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July 2016

Expectations – Forensic Audit

By Chetan Dalal Chartered Accountant
Reading Time 7 mins
What exactly is forensic accounting or forensic audit? How does it differ from an audit?

A very simple description of forensic accounting is the use of accounting, auditing and investigative skills to analyse financial information for use in legal proceedings. The word is “Forensic” means “suitable for use in a court of law”. Forensic accountants, also referred to as forensic auditors or investigative auditors, often have to give expert evidence at the eventual trial. There are many differences between an audit and a forensic audit. The most important difference between the two can be described as follows.

An auditor usually relies on documentary evidence for expressing an opinion, while a forensic auditor examines the reliability of the documentary evidence for making an assertion or a statement in a court of law. The forensic accountant has much greater responsibility and his report may have far reaching ramifications in a court of law. Forensic audit is specific to an issue and more often than not, its’ genesis is a dispute and its objectives and deliverables are unique in each situation. The forensic accountant usually visualises what kind of deliverables would be possible and there is some degree of flexibility in this aspect. However, an audit usually does not stem from any dispute and the objectives and disclosures of audits mandated under the Companies Act, 2013, or the Income Tax Act, 1961 etc are defined in the relevant Acts.

Forensic Audit – case study :

The concept of forensic audit can be best understood through a real life case. The chairman of a bank was worried. A borrower had failed to repay a huge loan of Rs 70 crores. The bank had two options. One option was to take legal recourse and commence recovery proceedings. The second option was to agree to the borrower’s request to fund a further 8 crore to revive his business. The borrower claimed that the recessionary conditions, which had caused his losses, had receded and now he had some big export orders on hand. Therefore he had a good chance to turn the corner and he expected to repay the loan to the bank in 4 years. Should the bank take the first option? If so it was certain that the legal battle would drag on for years and the chances of recovery, in the foreseeable future, were slim. On the other hand, in option two, the bank would be able to get the money back in 4 years. But the question was: “Is the borrower taking the bank for a ride? Was the past loss purely due to recessionary conditions and not due to mismanagement or siphoning of funds?” The borrower had indeed provided audited statements of his company for the past few years. However the information given in the audited financial statement and the auditor’s reports did not spell out reasons for the business loss. The financial information was not sufficient for the bank to ascertain whether there could have been any malpractice or abuse or misuse of assets or funds. This was a situation where the bank wanted information which was more specific, to enable it to decide which of the two options stated above should be selected. Essentially the bank wanted to know whether the borrower was a genuine victim of recessionary business conditions or not. The bank had to rule out the probability that the borrower was a manipulative, conniving, or deceptive borrower who had hoodwinked the bank in the past. The bank chairman was advised to get a forensic audit conducted to get answers to all these questions. The bank thus appointed a forensic accountant who was able to find a lot of information which provided valuable insights for the bank to take the right decision. The forensic audit report, on the one hand, prevented the bank from losing a further sum of Rs 8 crore per option two. On the other hand, the report facilitated the bank to go in for option one of recovery and legal proceedings including a police complaint for criminal actions of fraud and falsification of documents. What did the forensic auditor find out that the other officials in the bank, the auditor, the internal auditor, the tax auditor and others in corporate governance were unable to find? The forensic auditor found that the borrower had been transferring funds to satellite entities, which were his family concerns. Personal expenses and expenses of those satellite companies had been debited to the borrower’s company to show losses. Moreover the forensic auditor did some field investigation which revealed that the borrower used to take a lot of income in cash, thereby showing lesser sales. The combined effect of all these methods was that the borrower had been able to siphon out huge funds from those loaned by the bank and palm off such transfers as expenses resulting into losses. This process of collection of specific information and evidence which the bank could use for decision making and also for court proceedings is what is forensic auditing all about. The terms forensic accounting and forensic audit mean the same and are often used interchangeably.

What are the typical kind of forensic accounting assignments?

A large part of forensic accounting work relates to fraud detection and fraud investigation. Forensic accountants are asked to take up assignments relating to disputes, financial crimes, corrupt practices, business leakages and siphoning of funds, whistleblowers’ complaints of any kind, and the many other situations where any wrongdoing is suspected. Forensic accountants can be appointed by corporate management, third parties affected in any situation, bankers, or even under the law or by government agencies. In the last decade some of the really intensive users of forensic accountants are the police, ED, Reserve Bank of India, tax authorities and large public sector corporations. A recent trend is emerging where in individual courtroom cases even judges appoint forensic accountants for their own evaluation of disputes.

Does forensic accounting relate only to financial fraud?

Generally speaking, the answer is yes. However it would be incorrect to say that forensic accountants are not approached to investigate non financial crimes. For example in a public listed company there was a lady employee who got an obscene letter placed on her desk. She threatened to complain to the police. However the ethics counsellor stepped in and assured the lady that the company would look at this matter seriously and investigate and apprehend the culprit. They requested her to hold on till they completed an internal investigation. She relented and the ethics counsellor approached a professional forensic accountant and he did a remarkable job. The forensic accountant used his team which had comprehensive skill sets to perform computer forensics, interviewing techniques, and handwriting evaluation to nail the culprit. The aggrieved lady was satisfied and the company management was saved by the astute forensic accounting work. Similarly forensic accountants may even be used for marital disputes to understand what kind of assets and finances are held by the opposite spouse and to facilitate a fairer settlement. However such non financial cases are fewer in number.

What are the tasks usually performed by a forensic accountant?

A forensic accountant is expected to be able to perform all the tasks that an accountant and an auditor is able to perform. In addition, he should have in his team, reasonable expertise in interviewing, interrogation, data mining and investigative analysis, field investigations, computer forensics and handwriting and specimen signature analysis.

Steps in preforming forensic accounting

The broad steps in forensic accounting are (a) Establishing a clear mandate outlining specific objectives and deliverables, (b) data and evidence collection, (c) data analysis, and (d) evaluation of all data and evidence collected and finally (d) reporting.

Forensic accounting and fraud investigation have been gaining more and more importance particularly after the commencement of Companies Act, 2013. Opportunities for Chartered Accountants are plenty and appear to be increasing every day. It would be well worth the effort for chartered accountants to learn and implement forensic type techniques. They will be useful in regular audits in any case and further enhance their areas of practice in the foreseeable future.

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