Forensic Audits
1 Introduction
The word ‘forensic’ is found in the terms:
forensic accounting - involves the application of accounting knowledge and skills
forensic investigation - the process of gathering evidence
forensic audit - the application of traditional audit procedures and techniques in a forensic investigation
In all cases it implies investigating a company’s or person’s financial affairs for legal purposes - in both civil disputes and criminal matters. The investigation might be related to a real or suspected fraud, quantifying an insurance claim, estimating the effects of professional negligence and discovering the assets owned by individuals (such as the proceeds of crime hidden away by a criminal or assets owned by a party to a failed marriage).
For the rest of the chapter, we will simply refer to ‘forensic auditing’.
2 General nature of the work
Often, but not always, the work performed by the forensic accountant will be used as evidence either in a criminal or civil case. Often the accountant will appear as an expert witness and be subjected to cross-examination. Prosecutions or civil claims are invariably defended and the accountants and their work will be expertly challenged by the legal representative of the defendant. Any shortcoming or flaws in the accountant's work will be picked on in an attempt to undermine the whole case. It is therefore very important that the accountant’s work, records, findings and conduct are of the highest quality so that their evidence is as solid as possible. It would, for example, be harmful to a case if an accountant alleged a finding that could not be substantiated. If the accountant cannot justify one statement, doubt is cast on them all.
However, although the accountant will be hired by one or other side of the dispute, the accountant must show integrity (eg not hiding evidence that is useful to the other side) and objectivity (eg drawing fair and reasonable conclusions about the value of inventory lost in a fire). The accountant is and should be seen as a servant of the court and should help the court to discover the truth as far as possible. The accountant should beware of becoming an advocate for one side of the dispute.
Forensic work is of a specialist nature which requires professional competence and due care. For example, there are considerable skills needed in questioning suspects in a fraud case. Specialist skills are needed to trace money as it passes through various bank accounts and various countries in a money-laundering case.
3 Planning
As for all assignments, planning is essential. In addition, because each piece of forensic work will be unique, it is essential to agree with the client exactly what work is required.
Planning will start with a planning meeting where the following will be discussed:
The nature of the investigation and why it is required (eg fraud, money laundering, loss estimation).
The type of report(s) needed (eg quantifying the fraud, finding out how it was perpetrated, determining who was involved and for how long it went on). Remember that an engagement to perform agreed-upon procedures will report factual findings - no assurance opinion is given.
Agreement that the investigation team will have full access to whatever documents, information, personnel and explanations they need.
What work has been done already. For example, has the fraud mechanism been understood and stopped? Have the police been involved?
If the investigation work is likely to become evidence in a court case, the accountant will need to ensure that it is of the highest quality.
Determine who will receive the completed report.
When can the investigation start? By when is the report needed?
Some preliminary documents might be asked for, such as any insurance policy that might compensate for negligence payments, losses through fraud or fire.
If the client is not an audit client, then the amount of work that has to be done will be somewhat greater. For example, whereas auditors will have documented the accounting system and this might give insights as to how a fraud was perpetrated, if the investigating accountants are not the auditors they will have to start by documenting relevant parts of the system, getting to understand the nature of the business and the reporting structures within it.
4 Investigation procedures
Investigation procedures depend on the specifics of the engagement. In the AAA exam, the scenario will give you pointers that you need to pick up on to suggest appropriate procedures. The following are some examples to give you ideas only – do not learn them.
4.1 Insurance claim
Review a copy of any police report filed for details recorded soon after the loss.
Review the insurance policy to determine ‘coverage’ (what is insured, exclusion, etc).
Obtain evidence to quantify the loss. For example, cash/inventory records and details of sales/purchases reconciled to cash/inventory held. The amount of cash/inventory stolen may be only one of the reconciling items, so the accounting system and records will need to be tested for errors in the data.
Watch CCTV coverage (eg of a theft in progress or a fire in the warehouse).
4.2 Actual or suspected fraud investigation
Audit tests on all items (or above a specific amount) in ‘suspect’ areas. For example, in a ‘teeming and lading’ fraud, this could include external confirmation of receivables balances.
If original documents have been destroyed, obtaining copies (eg through external confirmation of suppliers).
Perform substantive analytical procedures (eg comparing profit margins over the period the fraud may have taken place with the before and after margins).
Test relevant internal controls to understand the weaknesses that did not prevent or detect the fraud.
4.3 Alleged bribery payments for new sales contracts
Interview the suspects if possible (eg they may still be employed pending the outcome of the investigation). Ask, for example, how their job role gives them access to cash and the accounting systems.
Review payments to new customers during the year (may be able to use CAATs here).
Review terms of contracts with new customers. Are there legitimate grounds for ‘incentives’?
Review email correspondence between the suspects and new clients (may need to use data analytics for this).
Perform tests of controls on the authorisation of payments. Who else might have known about them?
5 Main differences between a financial statement audit and a forensic audit
Financial statement audit | Forensic audit | |
Skills needed | Ordinary audit skills | Specialist eg how to question witnesses and suspects. |
Predictability | Regular, planned | Often unexpected and urgent, therefore there might be problems finding the appropriate staff resources: number of staff and possessing the required skills and experience |
Materiality | Not particularly interested in immaterial errors | Many frauds are committed by stealing small amounts frequently. For example, if a fraudster knows that payments under $100 are not subject to approval by a manager, small frauds of about $90 might be used. |
Computer-assisted audit techniques | Used for selecting/finding samples and for testing internal controls. | Can be used to examine 100% of transactions and this might be needed when materiality is of no importance. For example, all payments from the bank could be examined in the search for a specified recipient’s account number |
Work to be performed and for whom | Broadly standard (though differs in detail from audit to audit) and specified by the law and by auditing standards. Fairly standard engagement letter. | Open-ended, non-standard. Therefore, must be carefully agreed in advance with the client and an engagement letter issued and agreed. |
Interviews | Client staff are routinely interviewed about how transactions are performed, what a transaction is, what controls are present etc. | Client staff might additionally be interviewed if they are suspected of carrying out a fraud. This requires skill and care. The staff member might be entitled to have legal representation and if this is not provided the interview transcripts might not be accepted as evidence. |