How to audit a known fraud;

              HOW TO AUDIT A KNOWN FRAUD
by NORMAN C. GROSMAN
The magnitude of the Equity Funding fraud had not been seen in the American economy since the days of McKesson and Robbins in the mid-30's. Actually, to begin the reorganization of a company with a fraud as pervasive as this one is beyond the experience of most professionals in today's business world—be they accountants, attorneys, trustees, or anyone else.
The fraud continued for at least nine years. All of the mechanisms of regulation and scrutiny, including annual audits, did not uncover what was going on. It came to light because a disgruntled former employee talked to a securities analyst. How much longer the fraud might have continued is very problematical. It seemed that it could not have lasted very much longer, but I suspect that anyone looking at the situation two to three years before would have said the same thing.
The case was originally billed as a sophisticated computer and insurance fraud. Really.it was neither of these. It would be more accurately characterized as an ordinary securities fraud. Ordinary in the sense that the motivation was one of inflation of earnings to provide the basis for increased stock prices. The purpose of the fraud was to create artificial values for the stock. The other aspects of it developed during the later years of its existence.
In talking about Equity Funding as a securities fraud, it is necessary to understand that the illegal acts started before the company ever went public in 1964. The wrongdoing, as best as can be determined, was premeditated. In other words, it was planned to inflate earnings, to increase the price of the stock. It is unique of course in the length of time during which it continued. It is also probably unique in its pervasiveness. Most other cases seem to have been limited to a few major transactions, usually involving a limited number of people. In Equity Funding's case, however, there was direct involvement of at least 15 people. And the misrepresentation was not limited to a few transactions but involved the basic operating accounts of Equity Funding.
From the initiation of the fraud through at least 1969, the procedure was highly simple, took very little time, and involved little effort to cover-up. The basic fraud during this period was achieved through regular accounting entries-increasing both accounts receivable and commission
income. It was one accounting entry a month, or one accounting entry a quarter. There was no computer involvement at all.
As the fraud developed, it was expanded into the Equity Funding's insurance operations, through the creation and reinsurance of fictitious insurance policies. Since this required significant detailed support, the use of the computer became important.
But the use of the computer in the Equity Funding operations was still not extensive compared to its use in today's business. While certain fictitious information was maintained on the computer, none of it was inputed on a regular basis. The information that was added to the records was done off-line. It did not involve any special technology, or any unusual programming. It did, however, require a lower level of controls and less systems integration than one would ordinarily expect.
Part of the nature of the fraud was that it had to increase in magnitude in order that the company could show increased earnings. Thus, increasing amounts of fictitious income had to be created. The company was in an extremely tight cash position at the time of the discovery of the illegal acts, and it undoubtedly had similar problems in the past as well. This required the continual raising of additional capital and additional borrowings. How much longer all this could have continued is unclear,
The fraud got its first major publicity at the end of March, 1973, when an extensive article appeared in the Wall Street Journal. A day or two after this disclosure, the Touche Ross office in Los Angeles received a phone call from a law firm in our city asking us if we would be interested in becoming the auditors for Equity Funding. We met with the law firm and with the judge and were appointed as auditors on April 2, The company went into Chapter X reorganization on April 5, 1973 and we were reappointed as auditors to the company under the Chapter X proceedings. We were actually appointed before the trustee. This was an unusual situation, but it was necessary because of the extent of the fraud, the publicity that was given to it, and the need for some work to be done immediately.
When we started our work, senior audit personnel from the California and Illinois insurance departments were
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