Financial fraud investigation: Forensic accounting

What happens when a business discovers potential illegal activity in its financial records? Hopefully, an internal audit is enough to uncover an inefficient process. When it’s not enough, businesses call on forensic accountants to investigate, report, and litigate their findings to recover losses.

The original Public Enemy #1, notoriously dangerous Chicago mobster Al Capone, was not incarcerated based on his acts of brutality. Capone’s trial is seen as the first substantial application for what is now known as Forensic Accounting. Frank Wilson, a CPA with the IRS in the 1930s, used investigative techniques to dissect some two million documents related to the mobster’s activities. The investigation took nearly six years and revealed that the mobster was guilty of tax evasion. Capone was charged with 22 counts—convicted on 5—and sentenced to 11 years in prison.

What is forensic accounting?

Today, businesses rely on knowledge of complex financial data to make decisions for growth and development, encourage investors, and safeguard accounting practices while remaining in compliance with federal and international reporting requirements. Internal audits of general accounting practices provide a means to review and make adjustments to processes in place as needed. Audits occur regularly and voluntarily and should not be seen as an indication that illicit activity has occurred, rather that the correct countermeasures are in place for fraud detection.

Forensic accounting, on the other hand, is a series of investigative procedures used to address and identify intentional acts of illegal financial activities and then use that information in a court of law to clear or condemn those accused. Forensic accountants “follow the money” by conducting research on a trail of funds, analyzing gaps or misleading or misused information, compiling reports on the financial findings, preparing data for litigation support, and are prepared to testify in court if necessary.

While there is no specific credential to be a forensic accountant beyond being a qualified certified public accountant (CPA), specialized degrees, a master’s degree, and certifications provide the breadth of knowledge and investigative skills required to perform the responsibilities. These may include being a certified fraud examiner (CFE) by the Association of Certified Fraud Examiners (ACFE)—and later a Certified in Financial Forensics (CFF) credential—or a forensic accounting certificate from AICPA. In addition to working with public accounting firms or financial institutions, persons with a criminal justice degree looking to work with law enforcement agency may also qualify.

What is forensic accounting used for?

Passwords, credit card security measures, PIN codes, multi-factor authentication, one-time passcodes, and knowledge-based authentication: These are all measures offered today to help secure identities and sensitive financial information. However, according to an Experian report, while 4 out of 5 consumers trust that data protection is a top priority, 72% of businesses cite fraud concerns; 33% of whom reported higher levels of fraud.

Situations that should send a red flag for potential fraud include recent turnover that aligns with inaccurate account balances, reconciliations that result in unidentified differences, vendors or customers that go unpaid or do not pay, poor quality products that do not meet laws and regulations, and any circumstance where the documentation of finances do not correlate to actual numbers.

Investigating fraud

When inaccuracies are discovered, an investigation into the source is conducted. Hopefully, discrepancies can be resolved through an internal audit. However, should it be determined that something more has occurred a company may turn to the forensic accounting profession to research, identify, and report on their discovery.

How forensic accounting audits work

The specifics of a forensic accounting audit vary depending on the nature of the activity. However, the general actions of a forensic accountant include these three measures:

Investigation

The first task that a forensic accountant completes is their investigation into the matter. This can be a lengthy process involving reviewing bank statements, balance sheets, interviewing employees, and researching the business to best paint a picture of what has transpired. During the investigation phase, the forensic accountant will identify what, if any, type of fraud has occurred, who the person(s) responsible are, what was done to conceal the fraud, what has been lost, how those losses might be regained, and even provide preventative measures for the future.

Reporting

Once a thorough investigation has been completed, a forensic accountant must put those findings into a report that provides a logical flow of evidence admissible in court. These reports are detailed and require close and scrupulous care of documentation to ensure no tampering or damaging can occur.

Litigation

Forensic accountants are considered an expert witness in a case. Some of these disputes are resolved outside of the courtroom, the forensic accountants report on how to recover the losses are resolved between the two parties. When the case does go to trial, the forensic accountant assigned to the case must be prepared to testify. A vital skill that these professionals must have is the ability to communicate their findings in a way that a jury will be able to comprehend.

Types of financial fraud

Tax Evasion. Even though paying taxes is an inevitable part of doing business, some companies operate in illegal ways to avoid paying a portion to the government. Forensic accounting is used to track earnings and identify taxes that are owed.

Securities fraud. When a business seeks investors, the financial information they provide must be accurate. When false claims are made, securities fraud is committed. Forensic accounting helps investors identify inaccurate information to help protect against financial losses.

Money laundering. Often occurring in tandem with tax evasion, money laundering occurs when large sums of money are broken down into smaller parts and deposited into numerous, seemingly unrelated accounts. Forensic accounting seeks to trace these complex systems to discover the truth.

Family and marital disputes. Financial disputes in family court can be brutal. Situations where a relationship is manipulated to steal money or when one party in divorce disputes the reported assets of the other party require forensic accounting to unravel accuracies.

Business economic damages and bankruptcy. Forensic accountants provide assistance to businesses experiencing significant financial loss. Sometimes these losses are due to fraudulent activity and a means to recover those losses is actualized. These professionals may also address issues that arise from mergers, acquisitions, and other contract disputes.

Hidden or misappropriated assets. Money or property that has been intentionally hidden and taken from a business are known as misappropriated assets. The fraudster will intentionally manipulate the financial records to cover their tracks. This type of financial fraud includes embezzlement, payroll fraud, and employee theft.

Insurance claims. Insurance scammers submit false claims in hopes of receiving insurance payouts. Insurance fraud can sometimes be difficult to prove, and a forensic accountant works closely with the insurance companies and the insured to determine the value of losses, including situations where a typical profit and loss statement may not exist.

Terrorism and counterintelligence. In a recent report conducted by IBM, of over 500 cyberbreaches studied, the average cost of a data breach increased 10% from 2020 to 2021. Forensic accountant work is being utilized by government agencies more and more to help contain and prevent terrorism and fraud through cyber activities.

How to mitigate financial fraud

The best way to stop fraud is to actively work to prevent it from occurring. Here are some tips to secure your systems:

Use technology to record all transactions

One of the best ways to keep financial records secure and accurate is using digital records. Even the IRS has switched over from traditionally requiring hard copy records to overtly accepting digital because it provides a more thorough view for IRS audit. Further, using a cloud-based option for digital records also reduces the time it takes to reach containment after a cyberbreach.

Keep audit logs

An audit log, or audit trail, is a capture of activity that shows who performed an action, what action was performed, and how a system responded to that action. It may also include additional information like dates, times, IP addresses, and location. These are vital pieces of information to tracing fraudulent activity.

Run internal audits from time to time

Best practice encourages an internal process audit at least once a year. Internal auditors determine the efficacy and efficiency of company processes and policies. High-risk industries like manufacturing and healthcare should consider increasing that frequency to quarterly or more. For publicly traded companies and non-profits, external audits are required to remain compliant.

Work with an accounting firm to find holes in your accounting processes

Getting a second pair of eyes on a situation can make all the difference in fraud deterrence. CPAs and forensic accountants are trained to review financial data and provide preventative recommendations. By working with an external auditor the business gains an objective overview of processes to help improve controls and avoid financial loss.

Conclusion

Financial records are a lot more than just numbers on a page. They paint a picture of a business’ activities—times and dates purchases occurred, tracing new hires, when vendors are being paid—and provide a means to look deeper than what’s on the surface. While all companies aim to mitigate financial loss from fraud, external audits and digital tracking are the best preventative measures. And when an illegal activity does occur, forensic accountants function to help identify and recover assets.