Classroom Case Demonstration “Something’s Fishy at Jones Company – from Investigation to Confession.” Designed for the classroom or a seminar, an intrepid seasoned internal audit manager and an inexperienced but willing staff auditor investigate suspicious financial activity at Jones Company. Their discoveries reveal their hunch was right, and they are able to stop the fraud. This case can be used in a classroom or seminar setting to: ● Discuss the Fraud Triangle and the importance of symptoms ● Discuss accounting symptoms of fraud ● Perform financial statement analyses to determine if fraud is suspected ● Identify and test a fraud hypothesis ● Analyze an interview ● Analyze an interrogation ● Draw conclusions and prepare fraud reports The case requirements include: 1. Perform horizontal and vertical analyses of the financial statements. 2. Describe other financial statement analyses that the auditor could have performed. 3. Describe a public records search. 4. Analyze this case using the fraud triangle. 5. What is the fraud hypothesis in this case? Session Topics This case includes teaching notes (provided on the conference website) and a video (30 minutes) depicting a suspect interview and a separate interrogation. The video highlights verbal and non-verbal cues to look for when interviewing and a non-confrontational approach to interrogation. During this session we will view the video and discuss how the case might be used in the classroom or seminar. Copies of the video will be available to session attendees. Speaker Biographies JOHN DELANEY is an Associate Professor of Accounting at Augustana College. He earned his D.B.A. from St. Ambrose University and M.B.A from the University of Iowa. John worked as an auditor for seventeen years with MidAmerican Energy Company and Archer Daniels Midland Company prior to a career change to academia. His published works include research on accounting ethics and internal audit outsourcing. John is a CPA, CMA, and CIA. JEFFREY COUSSENS is an Associate Professor and Chair of the Department of Theatre Arts at Augustana College. He earned his M.F.A. in Performance from Indiana University and served as a member of the performance faculty at the School of Drama, University of Oklahoma from 1983 through 1987. Jeff has worked as a professional actor and director at the Oklahoma Shakespeare Festival, The Black Hills Playhouse, The Brown County Playhouse, Street Player's Theatre, and Dollar Stock Summer Theatre. During his twenty-five year academic career Jeff has directed over fifty stage productions and acted in more than thirty roles. Jeff also has a special interest in stage combat, having choreographed fight scenes for over twenty stage plays. His work in video production includes voice-over narration and acting in several commercials and educational films. Jeff is a member of the Theatre Communications Group, Association for Theatre in Higher Education, Illinois Theatre Association, and the Society of American Fight Directors.

Something’s Fishy at Jones Company Fraud Case - Teaching Notes This case is fictional. Any companies or names mentioned in this case are not real. Likewise, none of the facts in this case are based on real facts. This case is designed for use in fraud examination courses or seminars. This case includes an accompanying DVD with video segments (available free of charge to instructors from the Association of Certified Fraud Examiners). These teaching notes are for instructor use. This case can be used in a classroom or seminar setting. The case can be used to: • • • • • • • Discuss the fraud triangle and the importance of symptoms. Discuss accounting symptoms of fraud. Perform financial statement analyses to determine if fraud is suspected. Identify and test a fraud hypothesis. Analyze an interrogative interview. Analyze an interrogation. Draw conclusions and prepare fraud reports.

The case can serve as a teaching tool in a variety of settings. For example, the case can be used: • • • As a case assignment in a college fraud examination course. As a case assignment in a college auditing course. As course material in a fraud examination seminar.

These teaching notes have been developed assuming the case will be used in a fraud examination course; however, these notes will also help instructors utilizing the case in other settings. Introduction This case can enrich the coverage of several topics contained in most Fraud Examination courses. This case can be used: • • • As a stand-alone case that students complete on their own or in a classroom setting. As a continuous case as topics are covered in the course. To compliment certain topic areas such as interviews and interrogations.

A suggested approach for how an instructor might use each case requirement follows. Case Requirements 1. Perform horizontal and vertical analyses of the financial statements. Many Fraud Examination Courses cover horizontal and vertical analyses. Thus, instructors may use this case as a way for students to perform common analyses within the context of a fraud investigation. The solution for the first requirement follows. -1-

Balance Sheet Data Cash Accounts receivable Inventory Fixed assets (net) Intangible assets Total assets Accounts payable Other current liabilities Long-term debt Common stock Paid-in capital Retained earnings Total liabilities and SHE

Year 3 $ % 1,598,654 10.0% 1,705,689 10.0% 7,459,826 44.0% 4,458,935 27.0% 1,586,666 9.0% 16,809,770 100.0% 1,156,396 194,000 2,000,000 1,000,000 5,000,000 7,459,374 16,809,770 7.0% 1.0% 12.0% 6.0% 30.0% 44.0% 100.0%

Vertical Analysis Year 2 $ % 1,568,791 10.3% 1,694,328 11.1% 5,593,294 36.6% 4,658,921 30.5% 1,758,666 11.5% 15,274,000 100.0% 660,228 222,000 2,500,000 1,000,000 5,000,000 5,891,772 15,274,000 4.3% 1.5% 16.4% 6.5% 32.7% 38.6% 100.0%

Year 1 % $ 2,589,348 20.7% 1,598,643 12.8% 2,317,452 18.5% 4,056,891 32.4% 1,958,666 15.6% 12,521,000 100.0% 567,734 203,000 3,000,000 1,000,000 5,000,000 2,750,266 12,521,000 4.5% 1.6% 24.0% 8.0% 39.9% 22.0% 100.0%

Horizontal Analysis Year 2 to 3 Year 1 to 2 Change % Change % 29,863 1.9% (1,020,557) -39.4% 11,361 0.7% 95,685 6.0% 1,866,532 33.4% 3,275,842 141.4% (199,986) -4.3% 602,030 14.8% (172,000) -9.8% (200,000) -10.2% 1,535,770 10.1% 2,753,000 22.0% 496,169 (28,000) (500,000) 0 0 1,567,601 1,535,770 75.2% -12.6% -20.0% 0.0% 0.0% 26.6% 10.1% 92,494 19,000 (500,000) 0 0 3,141,506 2,753,000 16.3% 9.4% -16.7% 0.0% 0.0% 114.2% 22.0%

Inc Stmt/Ret Earnings Data Net sales Cost of goods sold Gross profit Selling expenses Consulting fees Depreciation and amortization Total expenses Net income Beginning retained earnings Dividends Ending retained earnings

Year 3 $ 12,985,364 9,739,023 3,246,341 259,707 129,854 289,179 678,740 2,567,601 5,891,772 1,000,000 7,459,374 % 100.0% 75.0% 25.0% 2.0% 1.0% 2.2% 5.2% 19.8% 45.4% 7.7% 57.4%

Vertical Analysis Year 2 $ % 11,985,632 100.0% 7,191,379 60.0% 4,794,253 40.0% 239,713 119,856 293,178 652,747 4,141,506 2,750,266 1,000,000 5,891,772 2.0% 1.0% 2.4% 5.4% 34.6% 22.9% 8.3% 49.2%

Year 1 $ 10,895,687 6,537,412 4,358,275 217,914 108,957 281,138 608,009 3,750,266 0 1,000,000 2,750,266 % 100.0% 60.0% 40.0% 2.0% 1.0% 2.6% 5.6% 34.4% 0.0% 9.2% 25.2%

Horizontal Analysis Year 2 to 3 Year 1 to 2 Change % Change % 999,732 8.3% 1,089,945 10.0% 2,547,644 35.4% 653,967 10.0% (1,547,912) -32.3% 435,978 10.0% 19,995 9,997 (3,999) 25,993 (1,573,905) 3,141,506 0 1,567,601 8.3% 8.3% -1.4% 4.0% -38.0% 114.2% 0.0% 26.6% 21,799 10,899 12,040 44,738 391,240 2,750,266 0 3,141,506 10.0% 10.0% 4.3% 7.4% 10.4% (a) 0.0% 114.2%

(a) percentage not computed because denominator is 0.

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The vertical analysis shows that the gross profit was 40% for the first two years but dropped to 25% in the third year. The horizontal analysis indicates that cost of goods sold increased significantly in the third year. Thus, the horizontal and vertical analysis indicates that the decreased net income and profit margin are due to an increase in cost of goods sold. This would cause the auditor to take a closer look at cost of goods sold. 2. Describe other financial statement analyses that the auditor could have performed. The auditor could have compared account balances from one period to the next. (This is how the auditor identified the upward trend in consulting fees.) While this method can be useful, analyzing percentages tend to provide more insight than the raw numbers. For example, in this case while the consulting fees increased every year, they stayed constant as a percent of sales. The auditor could have computed key financial ratios. The definition of ratios is not standardized and may vary from analyst to analyst, textbook to textbook and annual report to annual report. However the following categories of ratios have gained wide acceptance. • • • • Liquidity Ratios – measures of an enterprise’s short-run ability to pay its maturing obligations (e.g. current ratio and quick ratio) Activity Ratios – measures of how effectively an enterprise is using the assets employed (e.g. receivable turnover, inventory turnover, asset turnover) Profitability Ratios – measures of the degree of financial success or failure of a given enterprise for a given period of time (e.g. profit margin) Coverage Ratios – measures of the degree of protection for long-term creditors and investors (e.g. debt to equity)

These categories are not distinct but rather are interrelated. Thus, profitability affects solvency, and the efficiency with which assets are used impacts the analysis of profitability. In measuring these relationships, ratios provide a profile of a company and its management’s operating, financial, and investing decisions. Thus, an intelligent analysis of the ratios can provide insight into a firm’s economic characteristics and competitive strategies. As an expanded exercise, instructors may require students to identify ratios for each of these categories and compute the ratios using the facts of this case. If students are not using a text that contains financial ratio formulas, instructors might consider having students perform research to identify the formulas. Note: instructors can consult Joseph Wells’ Corporate Fraud Handbook for ratio formulas 1 . 3. Describe a public records search. A public records search involves searching for information in federal, state, county and local records related to your investigation. In addition to information that is available to anyone via freedom of information laws, other pertinent information is available only to law enforcement. See Steve Albrecht’s text for a discussion of the following types of public records searches 2 : department of defense, department of justice, bureau of prisons, internal -3-

revenue service, secret service, postal service, central intelligence agency, social security administration, state attorney general, secretary of state, department of motor vehicles, department of vital statistics, department of business regulation, county clerk, county land office and tax assessor’s office, county sheriff, local courts, and permit departments. Valuable information regarding publically-traded companies can be obtained from the SEC Edgar database available via the Internet. For privately held corporations, information can be obtained from the state usually via the Internet. As an expanded exercise, instructors may require students to gather information for a publically-traded company via Edgar and a privately held company via the state’s web site. 4. Analyze this case using the fraud triangle. This case illustrates the three key elements common to all fraud: a perceived pressure, a perceived opportunity, and a way to rationalize that the fraud is acceptable. These elements are referred to as the fraud triangle. In this case, the elements included: Perceived Pressure: Tony DeMarco perceived pressure include the financial pressure to pay for his expensive cabin and boat. Perceived Opportunity: The fact that DeMarco could approve payments to Smith Company provided an opportunity to commit the fraud. Rationalization: DeMarco felt cheated - especially considering the many years of loyal service and hard work he put in at the company. He was essentially demoted and likely humiliated by the fact that instead of being the man in charge, he now reported to a bureaucrat in the home office. Rather than just accepting his fate, DeMarco decides to “take what he is owed.” 5. What is the fraud hypothesis in this case? Jack Robertson refers to the fraud hypotheses in his discussion of the fraud theory approach 3 : Every fraud examination begins with the prospect that the case will end in litigation or prosecution. Fraud examiners start with a “theory of the case.” Like a scientist who postulates a theory based on observation and then tests it, the “theory of the case” begins with assumptions, based on initial facts or suspicions of the events that might have occurred. These assumptions are then tested to try to determine a provable truth. The fraud theory approach involves the following logical steps: a. b. c. d. e. Analyze available data. Create a hypothesis. Test the hypothesis. Refine and amend the hypothesis. Decide to accept or reject the hypothesis based on the evidence. -4-

In this case, the fraud hypothesis is: Tony DeMarco was involved in a kickback-scheme where he caused and benefited from exorbitant charges from Smith Company to Jones Company for outsourced machine work. 6. Watch the introduction and interview segments on the case DVD. Describe the elements of an effective interview and indicate if this interview followed effective interview techniques. The interview provides the auditor or fraud investigator an opportunity to collect both verbal and nonverbal evidence, which may lead to the identification of a likely suspect. Before conducting the interview, the investigators would likely already have some evidence that makes them suspicious of fraud. In this case, Tony DeMarco is considered a suspect due to his ability to approve job costs and his relationship with Smith Company (evidence collected by the auditors via an analysis of job costs and a public records search). The audit manager initiates the interview to gauge DeMarco’s verbal and nonverbal reaction to questions concerning the case. By observing a suspect’s nonverbal behavior it is possible to identify cases in which the suspect is creating information (possibly lying) versus recalling information (telling the truth). A word of caution—the suspect’s normal nonverbal behavior must be established before the interviewer can effectively interpret nonverbal reactions to questions regarding the case. Consequently, initial questions posed to the subject should be designed to elicit truthful responses (e.g. length of service to the organization, job responsibilities) to allow the interviewer to observe nonverbal behavior when the subject is telling the truth. The following information concerning nonverbal behavior is taken from an ACFE course workbook 4 . The Head A subject can display both positive and negative signals. A positive signal that the subject is listening to the interviewer is the tilting of the head to one side or the other. Holding the head straight down without even looking at the interviewer indicates a negative sign or a state of anger, which generally means the subject is not listening. If the subject's head sinks down into the chest, this may indicate an acceptance of guilt or depression. The Face If the subject starts to feel stress, the face and neck may begin to get pale. The interviewer may notice that this also occurs when the subject experiences shock from a particular question or statement. When the subject responds to questions that cause blood pressure to increase, the face and neck may turn red and blotchy. There are many facial expressions that display the emotional feelings of the subject. When the interviewer is asking an accusatory question, the subject may have a facial expression of defiance while, at the same time, crossing the arms and the legs so as to create a barrier -5-

between the subject and the interviewer. Another negative signal is a hard stare at the interviewer which indicates a state of anger. Another sign of deception and extreme stress includes muscle spasms in the face or facial tics. Often a subject will try to fool the interviewer by masking emotions so as to not show any facial expression at all, or the subject will try to create a false expression. Typically, the interviewer will notice that there are other nonverbal signals, such as in the hands or the feet, that the subject is sending that will clue the interview in on whether the expression is false or not. A subject may be exhibiting a cold stare and showing no emotions, but at the same time may be tightly wringing his or her hands together, displaying some level of stress or nervousness. The Nose An increase in blood pressure will affect delicate tissue in the nose, which makes the nose very sensitive during stressful events. In order to relieve the stress stimulation in the nose, subjects may feel the need to touch, scratch or rub the nose. The subject scratching and/or rubbing the nose hints to the interviewer that the subject is feeling stress. Subjects may also touch their face by covering their mouth so as to create another barrier. The Mouth The subject may use a false smile to appear friendly to the interviewer; therefore, a large grin may indicate a defensive position. Yawning, aside from drowsiness or boredom, can be a sign of stress and can be used as a stalling behavior. Most deceptive yawning occurs in individuals 25 or younger due to their lack of maturity. Yawning signals that may show deception include: • Yawning that occurs continuously throughout the interview • Yawning to stall or to fake boredom • Yawning to show lack of respect for the interviewer Dry lips and frequent swallowing are also characteristic signs of stress. Also, watch for subjects who begin to bite their lips during times of stress. A subject may also attempt to create barriers in front of the mouth by: • Placing pens, pencils, or paperclips in the mouth • Chewing on hair, key rings, purse straps, corners of papers or folders The Eyes A break in the subject's normal pattern of eye contact may be a sign of stress. In order to determine whether the subject is experiencing a stressful situation, you must first pay attention to their normal pattern of eye contact. Shifting eye behavior may indicate a lack of consistency in eye contact, such as looking in many different directions in a short period of time. Subjects may begin to blink their eyes very rapidly when under stress, as well as -6-

closing their eyelids for a long period of time. During these times of stress, a subject is busy concentrating on processing response information to what the interviewer has said or explained. The interviewer should be aware of any eye contact that is very strong in an attempt to stare down the interviewer. This strong eye contact indicates a state of anger in the subject. Just before the subject is ready to confess the interviewer may notice that the subject's eyes will roll back as the eyelids begin to close slowly. Another clue to the acceptance of guilt that the interviewer may notice in the subject is almost no blinking at all. The interviewer will also notice changes in the eyebrow shape during different emotions. If the subject is angry, his eyebrows will take on a ''V'' shape scrunched in toward the nose. If the subject is surprised or shocked by what the interviewer is saying, his eyebrows may be raised very high in response. The Arms One of the most common arm behaviors is crossing the arms. The higher the subject's arms are crossed during an interview, the greater defiance he is representing. Another anger response includes the subject crossing his arms with fists clenched underneath at the same time. Crossing the arms with the hands tucked underneath and only the thumbs being displayed is considered a sign of arrogance. The interviewer should pay particular attention to the shoulders, arms, and hands. The Shoulders The first sign of anger that an interviewer may notice is when a subject first enters the room with one shoulder raised higher than the other (most often this will be the shoulder closest to the interviewer) creating an uncooperative barrier. Another sign of anger or defensiveness by the subject is throwing the shoulders back while straightening and stiffening the neck and back. A subject may respond in denial to a crucial question by shrugging his shoulders. Just before a confession, or as a sign of depression, the subject may drop his shoulders down and hunch them over. The Elbows A subject's body movements usually are a bit more relaxed when the subject does not feel stress. For example, the elbows will hang loose and not be closed in towards the body. This is a positive sign that the subject has no objection to what the interviewer is saying. By pulling the elbows in close to the torso, in an effort to protect himself, the subject tells the interviewer that he is feeling stress. The Hands -7-

There are three types of nonverbal behaviors involving the hands. • Emblems • Illustrators • Manipulators "Emblems" are hand gestures that represent a word, such as using your hands to say "okay" and "#1." "Illustrators" actually illustrate what the person is saying verbally. A subject might be saying that he "sat in a chair this big," while at the same time illustrating with his hands the size of the chair. A subject may also reenact a crime using illustrators. "Manipulators" give your hands something to do, in other words, busy work. Many people display manipulators when they are nervous, for example tapping the fingers. When under stress a subject may display a multitude of possible hand gestures or manipulators, some of which may also be used as a way to create a barrier between him and the interviewer. Listed below are just a few manipulators that the interviewer may notice. • Finger tapping or drumming • Picking at fingers or finger nails • Playing with jewelry • Checking and/or winding watches • Fixing or twirling hair • Scratching, pulling, or rubbing ears • Rubbing and squeezing the neck • Wringing hands together • Partially or fully covering the eyes • Fixing makeup There are a few signs that the interviewer may want to pay particular attention to. First, if the subject begins to rub or stroke the knob of his chin, he may be ready to confess. Second, if the subject places his thumb under his chin and another finger vertically against his face creating an "L" shape he may be displaying opposition or anger. Remember that not all subjects will have the same level of hand gesturing; therefore, the interviewer must always analyze what is normal for the individual subject. The Legs Subjects are less likely to notice any movements that they are making with their legs. They will notice their verbal symptoms above anything else. When a subject starts to feel discomfort from a critical question, he may cross his legs to create a barrier between him and the interviewer. If the subject's legs are already crossed, he may rearrange his entire body position and cross the other leg. His body alignment will most likely be turned away from the -8-

interviewer to create as much of a barrier as possible. Crossing and/or uncrossing the legs can also be used as a form of stalling by the subject. The more stress a subject is under, the more they will wobble their knees or bounce them up and down at a very rapid rate. The Feet The more stress the subject is under, the greater the movement of the feet. If the legs are crossed, the subject may wag or bounce the foot that is suspended in the air. At the same time, a subject may bounce the whole leg that is crossed up and down the more agitated he becomes. A subject also reacts to stress by crossing the legs at the ankles and putting them underneath the chair, when more relaxed, the subject may uncross their legs and eventually slide their feet out in front of them. A subject lightly tapping his feet may be displaying signs of nervousness, impatience, or fear. If a subject begins to tap harder, almost stomping, then he may be displaying signs of hostility or agitation. Posture The interviewer may notice that when a subject feels threatened by a crucial question which may indicate his guilt, he may lean his whole body away from the interviewer, usually towards a door or window in a desire to escape his environment. A subject who is attempting to appear relaxed and comfortable will sit slouched in the chair with his legs spread apart. The subject may go so far as to freeze all body motion in response to stress or as a display of deception. Emotions As we have seen, nonverbal communication is used to communicate a wide range of emotions, attitudes and other types of information including stress levels, defensive or aggressive postures, as well as the openness of the individual. During the interview, an astute observer can use these signals to help decipher the emotional state of the subject. We know when a person with whom we are speaking is nervous, happy, angry, sad, or friendly. We often know this without giving thought to the particular signals. Often, and in spite of a person's words, we know when one of the above emotions is projected in spite of denials to the contrary. How often have we seen a mime perform? They certainly are able to convey significant messages and emotions. Silent movies used nonverbal communication in a highly effective manner to convey emotions, messages, and a story. Anger

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We often recognize anger when it is manifested in some of its more expressive ways. Red face, raised voice, and pointing of fingers may all be readily recognizable indicators of anger. However, anger is manifested in more subtle ways as well, such as with indications of defense or withdrawal. Many individuals attempt to control their anger and do so quite well by internalizing it. Anger can be used as a means to throw the interviewer off guard and focus the attention on the interviewer and away from the topic of the interview. The effective interviewer will not be baited, but will handle any such outbursts objectively and professionally. Nervousness Individuals who are nervous look for means to release the nervousness and anxiety. Fidgeting, tensing of the body, constant changes in a seating position, clearing of the throat, shaking, nail biting or constantly manipulating some object such as a pencil, a paperweight or other inanimate object may all be signals of nervousness. It is the interviewer's job to determine why the individual is nervous and not jump to the conclusion that the subject is being deceptive. Honesty Interviewers often regard signs of stress as signs of dishonesty. Conversely, a relaxed, open person who does not appear to be concealing or hiding anything or who does not appear to be tense or nervous is often viewed as being honest. For the interviewer, if stress is to be a part of the interview and if it is to be created, it is best that it is created by the subject on his own and with no influence on the part of the interviewer. As discussed, anything that the interviewer does to create stress should be avoided. Although an individual who is being deceptive will often exhibit signs or indicators of stress or dishonesty, sometimes a truthful person will exhibit these same signs. Boredom In some cases, signs of boredom such as false yawns, picking of imaginary lint off of clothing or placement of hands behind the head in a faux-relaxed position, can be signs of nervousness or attempts to disguise the individual's true emotions. These false signals are often used to cover the subject's nervousness or stress. Frustration Individuals who display displeasure at the interviewer, the subject matter, or the questions may be using aggression to divert attention from the real issue. Generally, honest people who have nothing to hide will be cooperative and will not express emotions of frustration or aggression. Other Emotions

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As with other indicators, the interviewer should be alert to the corresponding language and tone of an individual who exhibits certain types of nonverbal language. A hand across the mouth at a time when the subject's volume of speaking is lowered, the subject's eyes look down and the subject states, "I would never do such a thing," is cause for the interviewer to pay attention and take note. If a subject who has been relaxed and has answered the interviewer's questions completely begins to provide one word or choppy answers, crosses his arms across his chest, and states, "I don't know what the purpose of all these questions is," the interviewer should take note. Quite often, the signs will not be as dramatic as the above two examples. However, the more the interviewer studies the subject and is sensitive to changes in the manner in which the individual is expressing himself, the more capable and effective a communicator and interviewer he will be. Nonverbal Clusters Most nonverbal signals come in clusters. During an interview, there is no one signal by itself that can positively tell you anything; it is usually a combination of many signals. All of the signals mentioned earlier are usually in combination with each other to display a behavior. A variety of any of the negative signals below may tell an interviewer that the subject is experiencing stress, anger, depression, denial, or even arrogance: • Subject positioning himself behind a desk or table to create a barrier • Abruptly sitting down in the chair • Rocking the chair on the back legs • Leaning back and sinking in to the chair • Crossing hands behind the head (arrogance) • Turning one shoulder towards interviewer • Never returning a smile • Blank face • Expressions showing anger or hostility When a subject moves towards acceptance the interviewer will notice many signals that will, result in an admission or confession. Some nonverbal clues to watch out for are: • Mimicking interviewer's facial expressions • Removing a jacket or sweater, loosening a tie, etc. • Turning palms of hands up and leaning in towards interviewer • Dropping shoulders and rolling them forwards • Dropping chin down • Crying or quivering chin • Slowly closing eyelids while at the same time rolling eyes back • Rubbing chin and smiling • Deep sigh • Rubbing lips together for a long period of time Irrespective of the emotions that the subject may exhibit, the interviewer should always consider them as part of a whole or as part of a pattern. A subject who is angry may be angry - 11 -

because he just learned he is being reassigned to another department and he considers it a demotion. The person who exhibits signs of nervousness may not be accustomed to being interviewed or he may believe that the interview will be used for purposes of promotions, demotions, or layoffs. The effective interviewer must always look for patterns of emotions in words, tone, nonverbal clues, or body language and use those patterns to build as complete a picture as he can before forming any opinions or reaching any conclusions. 7. What is the difference between civil and criminal as it relates to fraud investigation? Albrecht identifies differences between a criminal and civil case as follows 5 : Criminal Case To right a wrong Jail and/or fines Beyond a reasonable doubt Jury must have 12 people Determination by a grand jury that sufficient evidence exists to indict Unanimous verdict Only one claim at a time Civil Case To obtain a remedy Restitution and damage payments Preponderance of evidence May consist of fewer than 12 people Filing of a claim by a plaintiff

Purpose Consequences Burden of proof Jury Initiation

Verdict Claims

Parties may stipulate to a less than unanimous verdict Various claims may be joined in one action

As indicated in the previous table, a civil case might be easier to win. Indeed, in some cases, a civil case might only occur if a criminal case fails. In a time where so many fraud cases are making the news, some companies would do well to follow Biegelman and Bartow’s advice to adopt a zero tolerance policy 6 : Corporate codes of conduct should address the problem of fraud by clearly stating that there is a zero tolerance for fraud of any kind. Whether it is a $50 inflated expense report or a $50 million revenue recognition issue, an organization must take appropriate action against all fraud. A good rule to follow is that the amount of the fraud is immaterial and any fraudulent activity that is disclosed and proved through professional investigation should result in termination of the employee. In addition, organizations should consider referring fraud by employees, vendors and others to the appropriate law enforcement agency for criminal prosecution. 8. Prepare a preliminary fraud investigation report that will be provided to law enforcement prior to the interrogation. Albrecht describes the fraud report as follows 7 :

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Interrogation of suspect(s) is usually the final stage of investigation (although circumstances may dictate an alternative sequencing of investigation methods). Once the investigation is completed, a fraud report is prepared. This report includes all findings, conclusions, recommendations, and corrective actions taken. The report indicates all pertinent facts uncovered relative to the who, what, where, when, how, and why of the fraud. It also includes recommendations for control improvements that will minimize the exposure to similar occurrences in the future. It should not contain recommendations for disciplinary or legal action against anyone suspected of fraudulent or illegal activity, even when the investigation provides tenable evidence of probable culpability or complicity. Robertson indicates that you must be aware of the readers of the report 8 . Be aware that the fraud examination report will probably be used by company executives and managers, directors, internal auditors, external auditors, media press reporters, attorneys, law enforcement officials, judges and jurors, and by the accused person. Under no circumstance should the examiner prepare a communication with the idea that the information will not be disclosed to third parties. Write the report with this caveat in mind. A fraud examination should stand on its own. It should answer the classic questions of who, what, why, where, when, and how. If the report is prepared properly, the reader should not need to refer to any other documents to understand the issues. The basic report documents include: • • • • • Cover page Transmittal letter Memoranda Exhibits, documents, or enclosures Indexes

While the full fraud investigation report cannot be completed until after the interrogation, preparing as much of the report as possible prior to the interrogation will assist interrogators. Thus, a preliminary report that would be created prior to the interrogation is included as Appendix A. 9. Watch the interrogation segment on the case DVD. Compare and contrast the interview and interrogation. Discuss the pros and cons of this particular investigation. In the case the audit manager explained the differences between an investigative interview (a non-accusatory meeting to gather factual information through open-ended questions and study of behavior cues to deception) and an interrogation (an accusatory approach where the interviewer asks assumptive questions and does all the talking with the intent to seek admission that corroborates the details). The interview can take place anywhere there can be privacy. In this case, the auditors elect to meet Tony DeMarco in his office. This turns out to be a wise decision as through keen observation the auditors note pictures of DeMarco’s new boat and cabin—two points they will eventually use to develop the rationalization for the fraud. Before discussing the issues of the case, the auditors make small talk with DeMarco noting his normal behavior when - 13 -

answering questions truthfully. The mood changes once the auditors begin to question DeMarco about the job costs and his relationship to Smith Company. DeMarco becomes defensive and his nonverbal behavior changes considerably (see nonverbal cues discussed in question 6. above)—giving the auditors the impression that he might be lying. At this point the auditors conclude the interview and prepare a preliminary report (see question 8. above). The auditors have achieved one objective—they determined that DeMarco did not have a good explanation for the high machining fees and that he shows some signs of deception. Their own “fishing expedition” has yielded benefits to the case. On the other hand, they do not have firm evidence, as of yet, that DeMarco benefitted financially from the overcharges. More work needs to be done and it is obvious that DeMarco and his brother-in-law are not likely to cooperate. Law enforcement is called in which adds another layer of complexity to the investigation. If the auditors could have determined DeMarco benefitted financially from the scheme by some other means than through subpoena of Smith Company records it would not be necessary to alert the police as yet—though an argument could be made that law enforcement should be notified regardless. The interrogation differs substantially from the interview. First, the setting is completely different—a neutral cite arranged by the interrogators in a particular way to avoid distractions and a claim of false imprisonment by the suspect. Second, the investigators do most of the talking and ask assumptive questions (e.g. “Did you get other payments as well?”), rather than interview questions to establish case facts. The whole point of the interrogation is to obtain an admission of guilt and to determine if other crimes have been committed that have not yet been uncovered. Third, the auditors were looking for signs of deception when interviewing the suspect. During the interrogation, the interrogation team is looking for signs of submission and the opportunity to obtain an admission of guilt. Further, the suspect is not allowed the opportunity to deny the charges—when DeMarco begins to object the interrogators stop the denial and continue to develop the rationalization (DeMarco was out to “get what he was owed” and pay for his expensive hobbies). It would be hard to criticize an interrogation that results in an admission of guilt. However, a case could be made that the investigators should have pressed DeMarco further on the possibility of other fraudulent behavior. That said, the primary objective of obtaining an admission of guilt was achieved and CPI management now has the option of seeking restitution and/or criminal charges against DeMarco. 10. Prepare a final fraud investigation report that will be provided to CPI management. When preparing the final fraud investigation report the investigator should keep in mind the difference between facts, opinions, and conclusions. Further, the investigator should be aware that the report (and other case documentation) may be subpoenaed if legal proceedings follow. Consequently, the report should state the facts of the case and avoid stating opinions (interpretation of the facts) regarding the guilt or innocence of any person or party. Conclusions are statements based upon observation of the evidence—if used in the report they should be self-evident9. The following is an example of a final report.

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To:

From: Date: Re: Subject:

John Black, CPI President and CEO CPI Audit Committee CPI Legal Staff Barb Reynolds, CPI Internal Audit March 1, 2009 Tony DeMarco Jones Company Investigation

On January 9, 2009, CPI’s financial analysis group asked the internal audit department to investigate the cause of Jones Company’s reduced profit margin. Our preliminary analysis indicated the likelihood of fraudulent activity (see Appendix A – Preliminary Fraud Investigation Report). Consequently, as instructed by CPI’s legal staff, we referred our case to the Lansing Police Department and assisted with the investigation. Results Our investigation found that: 1. Jones Company’s reduced profit margin was due to outsourced machining operations performed by Smith Company. The fees charged by Smith Company were well above market fees for typical machining required for the jobs in question. 2. Jones Company’s production manager, Tony DeMarco admitted to receiving kickbacks of $1.2 million from Smith Company in return for approval of exorbitant fees for this outsourced machine work. Mr. DeMarco prepared a voluntary statement on February 28. Detective Brian O’Shea (Lansing Police) and I witnessed Mr. DeMarco prepare his statement. A copy of the complete statement may be located in our audit file. The following points summarize this statement. • • • Mr. DeMarco developed the fraud scheme shortly after he was informed that CPI would be purchasing Jones Company and that he would be “demoted to the position of production manager.” Mr. DeMarco convinced his brother-in-law Joe Thompson (Smith Company) to assist in the scheme by charging excessive fees for machining work in return for a kick-back in the form of dividend payments as a stockholder of Smith Company. Most of the dividend payments were used to finance a cabin and fishing boat, though these funds were also used to pay for trips by Mr. DeMarco and his wife.

The investigative phase of this case is now closed. Our findings have been forwarded to CPI legal staff. We are prepared to assist further with the case as directed.

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Case DVD This case includes an accompanying DVD with video segments. The DVD is available from Martin Coe (mj-coe@wiu.edu). The DVD contains three segments. 1. Fraud (Introduction) 2. Interview 3. Interrogation

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Appendix A – Preliminary Fraud Investigation Report

INVESTIGATION REPORT ON TONY DEMARCO Jones Company

Internal Audit Special Case File 123

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Appendix A – Preliminary Fraud Investigation Report

Jones Company Internal Audit Special Case File (IASCF) 123 Regarding Tony DeMarco FILE INDEX Item Page Transmittal Memo………………………………………………… 1 Financial Statement Analysis……………………………………... 2 Ted Jones Interview 1…………………………………………….. 3 Job Report Analysis………………………………………………. 4 Ted Jones Interview 2…………………………………………….. 5 Public Records Search………………………………………….. 6 7 Tony DeMarco Interview………………………………………… Exhibit 1, Smith Company Articles of Incorporation…………….. 8

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Appendix A – Preliminary Fraud Investigation Report

To: From: Date: Re: Subject:

CPI Corporate Security Barb Reynolds, CPI Internal Audit February 13, 2009 Tony DeMarco Jones Company Investigation

On January 9, 2009, CPI’s financial analysis group asked the internal audit department to investigate the cause of Jones Company’s reduced profit margin. Our investigation included the following procedures: 1. 2. 3. 4. 5. 6. We analyzed the financial statements. See memorandum on page 2. We interviewed the former owner of Jones Company. See memorandum on page 3. We created and analyzed a job summary report. See memorandum on page 4. We re-interviewed the former owner of Jones Company. See memorandum on page 5. We performed a public record search. See memorandum on page 6. We interviewed Tony DeMarco. See memorandum on page 7.

Results Our investigation found that: 3. Jones Company’s reduced profit margin was due to outsourced machining operations performed by Smith Company. 4. Jones Company’s production manager, Tony DeMarco is an officer of Smith Company and he approves payments to Smith Company. 5. DeMarco’s brother-in-law, Joe Thompson is also an officer of Smith Company. 6. DeMarco recently acquired an expensive cabin and boat. 7. DeMarco exhibited nonverbal cues suggested that he may be lying about having no involvement with Smith Company. The results of our investigation at this point suggest that Tony DeMarco may be involved in a kickback-scheme where he caused and benefited from exorbitant charges from Smith Company to Jones Company for outsourced machine work. Accordingly, we recommend that CPI’s corporate security department work with law enforcement to continue this investigation.

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Appendix A – Preliminary Fraud Investigation Report

To: From: Date: Re: Subject:

IASCF 123 Chad Collins, CPI Internal Audit January 13, 2009 Tony DeMarco Financial Statement Analysis

Synopsis A vertical analysis of the last three years shows that the gross profit was 40% for the first two years but dropped to 25% in the third year. A horizontal analysis indicates that cost of goods sold increased significantly in the third year. Thus, the horizontal and vertical analysis indicates that the decreased net income and profit margin are due to an increase in cost of goods sold. Details
Inc Stmt/Ret Earnings Data Net sales Cost of goods sold Gross profit Selling expenses Consulting fees Depreciation and amortization Total expenses Net income Beginning retained earnings Dividends Ending retained earnings Year 3 $ % 12,985,364 100.0% 9,739,023 75.0% 3,246,341 25.0% 259,707 2.0% 129,854 1.0% 289,179 2.2% 678,740 5.2% 2,567,601 19.8% 5,891,772 45.4% 1,000,000 7.7% 7,459,374 57.4% Vertical Analysis Year 2 $ % 11,985,632 100.0% 7,191,379 60.0% 4,794,253 40.0% 239,713 2.0% 119,856 1.0% 293,178 2.4% 652,747 5.4% 4,141,506 34.6% 2,750,266 22.9% 1,000,000 8.3% 5,891,772 49.2% Year 1 $ % 10,895,687 100.0% 6,537,412 60.0% 4,358,275 40.0% 217,914 2.0% 108,957 1.0% 281,138 2.6% 608,009 5.6% 3,750,266 34.4% 0 0.0% 1,000,000 9.2% 2,750,266 25.2%

Horizontal Analysis Year 2 to 3 Year 1 to 2 Change % Change % Net sales 999,732 8.3% 1,089,945 10.0% Cost of goods sold 2,547,644 35.4% 653,967 10.0% Gross profit (1,547,912) -32.3% 435,978 10.0% Selling expenses 19,995 8.3% 21,799 10.0% Consulting fees 9,997 8.3% 10,899 10.0% Depreciation and amortization (3,999) -1.4% 12,040 4.3% Total expenses 25,993 4.0% 44,738 7.4% Net income (1,573,905) -38.0% 391,240 10.4% Beginning retained earnings 3,141,506 114.2% 2,750,266 (a) Dividends 0 0.0% 0 0.0% Ending retained earnings 1,567,601 26.6% 3,141,506 114.2% (a) percentage not computed because denominator is 0. Inc Stmt/Ret Earnings Data

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Appendix A – Preliminary Fraud Investigation Report

To: From: Date: Re: Subject:

IASCF 123 Chad Collins, CPI Internal Audit January 15, 2009 Tony DeMarco Ted Jones Interview

Synopsis Initially thinking that the reduced margin might have been due to increased consulting fees paid to Ted Jones, the former owner of Jones Company, Chad Collins interviewed Ted Jones at 10:00 am on January 15, 2009 via telephone. Ted Jones indicated that the only way to analyze the results was to analyze job reports. Details Ted Jones explained that his consulting fees were directly related to sales. This was confirmed by the vertical analysis (see page 2). Jones explained that his fees related to the transfer of knowledge related to the type of parts that Jones Company’s customers require. Jones further explained that the job-cost system is the primary tool used by management to plan, organize and control costs at Jones Company.

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Appendix A – Preliminary Fraud Investigation Report

To: From: Date: Re: Subject:

IASCF 123 Chad Collins, CPI Internal Audit January 16, 2009 Tony DeMarco Job Report Analysis

Synopsis An analysis of the job summary report indicated that twelve jobs had negative profit margins. An analysis of the detailed job reports for these twelve jobs identified large charges for outsourced machining. A review of the line item detail for the outsourced machining indicated that the majority of the outsourced machining charges were associated with the same vendor, Smith Company. Details
Jones Company Job Detail Report Direct Material 1,307 1,322 1,327 1,324 1,314 1,335 1,338 1,324 1,307 1,342 1,211 1,324 Direct Labor 9,151 9,254 9,295 9,268 9,202 9,347 9,360 9,268 9,149 9,400 8,481 9,268 Machine Hours 12.0 11.0 9.0 6.0 14.0 15.0 32.0 84.0 3.0 59.0 2.0 16.0 Outsourced Machining 9,151 9,254 9,295 9,268 9,202 9,347 9,360 9,268 9,149 9,400 8,481 9,268 Applied Overhead 6,537 6,611 6,639 6,620 6,573 6,677 6,686 6,620 6,536 6,714 6,058 6,620 Total Cost 26,146 26,441 26,556 26,480 26,291 26,706 26,744 26,480 26,141 26,856 24,231 26,480

Job 1 26 51 101 126 151 176 201 226 251 276 301

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Appendix A – Preliminary Fraud Investigation Report

To: From: Date: Re: Subject:

IASCF 123 Chad Collins, CPI Internal Audit January 19, 2009 Tony DeMarco Ted Jones Interview 2

Synopsis Not sure who Smith Company was or the nature of their outsourced work, Chad Collins interviewed Ted Jones at 9:00 am on January 19, 2009 via telephone. Ted Jones indicated that he did not know who Smith Company was. He further indicated that for what Smith Company was charging; Jones Company would be better off buying the necessary machine and doing the work in-house. Details Ted Jones explained that Jones Company only outsources machining when they cannot justify the cost of doing the work in-house. He further explained that it is normal for Jones Company to outsource machining for new parts until they know the demand for the part justifies investing in a new machine. In the case of the machine work outsourced to Smith Company, Jones Company would normally have purchased a machine based on the demand for parts and the charges paid to Smith Company.

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Appendix A – Preliminary Fraud Investigation Report

To: From: Date: Re: Subject:

IASCF 123 Chad Collins, CPI Internal Audit January 20, 2009 Tony DeMarco Public Records Search

Synopsis A public records search indicated that Jones Company’s production manager, Tony DeMarco is an officer of Smith Company. Details After discussing the charges from Smith Company to Jones Company for outsourced machine work with Barb Jones, Chad Collins performed the following procedures: 1. Reviewed Jones Company data to determine which vendor Jones Company used prior to Smith Company for the same type of machine work. 2. Reviewed the vendor file for Smith Company. 3. Performed a public records search for Smith Company. Chad discovered that the vendor Jones Company used before Smith Company charged 50% less than Smith Company for the same machining operation. He also discovered that Jones Company paid Smith Company more than $2,000,000 for outsourced machining in the last twelve months. The vendor file contained all the necessary documentation to establish Smith Company as a valid vendor; however, Smith Company was added as a vendor after CPI purchased Jones Company. The public records search identified Smith Company’s articles of incorporation. A review of the articles of incorporation indicated that Jones Company’s production manager, Tony DeMarco, is an officer of Smith Company (see Exhibit 1). Further investigation also showed that DeMarco approved payment of invoices submitted by Smith Company.

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Appendix A – Preliminary Fraud Investigation Report

To: From: Date: Re: Subject:

IASCF 123 Barb Reynolds, CPI Internal Audit January 23, 2009 Tony DeMarco Tony DeMarco Interview

Synopsis Based on the fact that Jones Company paid exorbitant fees to Smith Company, DeMarco is an officer of Smith Company and he approves payments to Smith Company, Barb Jones decided that it was necessary to interview Tony DeMarco. Chad Collins, Barb Reynolds and Tony DeMarco met in the DeMarco’s office at 10:00 am on January 23, 2009. The prior evidence and DeMarco’s demeanor in the interview suggest that Tony DeMarco may be involved in a kickback-scheme where he caused and benefited from exorbitant charges from Smith Company to Jones Company for outsourced machine work. Details Facts gained from the interview include: 1. DeMarco’s brother-in-law, Joe Thompson is also an officer of Smith Company. 2. DeMarco recently acquired an expensive cabin and boat. 3. DeMarco exhibited nonverbal cues suggested that he may be lying about having no involvement with Smith Company. The results of the investigation at this point suggest that Tony DeMarco may be involved in a kickback-scheme where he caused and benefited from exorbitant charges from Smith Company to Jones Company for outsourced machine work. Accordingly, Barb Reynolds will recommend that CPI’s corporate security department work with law enforcement to continue this investigation.

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Appendix A – Preliminary Fraud Investigation Report

Form BCA-2.1 CORPORATE NAME Smith Company Inc.

ARTICLES OF INCORPORATION

INITIAL REGISTERED AGENT Joseph Thompson PURPOSE FOR WHICH THE CORPORATION IS ORGANIZED The transaction of any or all lawful purposes for which corporations may be incorporated under the Illinois Business Corporation Act of 1983. AUTHORIZED SHARED, ISSUED SHARES, AND CONSIDERATION RECEIVED Class Common Number of Shares Authorized 10,000 Numbers of Shares Issued 6,000 Consideration Received $6,000.00

INITIAL OFFICERS President Secretary Treasurer Joseph Thompson Mary Thompson Anthony DeMarco

NAMES OF INCORPORATORS Joseph Thompson DATE FORMED July 25, 2006

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End Notes
1

Wells, J. T. (2007). Corporate fraud handbook: Prevention and detection (2nd ed.). Hoboken, New Jersey: John Wiley & Sons, Inc (pages 392-395). Albrecht, W. S., Albrecht, C. C., & Albrecht, C. O. (2006). Fraud examination (2nd ed.). Canada: Thomson Southwestern (pages 247-255). Robertson, J. C. (2002). Fraud examination for managers and auditors. Austin, TX: Viesca Books (pages 143-144). ACFE. (2005). Finding the truth: Effective techniques for interviews and communication. Austin: Association of Certified Fraud Examiners (pages 8-15). Albrecht, W. S., Albrecht, C. C., & Albrecht, C. O. (2006). Fraud examination (2nd ed.). Canada: Thomson Southwestern (page 17). Biegelman, M. T., & Bartow, J. T. (2006). Executive roadmap to fraud prevention and internal control: Creating a culture of compliance. Hoboken, New Jerseu: John Wiley & Sons Inc. (page 356). Albrecht, W. S., Albrecht, C. C., & Albrecht, C. O. (2006). Fraud examination (2nd ed.). Canada: Thomson Southwestern (Pages 308-309). Robertson, J. C. (2002). Fraud examination for managers and auditors. Austin, TX: Viesca Books (page 177). ACFE. (2005). Finding the truth: Effective techniques for interviews and communication. Austin: Association of Certified Fraud Examiners (page 130).

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