FORENSIC ACCOUNTING

Ponzi Schemes
In 1919 and 1920, Charles Ponzi operated an investment scheme
through his business, Securities Exchange Co., which promised
investors returns of up to 50 percent, purportedly to be earned from
investing in and arbitraging International Postal Union reply coupons. In
reality, after some initial success in his venture, Ponzi sustained losses
and to keep the scheme going, began repaying old investors with funds
provided by new investors. Although Ponzi was exposed, jailed, and
eventually exiled back to Italy, where he died penniless, his name lives
on to identify a kind of financial fraud that depends on claims of
astonishing profits to investors in the form of rates of return, on attracting
more and more new investors to provide the funds repaid to old
investors, and on a pyramid structure in which only the initial investors
and the sponsor of the scheme recover their investments and earn
profits thereon. Modern versions of Ponzi schemes may involve multiple
pledging of assets claimed to be security for the investors’ loans or other
investments, commingling of funds and diversion of cash collateral, and
fraud in the inducement to invest by:
• Mischaracterizing the nature of, and risks associated with, the
investment
• Overstating anticipated returns and misstating the security backing
up the investment
• Misstating financial statements by overstating investment returns
and operating results and/or understating losses
• Misrepresenting the success of the product, service, or financial
scheme upon which the investment is to be based
• Concealing losses and the failure of the scheme—at least for a time
—by paying out later investors’ monies to earlier investors

Bank Frauds
Although they are not usually investors in equity securities, banks invest
in loans to entities that are based at least in part on reliance upon the
financial statements and other financial information provided by the
borrower. Thus, fraudulent

financial statements may be used to defraud lenders just as they

defraud equity investors: usually by overstating a company’s financial
condition and results of operations. Several additional forms of fraud
may also affect lenders. Typically, they involve overstating the value of
collateral, pledging fictitious collateral, multiple pledging of assets as
security, and fraudulently conveying assets— against which loans were
made—to related parties, third parties, or other lending institutions.
In the special case of so-called floor-plan loans, a fraud can be
committed by manipulation of asset identification records,
misrepresentation of improperly converted assets as in transit, and the
kiting of cash collateral to use proceeds from borrowing on new,
securitized assets to pay off loans made against old assets—another
form of the PONZI SCHEME

Nearly 75 years ago, Judge (later Justice) Benjamin Cardozo

recognized in the important Ultramares decision the danger of exposing
auditors to “a liability in an indeterminate amount for an indeterminate
time to an indeterminate class” for “failure to detect a theft or forgery
beneath the cover of deceptive entries”— in other words, management
fraud. Cardozo held that under the rule of privity of contract (the
relationship between contracting parties), only the audit client could sue
accountants for negligent auditing and failing to detect a fraud. To allow
other parties to sue on such grounds, Cardozo warned, would make the
“hazards of a business conducted on these terms . . . so extreme as to
enkindle doubt whether a flaw may not exist in the implication of a duty
that exposes to these consequences.”
Since then, with each wave of corporate scandals reformers have
pushed, often with some success, to enhance the safeguards for
investors, and implementation of those safeguards has fallen principally
on the shoulders of the accounting profession. From one perspective,
many of those measures aimed at closing

1. Ultramares Corp. v. Touche, Niven & Co., 255 N.Y. 170, 179; 174
N.E. 441, 444 (1931). The fraud in this case involved posting to the
general ledger a fictitious entry of more than $700,000 in accounts
receivable, thereby more than doubling the true amount of accounts
receivable.
The so-called expectations gap between the auditor’s legal
responsibilities and the widespread public belief that the audit process
should provide absolute assurance against financial fraud and
misstatement. Through the years, new rules have sought to redefine the
auditor’s role and make it easier in certain instances for people to seek
recovery from auditors for alleged injuries resulting from failures to
detect management fraud or financial misstatement.

Every company manoeuvres the numbers to a certain extent to achieve

budgets and get bonuses. This is nothing new. But sometimes
companies take the fact-fudging too far. Factors such as greed,
desperation, immorality and bad judgment drive some executives
to corporate fraud.

Enron, Aldelphia and WorldCom are extreme examples of companies

who cooked the books. They are the few bad apples that get all the
headlines. Most companies are run by ethical people. They may bend
the rules, but few take the process to the extremes of Enron or
WorldCom - companies that claimed billions in assets but promptly went
bankrupt when their false claims were exposed.

What can you do to protect your investments from Enron-style

disasters? You need to learn the basic warning signs of earnings
manipulation. While the details are usually hidden - even from the
accountants - learning these money-manipulation methods will keep you
alert to companies who may be cooking the books: