By Ron Klein

Subject: Incrementalization

Services: Review

Ernest Newton, CPA, is engaged by Hank Legerdemain to do some basic accounting work and tax return preparation. By all appearances, Legerdemain is the successful owner of Quantum Leap Investments, which specializes in producing high returns for investors by re-investing funds in the second-trusteed housing market.

During their first meeting, Legerdemain tells Newton that he wants the CPA to do some work for two side businesses of Quantum Leap. “We’ll see how this relationship goes,” Legerdemain says, implying that the bulk of Quantum Leap’s accounting work will be Newton’s if it goes well.

He asks Newton to “clean up” the books of the side businesses. Newton proceeds with the job, and notices a lot of wire transfers of funds between Quantum Leap and the side businesses. He puts them in a suspense account, asks the controller about them, and is told that they should all “zero out” at the end of the period. When the period ends,Newton’s books show $3.67 million in and $3.75 million out, an $80,000 difference.

Legerdemain is visibly upset by the news, says he is “fed up” with the previous accountant, and asks Newton for advice. The CPA recommends a process for balancing the books, but he never finds out why funds are being transferred back and forth from Quantum Leap to the side businesses.

Legerdemain later asks Newton to do all the accounting work for Quantum Leap. A few months go by, and Newton is still seeing transfers between Quantum Leap and the side companies. The news precipitates a heated argument between Legerdemain and his junior partner about helping Newton clean up the financial processes. Eight months later, Newton is finally able to issue a clean review of the financial statements.

Soon after that, the company collapses. An investigation shows that Quantum Leap was a Ponzi scheme using the side companies to move funds from new investors to earlier investors. Newton is named in the lawsuit filed by investors in an attempt to reclaim their investments.

Loss Prevention Tips

Screen new clients carefully. Client screening is now, more than ever, a vital process for CPAs and one of the most effective risk-management techniques. Do not attempt to judge a potential new client based on the appearance of success, but take the time to talk with the predecessor accountant regarding their experiences with the client. Also, consider the use of third-party credit checks. For example, Camico has an arrangement with Scherzer & Company to offer background services at reduced rates to policyholders.

Do not forget the importance of exercising your own professional skepticism in evaluating the reasonableness and appropriateness of your client’s activities. Although professional standards may indicate that you have no responsibility in the services you render to detect embezzlement or other fraudulent activities, juries may take a very different viewpoint.

Document! In addition to the engagement letter, CPAs need to be diligent about documenting items of significance. Significance is best defined in hindsight, so it is important to document abundantly. The failure to document conversations, decisions and actions is a grave mistake many CPAs make; juries will not usually give the CPA the benefit of the doubt.

Beware of “incrementalization”! Fraudulent clients are experts at concealing activities, falsifying documents and conspiring with others to slowly but surely acclimate accountants to substandard and illegal conduct.