Forensic Audit: 2019 08 01: Carla Tardi: https://www.investopedia.com/terms/f/forensic-audit.

asp
A forensic audit is an examination and evaluation of a firm's or individual's financial records to derive evidence that can be used in a
court of law or legal proceeding. Forensic auditing is a specialization within the field of accounting, and most large accounting firms
have a forensic auditing department. Forensic audits require the expertise of accounting and auditing procedures as well as expert
knowledge about the legal framework of such an audit. Forensic audits cover a wide range of investigative activities. A forensic
audit may be conducted to prosecute a party for fraud, embezzlement, or other financial crimes. In the process of a forensic audit, the
auditor may be called to serve as an expert witness during trial proceedings. Forensic audits could also involve situations that do not
involve financial fraud, such as disputes related to bankruptcy filings, business closures, and divorces. If you've ever padded an
expense report—or even thought about it—know that that is an example of fraud and could be uncovered easily via a forensic audit.
Reasons to Conduct a Forensic Audit: Forensic audit investigations can uncover, or confirm, various types of illegal activities.
Usually, a forensic audit is chosen, instead of a regular audit, if there's a chance that the evidence collected would be used in court.
Below, we cite instances that could necessitate a forensic audit:
Corruption or Fraud: In a forensic audit, an auditor would be on the lookout for: (1) Conflicts of Interest—when a fraudster uses his or her
influence for personal gains to the detriment of the company. For example, if a manager allows and approves inaccurate expenses of an
employee with whom he has personal relations; (2) Bribery—offering money to get things done or influence a situation in one’s favor; (3)
Extortion—the wrongful use of actual or threatened force, violence, or intimidation to gain money or property from an individual or entity.
Hypothetical Example of a Forensic Audit Case: Let's say that a computer manufacturer, WysiKids, on the recommendation of
its chief financial officer (CFO), entered into a contract with Smart Chips, Inc. to supply WysiKids with processors. At the time the
contract was signed, Smart Chips was not authorized to conduct business; its license had been indefinitely revoked based on certain
irregularities in a recent Internal Revenue Service (IRS) filing. WysiKids's CFO knew that Smart Chips' license was suspended, yet still
suggested that his company sign on with Smart Chips, as he was secretly receiving compensation from Smart Chips for doing so. The
fraud depicted above could be uncovered by investigating the intrapersonal relationships involved and exposing a conflict of interest.
Asset Misappropriation: This is the most prevalent form of fraud. Examples include: misappropriating cash, submitting falsified invoices,
making payments to non-existent suppliers or employees, misusing assets (like company equipment), and stealing company inventory.
Financial Statement Fraud: A company can get into this type of fraud to try to show that its financial performance is better than it
actually is. The goal of presenting fraudulent numbers may be to improve liquidity, ensure that C-level executives continue to receive
bonuses or to cope with the pressure to perform.
KEY TAKEAWAYS: (1) A forensic audit is an examination and evaluation of a firm's or individual's financial records to derive evidence
that can be used in a legal proceeding; (2) A forensic audit may be conducted to prosecute a party for fraud, embezzlement, or another
criminal behavior; (3) Forensic auditing is an accounting specialty; most large accounting firms have a forensic auditing department.
How Forensic Audits Work: The process of a forensic audit is similar to a regular financial audit—planning, collecting evidence,
writing a report—with the additional step of a potential court appearance. The attorneys for both sides offer evidence that either
uncovers or disproves the fraud and determines the damages suffered. They present their findings to the client, and to the court
should the case go to trial.
Planning the Investigation: During the planning stage, the forensic auditor and team will plan their investigation to achieve
objectives, such as: (1) Identifying what fraud, if any, is being carried out; (2) Determining the period during which the fraud occurred;
(3) Discovering how the fraud was concealed; (4) Naming the perpetrators of the fraud; (5) Quantifying the loss suffered as a result of
the fraud; (6) Gathering relevant evidence that is admissible in court; and (7) Suggesting measures to prevent such frauds from
occurring in the future.
Collecting Evidence: The evidence collected should be adequate enough to prove the identity of the fraudster(s) in court, reveal the
details of the fraud scheme, and document the financial loss suffered and the parties affected by the fraud. A logical flow of evidence
will help the court in understanding the fraud and the evidence presented. Forensic auditors are required to take precautions to
ensure that documents and other evidence collected are not damaged or altered by anyone.
Reporting: A forensic audit requires a written report about the fraud to be presented to the client so that they can proceed to file a
legal case if they so desire. At a minimum, the report should include: (1) The findings of the investigation; (2) A summary of the
evidence collected; (3) An explanation of how the fraud was perpetrated; (4) Suggestions for preventing similar frauds in the future—
such as improving internal controls.
Court Proceedings: The forensic auditor needs to be present during court proceedings to explain the evidence collected and how the
team identified the suspect(s). S/he should simplify any complex accounting issues and explain the case in a layperson’s language so
that people who have no understanding of legal or accounting terms can understand the fraud clearly.
Forensic Accounting: Forensic accounting utilizes accounting, auditing, and investigative skills to conduct an examination into a
company or individual's financial statements. 
What Is Racketeering? Racketeering typically refers to crimes committed through extortion or coercion. The term is typically
associated with organized crime. 
Auditor: An auditor is a person authorized to review and verify the accuracy of business records and ensure compliance with tax laws. 
White-Collar Crime: A white-collar crime is a non-violent crime committed by an individual, typically for financial gain. 
Internal Auditor (IA): Internal auditors (IA) are employed by companies to provide independent and objective evaluations of financial
and operational business activities. 
Fraud: Fraud, in a general sense, is an intentionally deceptive action designed to provide the perpetrator with unlawful gain or to deny
a right to a victim. 
Detecting Financial Statement Fraud: 2019 06 30: Arthur Pinkssovitch: https://www.investopedia.com/articles/financial-theory/11/detecting-financial-fraud.asp
Looking back at Enron, perhaps the company best known for committing accounting fraud, you can see the many methods that were
utilized in order to improve the appearance of its financial statements. Through the use of off-balance sheet special purpose vehicles,
the firm hid its liabilities and inflated its earnings. In 1999, limited partnerships were created for the purpose of purchasing Enron
1
shares as a mean of improving performance of its stock. It all worked for a while. But Enron's aggressive accounting practices and
financial statement manipulation began to spiral out of control, and its doings were eventually uncovered by The Wall Street Journal.
Shortly after, on December 2, 2001, Enron filed for Chapter 11 in what was the largest U.S. bankruptcy in history, only to be surpassed
by WorldCom less than a year later. The U.S. government responded with preventative measures. Despite passage of the Sarbanes-
Oxley Act – a direct result of the Enron, WorldCom and Tyco scandals – financial statement improprieties remain too common an
occurrence. And complex accounting fraud such as that practiced at Enron is usually extremely difficult for the average retail investor
to discover. However, there are some basic red flags that help. After all, the Enron fraud was not exposed by high-paid Ivy League
MBA-holding Wall Street analysts, but by news reporters who used journal articles and public filings in their due diligence process.
Being first on the scene to uncover a fraudulent company can be very lucrative from a short seller's perspective and can be rather
beneficial to a skeptical investor who is weighing in the overall market sentiment.
What Is Financial Statement Fraud? According to a study conducted by the Association of Certified Fraud Examiners (ACFE),
fraudulent financial statement accounts for approximately 10% of incidents concerning white collar crime. Asset misappropriation and
corruption tend to occur at a much greater frequency, yet the financial impact of these latter crimes is much less severe. ACFE defines
fraud as "deception or misrepresentation that an individual or entity makes knowing that the misrepresentation could result in some
unauthorized benefit to the individual or to the entity or some other party." Greed and work pressure are the most common factors
pushing management to deceive investors and creditors. Financial statement fraud can surface in many different forms, although once
deceptive accounting practices are initiated, various systems of manipulation will be utilized to maintain the appearance of
sustainability. Common approaches to artificially improving the appearance of the financials include: overstating revenues by
recording future expected sales, understating expenses through such means as capitalizing operating expenses, inflating assets' net
worth by knowingly failing to apply an appropriate depreciation schedule, hiding obligations off of the company's balance sheet and
incorrect disclosure of related-party transactions and structured finance deals.
Five basic types of financial statement fraud exist: (1) fictitious sales; (2) improper expense recognition; (3) incorrect asset valuation;
(4) hidden liabilities; and (5) unsuitable disclosures. Another type of financial statement fraud involves cookie-jar accounting
practices, a procedure by which a firm will understate revenues in one accounting period and maintain them as a reserve for future
periods with worse performance. Such procedures remove the appearance of volatility from the operations. And then, of course, there
is the total fabrication of statements. In the spring of 2000, financial fraud investigator Harry Markopolos approached the SEC,
claiming that the $65 billion wealth management business of Bernard Madoff was fraudulent. After modeling Madoff's portfolio,
Markopolos realized that the consistent returns achieved were impossible. For example, according to an interview with the Certified
Fraud Investigator, he "concluded that for Madoff to execute the trading strategy he said he was using he would have had to buy more
options on the Chicago Board Options Exchange than actually existed." Fortunately, this sort of fraud is pretty rare.
Financial Statement Fraud Red Flags: Financial statement red flags provide a general overview of the warning signs investors
should take note of. They do not necessarily indicate an occurrence of financial statement fraud, but merely signal that further in-
depth research must be conducted to assess the validity of the corporate documents. Creditors would find such information useful to
ensure that loans are not provided to firms operating with an elevated amount of risk. Investors, on the other hand, may want to take
note of the following factors to discover new shorting opportunities.
The most common financial statement fraud red flags:
 Accounting anomalies, such as growing revenues without a corresponding growth in cash flows. Sales are much easier to
manipulate than cash flow but the two should move more or less in tandem over time.
 Consistent sales growth while established competitors are experiencing periods of weak performance. Of course, this may be
due to efficient business operations rather than fraudulent activity.
 A rapid and unexplainable rise in the number of day's sales in receivables in addition to growing inventories. This suggests
obsolete goods for which the firm records fictitious future sales.
 A significant surge in the company's performance within the final reporting period of fiscal year. The company may be under
immense pressure to meet analysts' expectations.
 The company maintains consistent gross profit margins while its industry is facing pricing pressure. This can potentially
indicate failure to recognize expenses or aggressive revenue recognition.
 A large buildup of fixed assets. An unexpected accumulation of fixed assets can flag the usage of operating
expense capitalization, rather than expense recognition.
 Depreciation methods and estimates of assets' useful life that do not correspond to those of the overall industry. An
overstated life of an asset will decrease the annual depreciation expense.
 A weak system of internal control. Strong corporate governance and internal controls processes minimize the likelihood that
financial statement fraud will go unnoticed.
 Outsized frequency of complex related-party or third-party transactions, many of which do not add tangible value (can be
used to conceal debt off the balance sheet).
 The firm is on the brink of breaching their debt covenants. To avoid technical default, management may be forced to
fraudulently adjust its leverage ratios.
 The auditor was replaced, resulting in a missed accounting period. Auditor replacement can signal a dysfunctional
relationship while missed accounting period provides extra time to "fix" financials.
 A disproportionate amount of management compensation is derived from bonuses based on short term targets. This provides
incentive to commit fraud.
 Something just feels off about the corporation's business model, financial statements or operations
Financial Statement Fraud Detection Methods: Spotting red flags can be extremely challenging as firms that are engaged in
fraudulent activities will attempt to portray the image of financial stability and normal business operations. Vertical and

2
horizontal financial statement analysis introduces a straightforward approach to fraud detection. Vertical analysis involves taking
every item in the income statement as a percentage of revenue and comparing the year-over-year trends that could be a potential flag
cause of concern. A similar approach can also be applied to the balance sheet, using total assets as the comparison benchmark, to
monitor significant deviations from normal activity. Horizontal analysis implements a similar approach whereby rather than having an
account serve as the point of reference, financial information is represented as a percentage of the base years' figures. Likewise,
unexplainable variations in percentages can serve as a red flag requiring further analysis. Comparative ratio analysis also allows
analysts and auditors to spot discrepancies within the firm's financial statements. By analyzing ratios, information regarding day's
sales in receivables, leverage multiples and other vital metrics can be determined and analyzed for inconsistencies. A mathematical
approach, known as the Beneish Model, evaluates eight ratios to determine the likelihood of earnings manipulation. Asset quality,
depreciation, gross margin, leverage, and other variables are factored into the analysis. Combining the variables into the model, an M-
score is calculated; a value greater than -2.22 warrants further investigation as the firm may be manipulating its earnings while an M-
score less than -2.22 suggests that the company is not a manipulator Similar to most other ratio-related strategies, the full picture can
only be accurately portrayed once the multiples are compared to the industry and to the specific firm's historical average.
The Bottom Line: Having proper knowledge of the red flags to avoid companies indulging in unscrupulous accounting practices is a
useful tool to ensure the safety of your investments.
Look For These Red Flags In The Income Statement: 2019 06 25: Poonkulali Thangavelu:
https://www.investopedia.com/articles/investing/053115/look-these-red-flags-income-statement.asp
While Enron has become the poster child for blatant financial statement fraud, other companies have also been known to fudge their
numbers. The income statement is one of a company’s major financial statements, along with its balance sheet and statement of cash
flows, and it can be manipulated in a few common ways. Investors should watch for red flags related to revenue and expenses.
The income statement shows what a company’s earnings (or profits) are by showing all its revenues and expenses for a specific period.
Income statement analysis is an integral aspect of fundamental analysis. The statement should capture an honest and accurate picture
of a company’s financial situation so that investors can make informed decisions about buying or selling shares. Because these
numbers are so important, they must be reviewed and approved by an independent auditor. Unfortunately, auditors can be fooled by
fabricated numbers or even turn a blind eye to such happenings (see WorldCom and Global Crossing). That’s why investors should be
vigilant and skeptical when studying a company’s income statements.
Beware of Revenue Manipulation: Revenues are vulnerable to misrepresentation. Common ways to manipulate revenues include
recording revenue before it is actually earned or simply making up revenue that does not exist. Companies can do this by making
fraudulent sales to complicit related parties (for example by selling to a sister company with immediate plans to cancel the sale),
recording sales that are incomplete because they are tied to some condition (for example, recording the full value of an installment sale),
recognizing consignment as completed sales, and altering contracts to boost sales. A company could also delay acknowledging customer
returns to a later quarter, or perhaps ignore them altogether. But how can an investor know if a company is engaging in these income
statement manipulations? Examine the company’s revenues over the last few periods. If it seems to be growing in an inconsistent way,
that should be a red flag. Investors should look at the firm’s income statements for previous periods, including the last quarter and the last
year, to see if there is a sudden and unexplained change in its revenues that isn’t accounted for by its cash flows.
Misrepresenting Expenses: One common way of manipulating expenses is through inventory manipulation. For instance, a business
could buy materials and then not record the full expense of the purchase or not record the purchase at all. Companies can also exaggerate
vendor discounts to reduce costs or not write off inventory that is out of date and no longer saleable. Other schemes include overcounting
or undercounting inventory to present whatever picture management wants to paint or creating phantom inventory. To catch a hint of
these practices, examine the company's expenses. If expenses are changing in a way that is not consistent with previous periods, investors
should investigate the variance. The company’s balance sheet and footnotes could also provide additional input. 
Cookie Jar Accounting: Many businesses operate in industries where the flow of revenue is not consistent and consequently income
varies. Regardless of the natural rhythms of an industry, all publicly traded companies must report quarterly earnings and analysts and
investors keep track of these earnings. Companies are under great pressure to meet targets and consistently beat their earnings from
the previous quarter. Because of this, they might manipulate their revenues and expenses in different ways to paint a picture of
stability and continuous growth when in reality the business may be less profitable, or even more profitable, than represented. For
example, some businesses will keep reserves of revenue from past quarters, without explicitly stating this, or use other means to show
profitability in future quarters. Other methods of such cookie jar accounting include shifting current expenses to a future period so as
to boost current earnings. Future expenses can also be moved to an earlier period. Anything that looks like this sort of manipulation
should also be a cause for further inquiry. Look for red flags in the earnings of past periods and management’s discussion of earnings.
Also see if current earnings come from so-called “other income.” Other income can be a red flag for previous reserves being plugged in
to boost current earnings. Companies that have been implicated in cookie jar accounting schemes include Dell and Fannie Mae.
Other Red Flags: Some transactions don’t occur regularly and are called nonrecurring transactions. Such a transaction could include
the sale of the company’s headquarters. It is also worthwhile looking into these sorts of transactions to see if there is anything
irregular. These sorts of items could show up as a “gain on disposal.". These sorts of one-time transactions could be a way for the
company to manipulate its earnings and that’s why it merits investigation. 
The Bottom Line: An investor should be vigilant about investigating anything in a company’s income statement that raises a red flag.
Both revenues and expenses are vulnerable to manipulation. Company management often has incentive to engage in manipulation
and auditors do not always catch on. Reading the income statement and management’s discussion of its business (together with the
balance sheet and footnotes, as well as the cash flow statement) provides clues for vigilant investors. 

Understanding the Income Statement: 2019 06 25: Richard Loth: https://www.investopedia.com/articles/04/022504.asp

3
The income statement is one of three financial statements that stock investors need to become familiar with (the other two are balance
sheet and cash flow statement). Understanding an income statement is essential for investors in order to analyze the profitability and
future growth of a company, which should play a huge role in deciding whether or not to invest in it. In the context of corporate financial
reporting, the income statement summarizes a company's revenues (sales) and expenses, quarterly and annually for its fiscal year. The
final net figure, as well as various other numbers in the statement, are of major interest to the investment community.
An Introduction To The Income Statement: General Terminology and Format Clarifications: Income statements come with various
monikers. The most commonly used are "statement of income," "statement of earnings," "statement of operations" and "statement of
operating results." Many professionals still use the term P&L, which stands for profit and loss statement, but this term is seldom found
in print these days. In addition, the terms "profits," "earnings" and "income" all mean the same thing and are used interchangeably.
Two basic formats for the income statement are used in financial reporting presentations – the multi-step and the single-step. These
are illustrated below in two simple examples:
Multi-Step Format Single-Step Format
Net Sales Net Sales
Cost of Sales Materials and Production
Gross Income* Marketing and Administrative
Selling, General and Administrative Expenses
Research and Development Expenses (R&D)
(SG&A)
Operating Income* Other Income & Expenses
Other Income & Expenses Pretax Income
Pretax Income* Taxes
Taxes Net Income
Net Income (after tax)* --
In the multi-step income statement, four measures of profitability (*) are revealed at four critical junctions in a company's operations – gross,
operating, pretax and after tax. In the single-step presentation, the gross and operating income figures are not stated; nevertheless, they can
be calculated from the data provided. In the single-step method, sales minus materials and production equal gross income. And, by
subtracting marketing and administrative and R&D expenses from gross income, we get the operating income figure. If you are a DIY
investor, you'll have to do the math; however, if you use investment research data, the experts crunch the numbers for you. One last general
observation. Investors must remind themselves that the income statement recognizes revenues when they are realized – so when goods are
shipped, services rendered and expenses incurred. With accrual accounting, the flow of accounting events through the income statement
doesn't necessarily coincide with the actual receipt and disbursement of cash. The income statement measures profitability, not cash flow.
Income Statement Accounts (Multi-Step Format)
(1)Net Sales (a.k.a. sales or revenue): These terms refer to the value of a company's sales of goods and services to its customers. Even
though a company's bottom line (its net income) gets most of the attention from investors, the top line is where the revenue or
income process begins. Also, in the long run, profit margins on a company's existing products tend to eventually reach a maximum
that is difficult on which to improve. Thus, companies typically can grow no faster than their revenues.
(2)Cost of Sales  (a.k.a. cost of goods/products sold (COGS), and cost of services): For a manufacturer, cost of sales is the expense
incurred for labor, raw materials, and manufacturing overhead used in the production of goods. While it may be stated separately,
depreciation expense belongs in the cost of sales. For wholesalers and retailers, the cost of sales is essentially the purchase cost of
merchandise used for resale. For service-related businesses, cost of sales represents the cost of services rendered or cost of revenues.
(3)Gross Profit (a.k.a. gross income or gross margin): A company's gross profit does more than simply represent the difference
between net sales and the cost of sales. Gross profit provides the resources to cover all of the company's other expenses. Obviously, the
greater and more stable a company's gross margin, the greater potential there is for positive bottom line (net income) results.
(4)Selling, General and Administrative Expenses: Often referred to as SG&A, this account comprises a company's operational
expenses. Financial analysts generally assume that management exercises a great deal of control over this expense category. The trend
of SG&A expenses, as a percentage of sales, is watched closely to detect signs, both positive and negative, of managerial efficiency.
(5)Operating Income: Deducting SG&A from a company's gross profit produces operating income. This figure represents a
company's earnings from its normal operations before any so-called non-operating income and/or costs such as interest expense, taxes
and special items. Income at the operating level, which is viewed as more reliable, is often used by financial analysts rather than net
income as a measure of profitability.
(6)Interest Expense: This item reflects the costs of a company's borrowings. Sometimes companies record a net figure here for
interest expense and interest income from invested funds.
(7)Pretax Income: Another carefully watched indicator of profitability, earnings garnered before the income tax expense is an
important bullet in the income statement. Numerous and diverse techniques are available to companies to avoid and/or minimize
taxes that affect their reported income. Because these actions are not part of a company's business operations, analysts may choose to
use pretax income as a more accurate measure of corporate profitability.
(8)Income Taxes: As stated, the income tax amount has not actually been paid – it is an estimate or an account that has been created
to cover what a company expects to pay.
(9)Special Items or Extraordinary Expenses: A variety of events can occasion charges against income. They are commonly identified as
restructuring charges, unusual or nonrecurring items, and discontinued operations. These write-offs are supposed to be one-time events.
Investors need to take these special items into account when making inter-annual profit comparisons because they can distort evaluations.
(10)Net Income (a.k.a. net profit or net earnings): This is the bottom line, which is the most commonly used indicator of a company's
profitability. Of course, if expenses exceed income, this account caption will read as a net loss. After the payment of preferred
4
dividends, if any, net income becomes part of a company's equity position as retained earnings. Supplemental data is also presented
for net income on the basis of shares outstanding (basic) and the potential conversion of stock options, warrants etc. (diluted).
(11)Comprehensive Income: The concept of comprehensive income, which is relatively new (1998), takes into consideration the
effect of such items as foreign currency translations adjustments, minimum pension liability adjustments and unrealized gains/losses
on certain investments in debt and equity. The investment community continues to focus on the net income figure. The
aforementioned adjustment items all relate to a volatile market and/or economic events that are out of the control of a company's
management. Their impact is real when they occur, but they tend to even out over an extended period of time.
Sample Income Statement: Now let's take a look at a sample income statement for company XYZ for FY ending 2017 and 2018
Income Statement For Company XYZ FY 2018 and 2019
(Figures USD) 2018 2019
Net Sales 1,500,000 2,000,000
Cost of Sales (350,000) (375,000)
Gross Income 1,150,000 1,625,000
Operating Expenses (SG&A) (235,000) (260,000)
Operating Income 915,000 1,365,000
Other Income (Expense) 40,000 60,000
Extraordinary Gain (Loss) - (15,000)
Interest Expense (50,000) (50,000)
Net Profit Before Taxes (Pretax Income) 905,000 1,360,000
Taxes (300,000) (475,000)
Net Income 605,000 885,000
Now that we understand the anatomy of an income statement, we can deduce from the above example that between the years 2017
and 2018, Company XYZ managed to increase sales by about 33%, while reducing its cost of sales from 23% to 19% of sales.
Consequently, gross income in 2018 increased significantly, which is a huge plus for the company's profitability. Also,
general operating expenses have been kept under strict control, increasing by a modest $25,000. In 2017, the company's operating
expenses represented 15.7% of sales, while in 2018 they amounted to only 13%. This is highly favorable in view of the large sales
increase. As a result, the bottom line – net income – for the company in 2018 increased from $605,000 in 2017 to $885,000 in 2018. The
positive inter-annual trends in all the income statement components, both income and expense, have lifted the company's profit
margins (net income/net sales) from 40% to 44% – again, that's highly favorable.
The Bottom Line: When an investor understands the income and expense components of the income statement, he or she can
appreciate what makes a company profitable. In the case of Company XYZ, it experienced a major increase in sales for the period
reviewed and was also able to control the expense side of its business. That's a sign of very efficient management, and more likely than
not gives a really good clue as to how solid of an investment the company may be.
8 Ways Companies Cook the Books: 2019 08 26: Rick Wayman: https://www.investopedia.com/articles/analyst/071502.asp
Every company manipulates its numbers to a certain extent to make sure budgets balance, executives score bonuses, and investors
continue to offer up funding. Such creative accounting is nothing new. However, factors such as greed, desperation, immorality, and
bad judgment can cause some executives to cross the line into outright corporate fraud. Enron, Adelphia, and WorldCom are extreme
examples of companies who cooked the books claiming billions in assets that just didn't exist. They are exceptions to the rule.
Regulations such as the 2002 Sarbanes-Oxley Act, a federal law that enacted comprehensive reform of business financial practices
aimed at publicly held corporations, their internal financial controls, and their financial reporting audit procedures, has reigned in
wayward companies to a large extent. However, investors should still know how to recognize the basic warning signs of falsified
statements. While the details are typically hidden, even from accountants, there are red flags in financial statements that can point to
the use of manipulating methods. Some companies manipulate their accounting practices to paint a rosier picture when it comes to
their financials. The reasons for doing so include providing higher bonuses for executives or attracting investors.
1. Accelerating Revenues: One way to accelerate revenue is to book lump-sum payments as current sales when services are actually
provided over a number of years. For example, a software service provider might receive an upfront payment for a four-year service
contract but record the full payment as sales for the period that the payment was received. The correct, more accurate, way is to
amortize the revenue over the life of the service contract. A second revenue-acceleration tactic is called "channel stuffing." Here, a
manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales. But the distributor has
the right to return any unsold merchandise. Because the goods can be returned and are not guaranteed as a sale, the manufacturer
should keep the products classified as a type of inventory until the distributor has sold the product.
KEY TAKEAWAYS: (1) Most companies conduct accounting procedures to optimally reflect their performance; (2) Greed and bad
judgment can be a precursor to corporate fraud; (3) The 2002 Sarbanes-Oxley Act introduced reforms that control wayward companies
to a large extent; (3) Financial statements can point to the use of manipulating methods such as accelerating revenues; delaying
expenses; accelerating pre-merger expenses; and leveraging pension plans, off-balance sheet items, and synthetic leases.
2. Delaying Expenses: AOL was guilty of delaying expenses in the early 1990s when it was first distributing its installation CDs. AOL
viewed this marketing campaign as a long-term investment and capitalized the costs —that is, it transferred them from the income
statement to the balance sheet where the campaign would be expensed over a period of years. The more conservative (and
appropriate) treatment is to expense the cost in the period the CDs were shipped.
3. Accelerating Pre-Merger Expenses: It may appear counterintuitive, but before a merger is completed, the company that is being
acquired will pay—possibly prepay—as many expenses as possible. Then, after the merger, the earnings per share (EPS) growth rate of

5
the combined entity will appear higher compared to past quarters. Furthermore, the company will have already booked the expenses
in the previous period.
4. Non-Recurring Expenses: By accounting for extraordinary events, non-recurring expenses are one-time charges designed to help
investors better analyze ongoing operating results. Some companies, however, take advantage of these each year. Then, a few quarters
later, they "discover" they reserved too much and put an amount back into income (see next tactic).
5. Other Income or Expense: Other income or expense is a category that can hide a multitude of sins. Here companies book any
"excess" reserves from prior charges (non-recurring or otherwise). Other income or expense is also the place where companies can hide
other expenses by netting them against other newfound income. Sources of other income include selling equipment or investments.
6. Pension Plans: If a company has a defined benefit plan, it can use the plan to its advantage. The company can improve earnings by
reducing the plan's expenses. If the investments in the plan then grow faster than the company's assumptions, the company could
record these gains as revenue. During the late 1990s, a number of large firms, some of them blue chips, employed such techniques.
7. Off-Balance-Sheet Items: A company can create separate subsidiaries that can house liabilities or incur expenses that the parent
company does not want to disclose. If these subsidiaries are set up as separate legal entities that are not wholly owned by the parent,
they do not have to be recorded on the parent's financial statements and the company can hide them from investors.
8. Synthetic Leases: A synthetic lease can be used to keep the cost of a new building, for example, from appearing on a company's
balance sheet. Effectively, a synthetic lease allows a company to rent an asset to itself. It works like this: a special purpose entity
established by a parent company purchases an asset then leases it back to the parent company. As a result, the asset of the special
purpose entity is shown on the balance sheet, which treats the lease as a capital lease and charges depreciation expense against its
earnings. However, the asset does not appear on the balance sheet of the parent company. Instead, the parent company treats the
lease as an operating lease and receives a tax deduction for the payments on the income statement. Nor is it revealed that, at the end
of the lease, the parent company is obligated to buy the building—a huge liability that appears nowhere on the balance sheet.
The Bottom Line: Despite a succession of reform legislation, corporate misdeeds still occur. Finding hidden items in a
company's financial statements is a warning sign for earnings manipulation. This does not mean that the company is definitely
cooking the books, but digging deeper might be worthwhile before making an investment.
Financial Ratios to Spot Companies in Financial Distress: 2019 08 12: Ben McClure:
https://www.investopedia.com/articles/financial-theory/10/spotting-companies-in-financial-distress.asp
Following every bankruptcy, a company's investors, suppliers, customers, and employees invariably ask themselves: "Could we have
seen it coming? Could we have predicted that the company was in big trouble? Were there distress signs that we missed?"
Often, the answer is yes. There are many early warning signs that indicate that a company is experiencing problems. Being aware of
these signals can help prevent losses. If a company is in trouble, odds are that you'll see red flags in its financial statements. At the
same time, watch out for changes in its management activities and operations.
Financial Statement Warning Signs: You can learn a lot about a company's financial health from its financial statements. The first
places to look for trouble signs are in the cash flow statements. When cash payments exceed cash income, the company's cash flow is
negative. If cash flow stays negative over a sustained period, it's a signal that its cash could be running low and is insufficient to cover
bills and other obligations. So, keep an eye on changes in the company's cash position on its balance sheet. Without new capital from
equity investors or lenders, a company in this situation can quickly find itself in serious financial trouble. Remember, profitable
companies sometimes have negative cash flows and find themselves in distress. Long delays between the time when the company
spends cash to grow its business and when it collects cash receivables can severely stretch cash flow. Working capital may also decline
and become negative as accounts payable grow at a faster rate than inventory and accounts receivable. In any case, negative operating
cash flows, period after period, should be interpreted as a warning that the company could be headed for trouble.
Interest repayments can put pressure on cash flow, and this pressure is likely to be exacerbated for distressed companies. Because they have a
higher risk of defaulting on their loans, struggling companies must pay a higher interest rate to borrow money. As a result, debt tends to
shrink returns. The debt-to-equity ratio is a handy metric for gauging a company's debt default risk. It compares a company's long- and short-
term debt to shareholders' equity or book value. High-debt companies have higher D/E ratios than companies with low debt.
KEY TAKEAWAYS: (1) There are many warning signs present when a company is in distress, and most can be found in its financial
statements. (2) Sustained periods of negative cash flows (cash outflows exceed cash inflows) can indicate a company is in financial
distress. (3) The debt-to-equity ratio compares a company's debt to shareholders' equity and is a good measure in assessing a company's
debt default risk. (4) Audits of financial statements often uncover warning signs. (5) Business and managerial changes, such as a deviation
away from a traditional business model or the sudden departure of key management personnel, can also signal signs of distress.
Auditing Warning Signs: Don't forget to cast your eyes over the third party auditor's report, usually published at the front of a
company's quarterly and annual reports. If the report makes a mention of discrepancies in the company's accounting practices – such
as how it books revenue or accounts for costs, or questions the firm's ability to continue "as a going concern" – regard that as a red
flag. What's more, notification of a change in auditors mustn't be taken lightly. Auditors tend to jump ship at the first sign of corporate
distress or impropriety. Auditor replacement can also mean a deteriorating relationship between the auditor and the client company
or perhaps more fundamental difficulties, such as strong disagreement over the reliability of the company's accounting or the auditor's
unwillingness to report a "clean bill of health." Recent academic studies find that there are more auditor resignations when litigation
risk increases and a company's financial health is deteriorating; so, watch out for them.
The downfall of American energy and commodities company Enron and its auditing firm, Arthur Anderson, prompted the creation of the Sarbanes-
Oxley Act's Public Company Accounting Oversight Board (PCAOB), which governs accounting firms acting as auditors of public companies.
Business and Management Warning Signs: While the information found on financial statements can help gauge a company's
health, it is important not to ignore managerial and operational signs of distress. Many private companies do not disclose financial
statements to the public; as a result, business information may be all that's available for assessing their well-being. Look out for
changes in the market environment. Often, they can trigger – if not cause – deterioration in a company's financial health. A downturn
in the economy, the appearance of a strong competitor, an unexpected shift in buyer's habits, among other things, can put serious
6
pressure on a company's revenues and profitability. Unless these problems are effectively managed, they can be the start of a
downward slide in the company's fortunes. Be aware of the company's customers, competitors, market, and suppliers, and try to stay
in front of any changing market trends. Be wary of dramatic changes in strategy. When a company drifts away from its traditional
business model, the company might be in financial trouble. Consider a 100-year old company positioned as the global leader of a
certain widget shifting its central focus to produce a different, unrelated product. This shift could indicate a problem within the
company. When a company suddenly starts slashing prices, you should ask why. It may mean that the company is in a big rush to
increase sales volume and get more cash into the business – regardless of the potentially detrimental impact of such a move's long-
term impact on profits or its brand. A desperate grab for cash – also witnessed when companies suddenly start selling off core business
assets – could be a sign that suppliers or lenders are banging at the door. Another sign of distress is product and service quality
deterioration. Naturally, a company that is fending off bankruptcy will have an incentive to cut costs, and one of the first things to go
is quality. Look for the sudden appearance of shoddy workmanship, slower delivery times, and failure to return calls.
Lest we forget, the sudden departure of key executives or board directors can also signal bad news. While these resignations may be
completely innocent, they demand closer inspection. Warning bells should ring the loudest when the individual concerned has a
reputation as a successful manager or a strong, independent director.
The Bottom Line: Typically, when a company is struggling, the warning signs are there. Your best line of defense as an investor,
supplier, customer, or employee is to be informed. Ask questions, do your research, and be alert to unusual activities.
Financial Statement Manipulation
How to Spot the Signs When Considering a Stock: 2019 03 10: Troy Adkins: https://www.investopedia.com/articles/fundamental-analysis/financial-statement-manipulation.asp
Financial statement manipulation is an ongoing problem in corporate America. Although the Securities and Exchange
Commission (SEC) has taken many steps to mitigate this type of corporate malfeasance, the structure of management incentives, the
enormous latitude afforded by the Generally Accepted Accounting Principles (GAAP) and the ever-present conflict of interest between
the independent auditor and the corporate client continues to provide the perfect environment for such activity. Due to these factors,
investors who purchase individual stocks or bonds must be aware of the issues, warning signs and the tools that are at their disposal in
order to mitigate the adverse implications of these problems.
Reasons behind Financial Statement Manipulation: There are three primary reasons why management manipulates financial
statements. First, in many cases, the compensation of corporate executives is directly tied to the financial performance of the
company. As a result, they have a direct incentive to paint a rosy picture of the company's financial condition in order to meet
established performance expectations and bolster their personal compensation. Second, it is a relatively easy thing to do. The Financial
Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of latitude and interpretation in
accounting provisions and methods. For better or worse, these GAAP standards afford a significant amount of flexibility, making it
feasible for corporate management to paint a particular picture of the financial condition of the company.
Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the
corporate client. In the U.S., the Big Four accounting firms and a host of smaller regional accounting firms dominate the corporate auditing
environment. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are
compensated, often quite significantly, by the very companies that they audit. As a result, the auditors could be tempted to bend the
accounting rules to portray the financial condition of the company in a manner that will keep the client happy – and keep its business.
How Financial Statements Are Manipulated: There are two general approaches to manipulating financial statements. The first is to
exaggerate current period earnings on the income statement by artificially inflating revenue and gains, or by deflating current period
expenses. This approach makes the financial condition of the company look better than it actually is in order to meet established
expectations. The second approach requires the exact opposite tactic, which is to minimize current period earnings on the income
statement by deflating revenue or by inflating current period expenses. It may seem counterintuitive to make the financial condition
of a company look worse than it actually is, but there are many reasons to do so: to dissuade potential acquirers; getting all of the bad
news "out of the way" so that the company will look stronger going forward; dumping the grim numbers into a period when the poor
performance can be attributed to the current macroeconomic environment; or to postpone good financial information to a future
period when it is more likely to be recognized.
Specific Ways to Manipulate Financial Statements: When it comes to manipulation, there are a host of accounting techniques that
are at a company's disposal. Financial Shenanigans  (2002) by Howard Schilit outlines seven primary ways in which corporate
management manipulates the financial statements of a company.
Recording Revenue Prematurely or of Questionable Quality: (1) Recording revenue prior to completing all services; (2) Recording
revenue prior to product shipment; (3) Recording revenue for products that are not required to be purchased
Recording Fictitious Revenue: (1) Recording revenue for sales that did not take place; (2) Recording investment income as revenue;
(3) Recording proceeds received through a loan as revenue.
Increasing Income with One-Time Gains: (1) Increasing profits by selling assets and recording the proceeds as revenue; (2)
Increasing profits by classifying investment income or gains as revenue
Shifting Current Expenses to an Earlier or Later Period: (1) Amortizing costs too slowly; (2) Changing accounting standards to
foster manipulation; (3) Capitalizing normal operating costs in order to reduce expenses by moving them from the income
statement to the balance sheet; (4) Failing to write down or write off impaired assets
Failing to Record or Improperly Reducing Liabilities: (1) Failing to record expenses and liabilities when future services remain; (2)
Changing accounting assumptions to foster manipulation
Shifting Current Revenue to a Later Period: (1) Creating a rainy day reserve as a revenue source to bolster future performance; (2)
Holding back revenue
Shifting Future Expenses to the Current Period as a Special Charge: (1) Accelerating expenses into the current period; (2)
Changing accounting standards to foster manipulation, particularly through provisions for depreciation, amortization, and depletion.

7
While most of these techniques pertain to the manipulation of the income statement, there are also many techniques available to
manipulate the balance sheet, as well as the statement of cash flows. Moreover, even the semantics of the management discussion and
analysis section of the financials can be manipulated by softening the action language used by corporate executives from "will" to
"might," "probably" to "possibly," and "therefore" to "maybe." Taken collectively, investors should understand these issues and nuances
and remain on guard when assessing a company's financial condition.
Financial Manipulation via Corporate Merger or Acquisition: Another form of financial manipulation may happen during the
merger or acquisition process. One classic approach occurs when management tries to whip up support for a merger or acquisition
based primarily on the improvement in the estimated earnings per share of the combined companies. Let's look at the table below in
order to understand how this type of manipulation takes place.
Proposed Corporate Acquisition Acquiring Company Target Company Combined Financials
Common Stock Price $100.00 $40.00 -
Shares Outstanding 100,000 50,000 120,000
Book Value of Equity $10,000,000 $2,000,000 $12,000,000
Company Earnings $500,000 $200,000 $700,000
Earnings Per Share $5.00 $4.00 $5.83
Based on the data in the table above, the proposed acquisition of the target company appears to make good financial sense because the
earnings per share of the acquiring company will be materially increased from $5 per share to $5.83 per share. Following the acquisition, the
acquiring company will experience an increase of $200,000 in company earnings due to the addition of the income from the target company.
Moreover, given the high market value of the acquiring company's common stock, and the low book value of the target company, the
acquiring company will only have to issue an additional 20,000 shares in order to make the $2 million acquisition. Taken collectively, the
significant increase in company earnings and the modest increase of 20,000 common shares outstanding will lead to a more attractive
earning per share amount. Unfortunately, a financial decision based primarily on this type of analysis is inappropriate and misleading,
because the future financial impact of such an acquisition may be positive, immaterial or even negative. The earnings per share of the
acquiring company will increase by a material amount for only two reasons, and neither reason has any long-term implications.
Guarding Against Financial Statement Manipulation: There are a host of factors that may affect the quality and accuracy of the
data at an investor's disposal. As a result, investors must have a working knowledge of financial statement analysis, including a strong
command of the use of internal liquidity solvency analysis ratios, external liquidity marketability analysis ratios, growth, and
corporate profitability ratios, financial risk ratios and business risk ratios. Investors should also have a strong understanding of how to
use market multiple analysis, including the use of price/earnings ratios, price/book value ratios, price/sales ratios and price/cash flow
ratios in order to gauge the reasonableness of the financial data. Unfortunately, very few retail investors have the necessary time, skills
and resources to engage in such activities and analysis. If so, it might be easier for them to stick to investing in low-cost, diversified,
actively managed mutual funds. These funds have investment management teams with the knowledge, background, and experience to
thoroughly analyze a company's financial picture before making an investment decision.
The Bottom Line: There are many cases of financial manipulation that date back over the centuries, and modern-day examples such
as Enron, Worldcom, Tyco International, Adelphia, Global Crossing, Cendant, Freddie Mac, and AIG should remind investors of the
potential landmines that they may encounter. The known prevalence and magnitude of the material issues associated with the
compilation of corporate financial statements should remind investors to use extreme caution in their use and interpretation.
Investors should also keep in mind that the independent auditors responsible for providing the audited financial data may very well
have a material conflict of interest that is distorting the true financial picture of the company. Some of the corporate malfeasance cases
mentioned above occurred with the compliance of the firms' accountants, like the now-defunct firm Arthur Anderson. So even
auditors' sign-off statements should be taken with a grain of salt.
4 Famous Inventory Frauds: 2019 02 19: Maya Dollarhide: https://www.investopedia.com/articles/economics/12/four-unknown-massive-frauds.asp
You've probably heard of the Enron and WorldCom scandals, but you may be interested to learn of history's lesser-known large-scale
frauds. While all of these swindles have been surpassed in scale by recent corporate malfeasance, these earlier cases still bear mention,
as some led to major changes in the accounting profession and the introduction of new government laws.
Equity Funding Corporation of America (EFCA) began selling life insurance in the early 1960s with an innovative twist that combined
the safety of traditional life insurance with the growth potential of stock mutual funds. The company would sell a mutual fund to a
customer, who would then borrow against the fund to purchase life insurance. This strategy was predicated on the assumption that the
return on the mutual fund would be sufficient to pay the premiums on the insurance policy. The fraud began in 1964 when EFCA was
bumping up against a deadline to complete and issue its annual report. The company's new mainframe computer couldn't produce the
needed numbers in time and Stanley Goldblum, the CEO of the company, ordered fictitious accounting entries made to the company's
financial statements to meet the deadline. Goldblum and other employees of EFCA continued this fraud by creating phony life insurance
policies to produce revenue to back up these earlier false entries. The company then reinsured these fake policies with a number of other
insurers and even faked the deaths of some of these nonexistent individuals. The fraud eventually reached mammoth-sized proportions,
with tens of thousands of phony insurance policies and nearly $2 billion in nonexistent revenues over a multi-year period. One shocking
component was the number of employees that participated. Prosecutors successfully charged 22 individuals and estimated that 50 others
at the company had knowledge of the fraud. In 1973, a disgruntled ex-employee, who had been fired, reported the scheme to Ray Dirks,
a Wall Street analyst who covered the insurance industry. Dirks did his own research and then discussed the company with institutional
investors, many of whom sold the stock prior to the fraud becoming public knowledge. The case is that it led to the establishment of a
new legal precedent regarding insider trading. After the fraud became public, the Securities and Exchange Commission (SEC) censured
Dirks for aiding and abetting violations of the Securities Exchange Act of 1934 and Rule 10b-5, which prohibits insider trading. Dirks
fought the censure through several appeals, all the way up to the Supreme Court in 1983. The court ruled in his favor and said that no

8
violation occurred because Dirks had no fiduciary duty to the shareholders of EFCA and did not misappropriate or illegally obtain the
information. The fraud at EFCA is considered by some to be the first computer-based fraud, as the creation of phony documents needed
to back up the phony policies became so cumbersome that the company started using computers to automate the deception.
Crazy Eddie was an electronics and appliances retail store chain run by the Antar family, which began operations as a private
company in the 1960s. It was famed for its bargains: "Crazy Eddie—his prices are insane!" the once-ubiquitous the ads proclaimed. But
Eddie wasn't crazy so much as calculating, perpetuating a fraud that was one of the longest running in modern times, lasting from
1969 to 1987. The fraud began almost immediately, with the management of Crazy Eddie underreporting the firm's taxable income via
skimming cash sales, paying employees in cash to avoid payroll taxes and reporting fake insurance claims to the company's carriers.
As the chain grew in size, the Antar family started planning for an initial public offering (IPO) of Crazy Eddie and scaled back the
fraud so that the company would look more profitable and get a higher valuation from the public market. This strategy was a success
and Crazy Eddie went public in 1984 at $8 per share. The final phase of the Crazy Eddie saga began after the IPO and was motivated by
a desire to increase profits so the stock price could move higher and the Antar family could sell its holdings over time. Management
now reversed the flow of skimmed cash and moved funds from secret bank accounts and safety deposit boxes into company coffers,
booking the cash as revenue. The scheme also involved inflating and creating phony inventory on the books and reducing accounts
payable to boost profits. The fraud was uncovered in 1987 after the Antar family was ousted from Crazy Eddie after a successful hostile
takeover by an investment group. Crazy Eddie limped along for another year before being liquidated to pay creditors. Eddie Antar, the
CEO of Crazy Eddie, was charged with securities fraud and other crimes but fled before his trial. He spent three years in hiding before
he was caught in Israel and extradited back to the U.S. Antar and two other family members were convicted for their role in the fraud.
McKesson & Robbins was a drug and chemical company in the mid-1920s that attracted the attention of Philip Musica, an individual with
an unsavory past that included criminal acts and multiple fake names. Under the name Frank D. Costa, Musica greeted the advent of U.S.
Prohibition in 1919 with the creation of a company that manufactured hair tonic and other products that had high alcohol content. These
products were sold to bootleggers, which used the alcohol to produce liquor to sell to customers. Musica purchased McKesson & Robbins in
1924 using the name F. Donald Coster and seeded the company with family members to help loot the company. The fraud involved fake
purchase orders, inflated inventory and skimming cash from company sales, and occurred despite the presence of Price Waterhouse as the
company's auditors. When the scam was finally detected in 1937, the SEC determined that $19 million in fictitious inventory was on
the balance sheet—a sum equal to approximately $285 million in current dollars. The McKesson & Robbins scandal had a profound impact on
the accounting industry and led to the adoption of Generally Accepted Auditing Standards (GAAS), including the concept of an independent
audit committee. Another change included having auditors personally inspect inventory to verify its existence.
Republic of Poyais: The Poyais fraud was a major scandal in the 1800s. This fraud was certainly the most audacious and imaginative of
all, as the perpetrator, Gregor MacGregor, created an entirely fictional country. MacGregor served in the British army and was involved in
various operations in the Americas. During his travels, he visited the coastal areas of present-day Honduras and Belize. MacGregor
claimed to have received a land grant from a local native leader, and upon his return to London, announced the new nation of the
Republic of Poyais. MacGregor created a flag, a coat of arms, currency, and other trappings of a sovereign nation, and then proceeded to
sell off land to investors and settlers in the London markets. He also issued sovereign debt backed by the promise of this new nation, and
induced people to emigrate there with glowing accounts of the capital city and the fertility of the soil.
The first group of settlers arrived in Poyais in 1823, and found nothing except dense jungle and abandoned wood shacks. Three other
shiploads of settlers arrived over the next few years and found a similar situation. Disease and hunger soon worked through the colonists,
and almost 200 of them died. The news eventually reached London and the authorities arrested MacGregor. While awaiting trial, he fled
to France and attempted the same Poyais scam on French investors. MacGregor ended up in Venezuela, where he helped the nation in its
fight for independence and for his efforts was awarded a pension and the title of general by the newly established government.
The Bottom Line: As you now know, corporate fraud has a long and extensive history. Sometimes it takes advantage of state-of-the-
art technology and current events. But the motivations are as old as time: greed, cupidity, and laziness.
What Is a Forensic Audit? https://thelawdictionary.org/article/what-is-a-forensic-audit/
While a forensic audit may sound like something exciting you hear about on crime dramas like Law and Order or CSI, the truth is a
little more mundane. A forensic audit is the process of reviewing a person’s or company’s financial statements to determine if they are
accurate and lawful. Forensic accounting is most commonly associated with the IRS and tax audits, but it may also be commissioned
by private companies to establish a complete view of a single entity’s finances.
When Are Forensic Audits Used? Forensic audits are used wherever an entity’s finances present a legal concern. For instance, it is
used in cases of suspected embezzlement or fraud, to determine tax liability, to investigate a spouse during divorce proceedings or to
investigate allegations of bribery, among other reasons. Forensic audits are performed by a class of professionals with skillsets in both
criminology and accounting who specialize in following a money trail, keeping track of fraudulent and actual balance sheets and
checking for inaccuracies in overall and detailed reports of income or expenditures. If they find discrepancies, it may be the auditor’s
job to investigate and determine the reason for it, or it may be the job of a separate financial investigator.
Auditing for Quality Control: While many associated auditing with finding flaws, it can be just as important to strengthen a company’s
already good business practices. Many companies self-audit on a regular basis to make sure that production and workflows are running
smoothly without waste. By presenting regular audits of sound financial practices, a company improves its standing for shareholders, clients
and customers, and the report generated by the audit gives executives a better sense for the internal finances of the business. Of course, this
can lead to a downside if the auditing company itself is committing fraud or if it is in collusion with the company or its managers to falsify
reports. In this case, a forensic audit may be requested by a judge or an outside company to either determine the lost income as a result of a
fraudulent report or to determine the damage that falsified reports caused to shareholders, clients or employees.
How Are Forensic Audits Used in Court? Forensic audits are presented as evidence by a prosecutor or by a lawyer representing an
interested party. Because finance is a complex discipline, the jargon used by forensic auditors to describe a company’s financial
position is often highly precise. This either requires a prosecutor or lawyer to call upon expert witnesses to explain the significance of
the audit in layman’s terms or to have the auditor do so himself or herself in order to build a case.
9
Forensic Audit vs. Internal Audit: What’s the Difference? 2019 03 31: Doug Cash: https://www.eidebailly.com/insights/articles/2019/3/forensic-audit-vs-internal-audit
Many organizations don’t know the difference between a forensic and internal audit and wonder which they need. The answer to this question is
not always easy to determine. In many organizations, members of the audit committee, board of directors, owners, managers or other individuals
in supervisor positions have limited (if any) experience with forensic or internal audits. If they are unsure of which direction to turn, they may go
seeking the wrong solution. Let’s look at the differences between these two audits. According to the Cambridge Dictionary, a forensic
accountant is defined as “someone whose job is examining financial records to help find out whether a crime has been committed, or help with a
legal case.” Cambridge also defines an internal auditor to be “a person who does internal audits for a company.” Taking it a step further, a forensic
audit examination is defined as “an examination of financial records to find any illegal financial activity,” while an internal audit is defined as “an
examination of a company’s accounts or activities by its own accountants or managers.” The word “forensic” is often misunderstood in the
context of an audit. Forensic simply means “suitable to courts of judicature or to public discussion and debate.” When you compare that to the
definition of the an audit, which is “a formal examination of an organization’s or individual’s accounts or financial situation,” you will see a major
difference between the two: a forensic audit is conducted with the understanding the matter will appear in court for some type of trial or
mediation, and an audit is prepared to be presented to the company’s governing body or owners to discuss the financial health of the
organization. Most forensic audits and forensic examinations are conducted by Certified Fraud Examiners (CFEs), or forensic accountants who
are normally considered experts in a specific field of forensic accounting. Internal audits are often conducted by either Certified Internal Auditors
(CIAs) or other accounting professionals. To determine the need for an internal audit or a forensic audit/examination, consider the following: (1)
Ethical or accuracy lapses have occurred and/or accountability is lacking. (2) Specialized expertise is required to accomplish projects beyond
regular operations. (3) Risks in operations, compliance and reporting are unrecognized or are increasing due to significant changes in the
industry, technology, laws and regulations. (4) Existing policies and procedures are not being followed. (5) Information technology data breaches
have occurred or there is significant concern that such risk exists. (6) Compliance with laws and regulations is a significant burden;
noncompliance may become a serious issue if not monitored and evaluated. (7) Those charged with governance are focused on the "big picture,"
but remain concerned about what they may not know about the specifics (or vice versa). (8) Communications internally have led to morale and
turnover issues, and/or external communication quality has led to an air of skepticism from stakeholders about operations. (9) Suspicions of
fraud or theft arise. (10) Turnover has occurred and account balances are not what they should be (positively or negatively). (11) Accounts that
were thought to be in your entity’s name are not really owned by your entity. (12) Reconciliation procedures result in timing differences or
unidentified differences, or they don’t reconcile at all. (13) Vendors that should have been paid have not been paid, and/or customers that should
have paid have not. (14) Theft of personally identifiable information has occurred or business systems have been hacked. (15) Labor and materials
have resulted in poor quality products that are not selling (or worse, are out of compliance with laws and regulations). (16) A whistleblower
hotline identified issues such as assets stolen or other defalcations.
While some matters require both a forensic audit/examination and an internal audit, the key to determining which service to use is to
determine the time and objectives of the project(s). A forensic audit/examination is designed to focus on reconstructing past financial
transactions for a specific purpose, such as concerns of fraud, whereas an internal audit is typically focused more on compliance and/or
the performance of the organization. When in doubt, your organization should reach out to both a forensic accountant (also known as
forensic auditor) and an internal auditor to further discuss your needs. These professionals can assist you with determining which service
offering is more appropriate for the scope of the matter as well as ensure that the most qualified person(s) are on your engagement team.
Important Skills for a Forensic Accountant
Forensic accounting skills enable an accountant to gather evidence of fraud and other financial crimes and present it clearly, often in a
courtroom. Forensic accountants need to be well-versed in both accounting and law in order to determine whether a financial crime
has occurred. The following skills are all necessary to perform successfully as a forensic accountant.
1. Detail-Oriented Approach: Like all types of accountants, forensic accountants must be detailed-oriented. The process of detecting
financial irregularities and noting small discrepancies that can indicate a larger pattern of fraud requires careful focus and attention.
Forensic accountants spend a lot of time looking at and interpreting numbers. Furthermore, they also need to carefully document
their investigation in an organized fashion.
2. Interviewing Skills: The work of a forensic accountant is not limited to pouring over documents. They may also gather evidence or
seek to better understand a situation by interviewing people. In some cases, these people may be under a significant amount of stress,
and a good forensic accountant can put them at ease and draw out necessary information. Forensic accountants also need to be able to
detect when a person is not being truthful and when they need to push for more information. Good listening skills are an important
part of good overall interviewing skills that forensic accountants should also have.
3. Analytical Skills: As the Bureau of Labor Statistics points out, analytical skills are important for all accountants. In the case of a
forensic accountant, analytical skills are necessary throughout the process of reviewing documents and numbers and while
interviewing people. The forensic accountant would then use those analytical skills to construct a picture of what kind of financial
crime may have taken place in order to present that evidence to others. Sometimes, forensic accountants work on divorce cases, and
that may involve analyzing financial documents to determine whether a person is attempting to hide assets.
4. Communication Skills: Forensic accountants need communication skills for more than just interviewing people. They need to be
able to clearly communicate their conclusions in both oral and written forms. They may work closely with law enforcement or court
officials. Some forensic accountants act as expert witnesses, and this means they must have the ability to summarize complex and
sometimes technical ideas for a jury and clearly explain their bearing on the overall case. Strong writing and speaking skills are critical
for a forensic accountant.
5. Creative Thinking and Problem-Solving Skills: It is important for people in forensic accounting to be adaptable and solve
problems effectively. The course of an investigation may change quickly based on new information or some other factor. A forensic
accountant needs to have the creativity to imagine various scenarios and possibilities and consider whether they are consistent with
the evidence. Some people may think of accounting jobs as involving people working with numbers and largely alone, but working as a
forensic accountant is far from a solitary position. Combining the attention to detail of traditional accounting jobs with strong people
skills, forensic accounting is a field that can offer an interesting and challenging future.
10