Forensic accounting

DEFINITION: Profession that interweaves accountancy, auditing, and other investigative skills to assist in criminal investigations and prosecutions, legal defenses, and valuation cases.

SIGNIFICANCE: In the prosecution of white-collar crime, forensic accountants and auditors provide accounting analyses to courts. Practitioners of forensic accounting who serve as expert witnesses must be able to communicate complicated accounting data to judges and juries in a clear and concise manner. In addition to criminal fraud and embezzlement cases, forensic accounting is often important in divorce cases, business valuation disputes, insurance fraud cases, cases involving accusations of professional negligence, and partnership disputes.

Forensic accounting is accounting or auditing that provides results suitable for use in a courtroom. Forensic accounting is so thorough and so provable that in the accountant’s or auditor’s professional judgment, a conclusion can be reached regarding the accounts that would be sustainable in a court of law or within a judicial or administrative review (the latter would include events involving mediation or arbitration).

The findings of forensic accountants are based on the scientific evaluation and interpretation of the in the books and records (such as journals and ledgers) of accounting systems. The usual objective of a forensic audit is to ascertain whether deception or fraud has been introduced into the accounting records. In a sense, all auditors and tax preparers are forensic accountants because they deal with either protecting the investment public or seeing that people pay their proper taxes. The formal phrase “forensic accounting,” however, is usually reserved for accounting cases in which the accountant’s work has to hold up to legal scrutiny. In such cases, the accountant seeks a level of evidence that will be sustainable within the judicial framework. It has been said that accountants look at the numbers, whereas forensic accountants look behind the numbers. Forensic accountants combine accounting skills with investigative skills.

Forensic Accountants and Their Jobs

The work of forensic accountants is scientific and detailed; many practitioners who find the work enjoyable liken it to putting together a puzzle. Forensic accountants use their skills to determine whether accounting records mirror economic reality, and when the records do not match the events, the courts are interested. Forensic accountants are involved in both criminal and civil cases, but the criminal cases have tended to be those in the media spotlight.

Forensic accountants are typically certified public accountants (CPAs) in the United States and chartered accountants (CAs) in Canada and Great Britain. They also often hold another certification—that of certified fraud examiner (CFE). Such accountants specialize in engagements where there is a need for evidence to support a case in court. Examples include investigating suspected embezzlements by employees, bankruptcy fraud, arguments in matrimonial divorce cases, and identification and valuation of assets in probate.

Falsifications and fraud in accounts or the valuation of inventories are also common engagements for forensic accountants. For example, a bank might hire a forensic accountant to determine whether a bankrupt debtor overstated personal inventories for purposes of getting a loan. One spouse seeking a divorce might hire a forensic accountant to determine whether the other spouse’s business is worth more than the firm’s accounting records indicate. Creditors will sometimes hire forensic accountants to reconstruct transactions to be sure that bankrupt individuals have not tried to hide assets or otherwise make fraudulent conveyances of assets. Occasionally, the owner of a shopping mall will hire an accountant to conduct a forensic investigation to determine whether tenants in the mall are paying the appropriate amount of rent, when such rents are based on each store’s sales levels. Similarly, publishers sometimes undergo “royalty audits,” in which forensic accountants determine whether the publishers are paying the proper royalties to their authors. Forensic accountants may also be involved when partnerships are dissolved or corporations are liquidated, as such situations often lead to disputes concerning the allocation of assets.

Sometimes forensic accountants provide litigation support services to quantify economic damages. For example, an accountant might testify in court regarding the calculation of economic loss resulting from a breach of contract or the economic loss from the breach of a noncompetition agreement. Loss quantification from professional negligence is also an area of practice for forensic accountants.

Essentially, a forensic accounting engagement is any engagement that involves providing an accounting or auditing analysis that is suitable for presentation to a court and will provide the basis for debate and ultimate dispute resolution. The work of forensic accountants includes obtaining documentation needed to support or refute claims, reviewing documentation to identify areas of loss, assisting attorneys in formulating questions to be asked regarding financial evidence, evaluating the opposing expert’s damages report to evaluate the weaknesses and strengths of the positions taken, assisting with negotiations, and providing assistance with cross-examination.

In addition to investigating and analyzing financial evidence, forensic accountants must be able to communicate their findings in the form of reports, exhibits, and collections of actual documents. Such findings are presented to courts or in other legal proceedings. Forensic accountants must thus be familiar not only with accounting and auditing techniques but also with legal concepts and procedures, including rules of evidence. The reports written by forensic accountants are designed to present evidence in a concise and professional manner.

Occupational Fraud and Forensic Accounting

Although occupational fraud, and the forensic investigation thereof, has been around for thousands of years, forensic accounting has only truly become a growth area for accounting firms since the mid-1980s. Media attention has given forensic accounting a somewhat glamorous aspect that it did not previously have. Numerous cases of corporate fraud, ranging from embezzlement by a single employee to organized attempts to defraud thousands of shareholders, have been uncovered by forensic auditors, and their work has been widely publicized in the popular media, leading increased numbers of people to pursue careers in the field. The media coverage reached a peak in 2002 when Time magazine named three forensic auditors as joint Persons of the Year.

Occupational fraud falls into three categories: asset misappropriation, which usually involves employees stealing company assets; corruption and bribery, wherein employees use their positions within companies for personal gain (for example, a bank president might make a loan to a friend at a below-market interest rate and then accept a kickback from the friend); and fraudulent financial statements, wherein accounting records are manipulated to make companies look better financially than they really are. This last technique is sometimes employed by unscrupulous corporate executives who want to receive larger bonuses or who own stock in their companies and want the market price of their stock to increase. The cases that receive the most news coverage are often of this type. For instance, the discoveries of fraud at Enron Corporation in 2001 and WorldCom in 2002 were made by forensic accountants who observed that the corporations’ accounting records did not seem to mirror economic reality. The auditors at these two companies were among those honored in 2002 by Time.

Corruption and bribery are among the most difficult types of crimes for forensic accountants to uncover because these are off-the-books crimes. In other words, the accounting records are accurate because the perpetrators are receiving bribes or kickbacks that never go through their companies. Such cases are usually solved only with the help of tips from outsiders. For instance, a person who has been paying kickbacks to a corrupt employee may get tired of making the payments and so may blow the whistle on the employee. Sometimes corruption can be as simple as conflict of interest, such as when employees have undisclosed financial interests in transactions that adversely affect the companies for which they work.

Red Flags

Forensic audits sometimes uncover clues, often referred to as "red flags," in accounting records that indicate something is amiss. A red flag can be something as simple as a large discrepancy between what an employee earns and the amount of property that person owns. For example, if a company cashier earns $40,000 a year but lives in a million-dollar house and drives a $100,000 automobile, the auditor should be alert to the possibility that the cashier is stealing from the employer, although an alternative explanation may exist for how the employee can afford the high-priced home and car. That is the nature of a red flag: it does not necessarily indicate fraud, but it does alert the auditor to look at the situation more closely. In this example, a good auditor would try to determine where the cashier got the money for the house and car; perhaps it was from an inheritance or some other legitimate source. If no alternative explanation can be found, the auditor needs to examine the ledgers closely for fraudulent entries.

Another red flag is if an employee begins receiving visits or phone calls from bill collectors or collection agencies. Auditors become especially alert when they learn that employees are having trouble making ends meet, because this can mean the employees may be tempted to embezzle. Auditors also may inquire as to which employees regularly visit casinos and racetracks. If employees are gambling, they are probably losing money, and if they are losing money, it may be the company’s money they are losing. Forensic auditors sometimes visit gambling establishments simply for the purpose of looking for employees of the companies they are investigating, particularly those employees who deal with cash.

Other red flags include instances of missing documentation. When an auditor asks for a particular invoice and that invoice is not in the files, it indicates a problem—either someone is trying to hide that transaction, or the company’s filing system is inefficient. Given that mistakes happen, auditors always try to satisfy themselves by alternative means when documents turn up missing. Shortages of cash in cash drawers are often a sign of embezzlement, but auditors are also cautious when there is an overage in a cash drawer: perhaps the cashier has figured out how to hide a theft (juggled the books) but has not yet stolen the money. An overage can be just as important a red flag as a shortage of cash.

One thing that forensic auditors always check is whether any vendors’ addresses match any employees’ addresses, because matches may indicate that employees have figured out ways to have company checks sent to themselves. Such comparisons are easy to make in computerized systems.

Another possible red flag is the refusal of employees to take vacations. Sometimes employees who are defrauding their companies must be at work every day to keep hiding their activities, so in some cases, employees who are praised because they never take vacations or sick time turn out to be their companies’ biggest crooks. Similarly, employees who are always volunteering to work overtime may seem incredibly loyal to their companies, but in reality they may be working the extra hours to perpetuate their fraud schemes.

Sociological Aspects of Forensic Auditing

Forensic auditors must always consider the sociological aspects of fraud perpetrators’ work. Employees typically need reasons to steal from their employers. Sometimes they steal from employers after learning that coworkers are paid more than they are, justifying their theft as “equalizing” their salaries with those of others.

Psychologists say that most people who perpetrate fraud try to rationalize their actions. In many cases, the extended illness of a spouse or child is given as the reason for committing fraud. In other instances, addictions to drugs, gambling, or pornography can lead people to commit fraud. Some people who become involved in embezzlement rationalize that they are only borrowing the money and will pay it back in the future.

In some instances, the fraud perpetrated by employees is not financially based. Such cases are often the most difficult to discover because they do not raise the typical red flags that could indicate problems.

Bankruptcy and Divorce Cases

Although lacking the glamour of occupational fraud cases, bankruptcy and divorce cases have long been mainstays of the field of forensic accounting. Bankruptcy fraud results when a person filing for bankruptcy protection files false financial information on the bankruptcy petition. A similar kind of fraud also occurs in matrimonial divorce cases. In both types of proceedings, a person’s assets are taken away and given to others, so an incentive exists for that person to commit fraud when preparing financial statements.

Because transferring assets to offshore bank accounts or to friends is a common ploy in both bankruptcy and divorce cases, bankruptcy trustees and creditor committees often hire forensic accountants to investigate for fraudulent transfers of assets. In fact, CPAs and CFEs may even serve as trustees or on creditor committees in bankruptcy cases.

In some cases, a bankruptcy is legitimate, but it was brought on by fraudulent activity. In other words, the bankrupt person may have stolen the assets long before bankruptcy was contemplated. In such a case, the forensic accountant would concentrate on the earlier period, whereas an accountant concerned with fraudulent transfers would normally look only at the period starting one year before the time of the court filing.

In divorce cases, the party alleging fraud will hire a forensic accountant to determine whether the other party made fraudulent transfers of assets prior to the divorce proceedings. The accountant then has to testify in court as to the nature of any hidden assets found in the audit. Divorce fraud cases are typically civil cases, but criminal charges can be filed if the fraudulent act is egregious.

Assets can be fraudulently transferred prior to a bankruptcy or divorce in many different ways. Inventory or other assets may be sold at greatly reduced prices, but with the agreement that the seller can buy back the assets after the court proceedings. Failing to record sales and receipts of cash can also hide assets. A debtor or divorcing party might make payments to fictitious individuals, writing checks that are in reality deposited in offshore bank accounts. Conspiring vendors may send fraudulent invoices and then credit the payments to the account of a debtor, with eventual repayment after the case has been closed.

In some cases of bankruptcy and divorce fraud, the perpetrators destroy all of the books and records to hide their fraudulent actions. In such instances, forensic accountants have to reproduce the original journals and ledgers as completely as possible.

Bibliography

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