- By Joseph Ammirati
- March 21, 2023
Are your client’s losses due to a downturn in the economy, obsolete products, poor management or fraud? These are the questions that Board of Directors, upper management, investors, external auditors, and attorneys need to ask if there are observed abnormalities or unexplained losses in a company’s financial statements.
In situations where fraud is suspected, utilizing the services of a forensic accountant can be prudent. Forensic accounting is simply defined as the intersection of accounting and the law.
Forensic accounting is the application of financial principles and theories to facts at issue in a legal dispute and consists of two primary functions:
- Litigation Advisory Services, which recognize the role of the forensic accounting professional as an expert or consultant.
- Investigative Services, which makes use of the forensic accounting professional’s skills and may or may not lead to court room testimony.
Forensic accounting professionals provide technical, educational, functional, and industry-specific services to financial statement fraud cases.
Questions often asked are, what is the difference between external auditors and forensic accountants? Isn’t it the external auditor’s job to uncover the fraud? Why can’t the auditors provide absolute assurance that no fraud is occurring?
External auditors cannot guarantee that the financial statements they audited are entirely free of material misstatement. Auditors cannot provide absolute assurance for two reasons:
- The nature of audit evidence – Auditors test only selected data. They do not audit all subsidiaries, divisions, accounts or transactions as it is not economically feasible.
- The characteristics of fraud, particularly fraud based on collusion among management or falsified documents are problematic for auditors to see.
Forensic accounting and traditional auditing have commonalities yet there are some distinct differences between the two.
Commonalities include:
- Knowledge of the industry and the company, including its business practices and processes
- Knowledge of the generally accepted accounting principles
- Interpretation of business documents and records
- Independence and objectivity
It is important to understand that Audits are not the same as forensic accounting investigations. Statement on Auditing Standards No. 1 states, the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. This statement establishes standards and provides guidance to auditors in fulfilling that responsibility, as it relates to fraud, in audit of financial statements conducted in accordance with generally accepted auditing standards.
Forensic accountants on the other hand, provide more investigative services. The scope is more defined depending on the case requirements. In addition, forensic accountants are consistently evaluating and interpreting documents relating to the assignment and utilizing specific financial forensic tools and techniques as part of their analysis and ultimate conclusion.
Forensic accountants must have three major skill sets:
- Technical competence – Requisite accounting and auditing skills as well as a knowledge in certain areas of law and research.
- Investigative – Knowledge in collecting, analyzing and evaluating of evidential matter and critical thinking ability.
- Communication skills (verbal and written) – The forensic accountant must be able to communicate and present their findings in a way that is easy to understand and supported by facts.
One skill set that usually clearly separates the forensic accountant from the tradition accountant or auditor is the level of professional skepticism. Professional skepticism is the ability to recognize that a fraud may be present and having the attitude that includes a questioning mind and a critical assessment of the evidence.
Auditing standards state that the main difference between fraud and error is intent. Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements.
Fraud on the other hand includes four essential elements:
- A materially false statement is made.
- There is knowledge that the statement was false when it happened.
- There was reliance on the false statement by the third parties and/or the victim(s).
- Damages resulting from the third party or victim’s reliance on the false statements.
Three major categories of fraud are as follows:
- Asset misappropriation which involves the theft or misuse of a company’s asses. Examples include stealing inventory, skimming cash or payroll fraud.
- Corruption which entails abuse of influence to achieve a desired result such as receiving illegal kickbacks or bribes.
- Financial statement fraud which involves the intentional misrepresentation of financial and non-financial information to mislead those relying on the financial statements to make economic and management decisions. Massive financial statement fraud includes intentional inappropriate or unauthorized journal entries or unsubstantiated adjustments of amounts reported in the financial statements.
One of the basic investigative techniques utilized by forensic accountant is identifying red flags which are defined as a warning signal or something that demands attention or provokes an irritated reaction.
Red flags may be divided into the following categories: (1) accounting anomalies, (2) internal control weaknesses, (3) identified analytical anomalies where non-financial data does not correlate with the financial data (e.g. substantial losses in a booming economy), (4) observed unusual behaviors by management/employees, and (6) whistleblower tips.
Beside observing red flags, the forensic accountant also needs to understand the fraud risks that might be present in the company being analyzed. Fraud risk factors generally fall into three categories:
- Motivational – Is management focused on short term results or personal gain?
- Situational – Is there ample opportunity for fraud?
- Behavioral – Is there a company culture for a high tolerance of risk?
As mentioned, the biggest difference between fraud and error is intent. Intent must be grounded in the evidence. In a fraud case, the challenge is that short of a confession, evidence of intent tends to be circumstantial. The elements of fraud include the act (e.g., fraud act, tort, breach of contract), the concealment (hiding the act or masking it to look like something different) and the conversion (the benefit to the perpetrator).
In a forensic accounting examination, evidence is usually gathered in a manner that moves from the general to the specific. In the case of financial statement fraud, the forensic accountant starts with the suspected perpetrator. This is because the forensic accountant is assuming the person knowingly created false financial statements.
The power of using non-financial data to corroborate financial information cannot be understated. What is non-financial data? It is data from any source outside of the financial reporting system that can be used to generate an alternative view of the business operation. Non-financial data may include payroll hours, employee records, complaints, shipping records and dates.
Before any forensic accounting examination begins, the forensic accountant needs predication. Predication is the totality of circumstances that would lead a reasonable, professionally trained, and prudent individual to believe a fraud has occurred, is occurring, and/or will occur. An anonymous tip or complaint is a common method for uncovering fraud and is generally considered sufficient predication. Mere suspicion, without any underlying circumstantial evidence, is not a sufficient basis for conducting a forensic accounting examination.
For further information on MPI’s Forensic Accounting Services, please visit www.mpival.com/services/commercial-litigation-forensic-accounting
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