Tyco's Forensic Audit Poses Serious Risk

The forensic accounting investigation at Tyco International Ltd. (TYC) poses substantial risk for investors betting that the allegations of corruption against former chairman Dennis Kozlowski did not infect the rest of the sprawling conglomerate.

"Adding a forensic investigation into the mix, the risk increases 10-fold," said Tom Carlucci, head of Foley & Lardner's West Coast white collar fraud practice.

"They're always going to find something," Carlucci said. "Every investigation I did as a prosecutor, you have a particular target, but it always branches off because something else gets your interest. And that's what is going to happen with a forensic accountant."

Forensic accountants recently hired to inspect the financial plumbing of Tyco may find small irregularities that the company's outside auditor looked past as immaterial, said Larry Crumbley, editor of the Journal of Forensic Accounting.

"A fraud auditor actually will look for these small errors and irregularities because that may give us a modus operandi of a corrupt executive," Crumbley said. "What the forensic auditor is doing is looking for the tip of that fraudulent iceberg."

"You go in there and you don't trust anything," added Crumbley, the KPMG professor of accounting at Louisiana State University. You're very suspicious. You sort of assume the person is guilty."

While the word forensic conjures up images of death and gore, forensic accountant Bill Kauppila sees his craft as "coming up with the story behind the story."

Tyco says the fraud alleged against Kozlowski and other former senior leaders does not require material adjustments to prior financial statements.

Investors and some analysts have embraced this as a sign that Tyco's underlying businesses were decentralized and not tainted by senior management. They're hoping that Kozlowski's nearly 30 years at Tyco did not put an indelible stamp on a conglomerate with more than 2,000 subsidiaries.

Tyco Chief Executive Edward Breen has brought in forensic accountants from Urbach Kahn & Werlin to clear the air over Tyco's accounting, which has been the subject of persistent suspicion. Critics claim Kozlowski used a decadelong acquisition spree to artificially boost earnings.

Superstar lawyer David Boies is overseeing the internal investigation, and Carlucci said the Boies team won't tread lightly.

"They're going to crack heads," Carlucci said.

Tyco shares, which closed at $14.96, a slide of 2.2 percent on Friday, have climbed from a near 6-year-low of $7 since Breen took over July 25 and initiated several housecleaning moves. Still, more than $80 billion in market capitalization has been erased at Tyco this year.

The stock's steady climb has abated for now as Wall Street awaits the results of the forensic review, which is expected sometime this fall.

The job of Tyco's longtime outside auditor, PricewaterhouseCoopers, has been to ensure the company's accounting follows generally accepted accounting principles.

"They don't really look for fraud," Crumbley said. "In the past, (outside auditors) have not been very suspicious."

Brad Bennett, a former SEC lawyer, said the U.S. agency will look closely at the working papers exchanged between company management and PricewaterhouseCoopers.

"They'll want a pretty good explanation for why millions of dollars in expenses (for luxury items) flew under the audit," said Bennett, who now defends clients against fraud claims.

Kozlowski is accused of spending Tyco's money on a $15,000 dog umbrella stand, for example. In many cases, it appears Kozlowski easily overrode Tyco's internal controls to award millions in unauthorized bonuses.

"The forensic accountant is more behavioral," Crumbley explained. "They get out and listen to employees. Do the bosses at the top encourage you to do ethical things, or pump up profits?"

Forensic accountants also follow the paper trail of individual transactions, looking at the debits and credits in a journal entry while questioning their validity.

"A normal accountant may assume an invoice is correct," Crumbley said. "A forensic accountant may say, 'Maybe this is a fake invoice.

"Finding fraud is like taking a metal detector to a garbage dump looking for rare coins," he said. "You're going to find a lot of junk out there."