ICAI - CIFAFP

Understanding Forensic Accounting & Fraud Prevention

Keep On Trucking
Narrated by RALPH WILSON

Jenny Baker was viewed by her associates as a brilliant CFO. She was known for her ability to predict the outcome of
future uncertainties with startling accuracy. She was also known to be very demanding, even intimidating at times. Many
of her staff had experienced one of her famous outbursts; consequently, they didn’t always feel comfortable asking her
many questions. She had started her career as a staff auditor for one of the Big Four accounting firms, where she
specialized in the transportation industry and was well regarded for her understanding of the nuances of sometimes
complex financial transactions.

Using her experience as a launching pad, she had made several strategic career moves that finally landed her a job
as vice president of finance at a national transportation company. During her tenure there, Jenny had gained the
confidence of those around her, including the CEO and many of the directors on the company’s board. She was
instrumental in getting the company listed and was part of blue chip shares due to the consistent increase in profitability.

Jenny had also found time to marry and have two children; she even had three grandkids. When she wasn’t
working, she loved to spend time with her grandchildren. She was satisfied with where she was in life. Her long-term
plan was to retire early and enjoy all of the things she had worked so hard to earn.

Always Learning
I was the internal audit director for Atkins Transportation Services. My department consisted of six employees, one of
whom was designated as a special projects auditor. One of the things we liked to do was proactively look for fraud. We
often undertook data mining to look for improper expenditures or unusual vendor relationships. Sarah Harrington, the
special projects auditor, routinely brainstormed with me about new approaches for finding fraud. One day we received a
brochure describing a forensic accounting class focusing on financial statement analysis. Since neither of us had taken
such a class before, we signed up for it. It turned out to be a wise investment.

Forensic financial statement analysis typically includes techniques involving horizontal and vertical relationships
among the basic financial statements — the balance sheet, the income statement, and the statement of cash flows. I
remember the instructor specifically telling us to focus on “time-sensitive interdependencies” to identify possible
manipulation. In other words, look at what happens over time, not just the current year or the previous year. He also said
the most important indicator of earnings manipulation is the correlation of reported earnings with reported cash flows
from operations. After completing the class, we had lots of new tools at our disposal to look for fraud.

Armed with this information, I downloaded ten years of company financial data into a spreadsheet and began the
process of selectively graphing the relationships we had been taught in class. This was a tedious process, but it began
to reveal some unusual patterns. For the early years on the graph, the reported earnings did correlate well with the cash
flows from operations; however, the most recent five years showed a remarkable divergence in correlation. Moreover, an
analysis of the allowance for doubtful accounts showed entirely unexpected results. For example, during a period of
strong revenue growth, the allowance had increased dramatically. According to what I had heard, the company was
doing a great job at collecting accounts receivable. What I was seeing painted a different picture.

This was all new territory to me. We weren’t quite sure what to do next. However, I remember thinking, “This is
exciting . . . this stuff really works!” . As I continued my analysis, Sarah began to download journal entries from the
company’s accounting system. She organized the entries and looked into some of the accounts that didn’t make sense.
One day Sarah came into my office and said, “I found some journal entries with the notation ‘Jenny’s entry’ as the
explanation for the transaction.” I asked, “Is there any other information about the purpose of the entry?” “No, that’s all
there is,” she said.

Only for Class room discussions – Based on original Case study made by Ralph Wilson, CFE, CPA
ICAI - CIFAFP
Understanding Forensic Accounting & Fraud Prevention
Sensing that we had found something significant, we began to discuss what to do. Soon a consensus emerged that
we should talk to our external audit firm. They seemed interested in our work, but their initial response was, “We need to
finish the engagement . . . our opinion is due by the 30th of next month.” and they were not going to pursue the issue
this year. They had looked at their work papers and they were satisfied with the explanations they had received from
management. However, they suggested that we look more closely at the issues. I thought, “Great . . . what do we do
now?”

Management by Intimidation
“Why can’t the controller explain these entries?” I asked. Sarah and I had just come from a meeting with the company
controller and the director of accounts receivable. Rather than take a more direct approach in our investigation, we had
decided to initiate an audit of accounts receivable. That way, we could gather more information and not raise too much
concern.
Our meeting had started off well, but soon became uncomfortable when we asked about some of the entries that
had been made to the allowance for doubtful accounts. We showed the controller, Stewart Wood, some of the journal
vouchers with the notation “Jenny’s entry” and asked if he could explain them. He responded, “If you want to understand
those entries, you’ll have to go and talk to Jenny.” “Why is that?” I said, “Don’t you know the reason for these entries?”
At that point, Stewart became defensive and said, “Those entries are communicated to me by management; you’ll need
to talk to them.” I asked him who approved the entries to this account and he told me that no one approved them.
“These entries are made at Jenny’s direction,” he said. “No one needs to approve them.”

This was astounding to me. There were absolutely no controls over some very material accounting entries. How
could the external auditors have missed this? I knew from prior audits that the monthly process for estimating bad debts
was well substantiated and that all entries were required to be approved. We had apparently stumbled into a dark closet
and we soon discovered that no one appreciated us trying to shine some light in there.

Before proceeding further though, Sarah and I decided to dig into the accounting records some more. We
downloaded all the entries made by Stewart over the past five years and then performed text searches looking
specifically for the words “Jenny’s entry” in the description field. We learned that Jenny concentrated her unusual
activities in two areas: accounts receivable and regulatory reserves. We already knew what was happening in accounts
receivable so we began to focus on the regulatory reserves.

Regulatory reserves were contingent liabilities established for settling accounts with various taxing authorities. In
the transportation industry, licensing fees and taxes were subject to audit and sometimes the taxing authorities would
make adjustments to what the company had already paid. The reserve accounts were established to estimate potential
audit adjustments.

The next morning, I received a call from the CEO, Todd Martin. He wanted me to know that he had received a call
from Jenny Baker. She had complained that I was being unprofessional in dealing with her staff. Later that day I
received an e-mail from Jenny telling me that she wanted to know the scope and objectives of our audit. She said her
people were busy doing their work and didn’t have time for all of the questions we were asking. I replied that we had
sent a memo to the director of accounts receivable announcing the audit and that she had been copied. I also explained
to her that once we began collecting information, we had found some entries that didn’t make sense. I stated, “As
auditors, we have the responsibility and the authority to follow the trail wherever it leads.” I copied the CEO on my
response. Jenny didn’t reply.

After talking it over with Sarah, we decided to go directly to Jenny for answers. We scheduled a meeting for the
following Monday. When we arrived, we noticed several of her high-ranking staff members arriving in the conference
room as well. We had expected to be meeting with Jenny alone. Perhaps this was an intimidation tactic — Jenny was
famous for intimidating her own employees. Now it was our turn. I leaned over to Sarah and whispered, “Looks like this
is going to be a big meeting.”

Only for Class room discussions – Based on original Case study made by Ralph Wilson, CFE, CPA
ICAI - CIFAFP
Understanding Forensic Accounting & Fraud Prevention
Once the meeting got started, we proceeded to explain our concerns about the accounting entries we had found.
We reported that internal controls over certain transactions were nonexistent and asked Jenny if she could explain what
was happening. Her response was unusual. Rather than discuss the specific transactions, she began by talking about
the complexity of the transportation industry. Her message to us was that we had to rely on her experience rather than
normal accounting rules. That’s where I turned my attention next. Prior to the meeting, I had brushed up on internal
controls over accounting estimates as well as the rules for recording contingent liabilities. I asked her, “So, you’re telling
me that with all of the uncertainty in the transportation industry, it’s hard to estimate things like bad debts and tax
liabilities?” “Yes,” she replied. “It’s almost impossible to estimate things like bad debts or regulatory reserves. We look at
our financial statements each month and if the numbers don’t look right, we make adjustments as needed based on our
experience. We try to reflect the underlying business.”

I informed her that according to, “Accounting for Contingencies”, contingent liabilities may be recorded only if it is
probable that an asset has been impaired or a liability has been incurred. Moreover, any contingency must be capable of
reasonable estimation. If those criteria aren’t met, then the proper accounting treatment is to disclose the contingency
rather than to record it. She then stated firmly, “Our financial statements have been audited by our external auditors and
they had no problems with any of the entries.” I told her that we planned to talk to the external auditors, but any further
information she could provide might be helpful. After some additional comments by Jenny, the meeting concluded.

When she got back, we began to review the vouchers. After looking at a number of documents, Sarah suddenly
exclaimed, “Look at this!” She handed me a voucher with a copy of an e-mail from Jenny attached to it. It was written to
the controller instructing him not to report some extra income the company had received that quarter. It stated, “Don’t
book this as income. Put it in the reserve accounts.” That was all we needed to make our case. I immediately called the
CEO’s office to schedule a meeting.

Dreading the News

All of this painted a clear picture of improper earnings management, the goal of which is to smooth reported
earnings. Jenny accomplished this by increasing contingency accounts like the allowance for doubtful accounts and
other reserves when business was good and decreasing the accounts when business was bad. Within generally
accepted accounting principles, management has the ability to influence reported earnings, but only within reasonable
limits. Jenny was clearly out of bounds.

After the presentation, CEO leaned back in his chair, thought for a few minutes, and said with a sense of
resignation, “I need to call the chairman of the board; why don’t you go call our audit firm and get them over here.” I
agreed and left the room. I wasn’t happy about any of this, but it was my job. Atkins Transportation Services had built an
excellent reputation. This kind of behavior could permanently damage that reputation. These practices needed to be
stopped.

In few days, I had meetings with the audit committee, a meeting with the chairman of the board and a meeting with our
audit firm. The audit firm formulated a plan to restate earnings and my staff was enlisted to provide assistance. Our legal
counsel began the process of contacting the stock exchange and our debt underwriters to inform them of the situation
and what we planned to do about it. W we believed we were doing the right thing to protect our reputation.

Rather than being fired, Jenny was given the option to retire. She gladly accepted the opportunity to “spend more time
with her family.” I believe it was the right outcome. Jenny’s departure would allow her to spend time with her grandkids,
and she would no longer be under the pressure she felt to achieve a certain level of financial performance. I was certain
her employees would be relieved.

Only for Class room discussions – Based on original Case study made by Ralph Wilson, CFE, CPA