audit, independent auditors retained by a national food products distributor in New York believed they had uncovered a fraudulent scheme perpetrated by two vice presidents who managed the seafood division. Auditors determined that the executives had purchased over $2 million in cod from a foreign seafood distributor. In reality, the executives established the transaction as an advance purchase - they consummated the deal before the fish were caught. They also structured the deal so that they each would receive a 10 percent personal commission on the entire purchase agreement. Not only did the executives violate company policy with this purchase, but the auditors also suspected criminal wrongdoing by both employees.

Although the company's management initially remained hesitant, partners from their independent CPA firm convinced the auditors to file a formal complaint with law enforcement authorities. The subsequent investigation determined that the fraud involved a complex series of wire transfers between the company and several European intermediaries. Within 6 months of the complaint, law enforcement charged both conspirators with fraud. One of the two executives pleaded guilty, and a jury trial convicted the other. The company's president described this joint success as the single best internal control his company ever had implemented.(15)

CPA Helps Chill Boiler Room

During the summer of 1991, an independent CPA in Florida was hired by a company to compile monthly financial statements and prepare annual consolidated income tax returns. Additionally, the company began preparing to initiate a public offering during the next few months. When provided with monthly financial information, the CPA became suspicious about the company's business activities. Specifically, the legitimacy of the company's pursuits and its negative cash flow, despite reported operating profits, caused concern for the CPA.

During 1992, the CPA met with the company's owner and requested to review all of the corporate facilities. The owner only agreed to a limited walk-through of the premises. What the accountant saw appalled him - salespeople screaming into telephones while selling products and promising prizes. He correctly surmised that the operation was an illegal telemarketing prize room and promptly withdrew from the job. Especially concerned about thousands of people around the country falling for the scheme, the CPA contacted the FBI. Fortunately, the FBI, along with other agencies, already had begun an investigation of the subject company. By leading investigators through an array of different companies and financial transactions, the CPA's contributions to the case proved invaluable. The FBI eventually raided this company, and the owner and 11 other individuals were convicted and subsequently sentenced to various prison terms.(16)


Heading into the 21st century, the need for law enforcement and public accounting cooperation remains imperative. Congress has greatly assisted law enforcement efforts in combating corporate fraud through the enactment of the Economic Espionage Act of 1996. Yet, the vast majority of these crimes still go unreported. Law enforcement agencies should not only tenaciously investigate these crimes but also should educate the public about their consequences and effect on the U.S. economy. More important, agencies that develop a continuing liaison with the private sector, particularly the accounting profession, help ensure that companies report all types of fraud for criminal investigation. In addition to private firms, professional organizations such as the AICPA, Institute of Management Accountants, and state boards of accountancy can learn how to deal better with fraud and its industrial impact. With continued cooperation from both sides, corporate America will undoubtedly reap the benefits of improved fraud detection, deterrence, and prevention.

RELATED ARTICLE: The Collapse of the Carpet Cleaner

Barry Minkow, an entrepreneur, fully understood the laws of supply and demand. Growing up in California, Minkow began working for a local carpet cleaning company at the age of 14. A year later, he set up his own carpet cleaning/restoration business in his parent's garage. He incorporated the operation and called it ZZZZ Best, as in "ze best." Within 5 years, by the age of 21, Minkow had built his company into one of the largest independent carpet cleaning and restoration businesses in the country, with profits escalating at a rate of 400 percent per year. ZZZZ Best stock traded publicly, opening at $4 and climbing to nearly $19 per share within 4 months of its initial offering. During 1987, ZZZZ Best was worth over $300 million, and Minkow prepared to take over another carpet cleaning business - a public company nearly twice the size of ZZZZ Best.

Minkow arranged for $40 million in acquisition financing through a bevy of investment bankers in preparation for making ZZZZ Best the largest nonfranchised carpet cleaning and restoration business in America. Four days before the finalization of the acquisition, an article appeared in a major California newspaper that nixed the merger and abruptly ended the seemingly stellar fortunes of the brash and bold ZZZZ Best founder.(17) How did this corporate leader collapse overnight? The answer is simple; ZZZZ Best never existed as advertised - the entire company was a fraud.

Minkow's high-wire act merely included a collage of check kiting, loan fraud, and fictitious record-keeping activities that duped everyone from shareholders to accountants to the country's most savvy investment bankers. Although Minkow continued to operate a small time carpet cleaning operation, ZZZZ Best represented a rising industrial conglomerate on paper. Minkow created reams of phony documents including loan files, check registers, general journals, and accounts receivable invoices. He routinely misled associates with bogus files and cunning deceit. For example, when one auditor demanded to personally view an ongoing carpet restoration job, Minkow simply picked one of the nicest office buildings in town, bribed the landlord to act as if Minkow belonged on the premises, and led the auditor through a series of offices in various stages of refurbishment. The auditor never suspected the scam.(18)

Minkow knew he could not continue the charade forever, but he appeared surprised at how quickly others believed his often bizarre explanations for irrational corporate behavior. Additionally, Minkow also knew that he could easily entice or replace overly suspicious auditors as necessary. He hoped to sell his own shares of ZZZZ Best stock (valued at over $100 million) and find a way to compensate everyone. Finally, a former employee exposed Minkow's scheme to a reporter, and less than a year later, Minkow received a 25-year prison sentence.(19)

Released early from prison in 1993, Minkow has spent much of the past several years speaking to various groups about his scheme and analyzing ways it could have been prevented. Like the savings and loan crisis, much of the blame was placed on his auditors. Minkow alleges that auditors never used proper cash cut-off procedures or inquired why he constantly switched his accounts to different banks. If the auditors had inquired, they would have learned that Minkow submitted phony tax returns and that banks closed his accounts for check kiting, writing excessive non-sufficient-fund checks, using fictitious checks, and conducting loan fraud. Additionally, Minkow failed to disclose millions of dollars in private loans and managed to divert accounts receivable confirmation reports. He asserts that if auditors had persisted and made a thorough examination, ZZZZ Best would have collapsed years before its eventual demise.(20)


1 The Association of Certified Fraud Examiners, "Report to the Nation on Occupational Fraud and Abuse," Austin, Texas, 1996.

2 "Shattered Faith-White-collar Crime in America," video coproduced by the Financial Crimes Section, FBIHQ, Washington, DC, and the Instructional Technology Services Unit, FBI Academy, Quantico, Virginia.

3 Lee Berton, "Big Accounting Firms Weed out Risky Clients," The Wall Street Journal, June 26, 1995, B1.

4 The six largest accounting firms in the United States, known as the Big Six, consist of: Arthur Andersen, Price Waterhouse, Ernst & Young, Deloitte & Touche, KPMG Peat Marwick, and Coopers & Lybrand.

5 Marvin M. Levy, "Implementing SAS 53: Detecting Financial Fraud Within a GAAS Audit," AICPA Newsletter, December 1989.

6 1994 Fraud Survey, Forensic and Investigative Services Division, KPMG Peat Marwick.

7 "Fraud, the Unmanaged Risk," International Survey of the Effect of Fraud on Business, Ernst & Young International Fraud Group, May 1998.

8 Ibid.

9 1996 Fraud Survey, Investigative Services Division, Ernst & Young.

10 "Public Accounting/Law Enforcement Liaison-Teamwork in Combating Fraud," Financial Crimes Section, FBIHQ, Washington, DC, 1995.

11 David J. Lynch, "FBI: Accountants Should Turn in Crooked Clients," USA Today, August 3, 1995, B1.

12 Supra note 10.

13 "A Meeting of Minds," video by the FBI and the City of London Police Department, produced by Main Image Limited, 1997.

14 Ibid.

15 Supra note 10.

16 Supra note 10.

17 Barry Minkow, Clean Sweep - A Story of Compromise, Corruption, Collapse, and Comeback: The Inside Story of the ZZZZ Best Scare... One of Wall Street's Biggest Frauds, (Thomas Nelson Publishers, 1995).

18 Ibid.

19 Ibid.

20 Barry Minkow and Dan Hatch, "Manual to the Fraudo Dynamics Video Series-A Series on Fraud Detection and Prevention," video produced by A & A Productions, 1995.
COPYRIGHT 1999 Federal Bureau of Investigation
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:certified public accountant; includes related article on Barry Minkow and the ZZZZ Best carpet cleaning company
Author:Slotter, Keith
Publication:The FBI Law Enforcement Bulletin
Date:Jul 1, 1999
Previous Article:Drug conspiracies.
Next Article:Operation Linebacker: using status offenses to reduce crimes in communities.

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