FORENSIC AUDITING- A much required tool in the recent era of Frauds & Misappropriations

“if you see a fraud and do not say fraud, then you are a fraud”…Naasim Nicholas Taleb

The article briefly explains the concept of Forensic Auditing and the use of the technique in the detection of the frauds. The relevance of the concept has been highlighted -especially in the emerging scenario of continuous development in the fields of accounting and auditing. The article also touches upon the various  inter-related concepts and the vital areas where the technique of Forensic Auditing can be best used in detecting the misappropriations and manipulations in the financial as well as operational matters. 

Introduction

The manipulations and misappropriations in the corporate world relates back to Sept 1720 when after the War of Spanish Succession, the UK signed the Treaty of Utrecht 1713 with Spain, ostensibly allowing it to trade in the seas near South America. In fact, barely any trade took place as Spain renounced the treaty; however this was concealed on the UK stock market. A speculative bubble saw the share price reach over £1000 in August 1720, but then crash in September. A Parliamentary inquiry revealed fraud among members of the government, including the Tory Chancellor of the Exchequer John Aislabie, who was sent to prison. (source-online published story)

And since then there has been a steep rise in such manipulations being continuously occurring all over the world, such as Quintex-Real Estate (1989), Poly Peck-Electronics, Food, Textiles (1990), Bre-X-Mining (1997), Equitable Life Assurance Society-Insurance (2000),WorldCom-Telecommunication (2001), Enron-Energy (2001), Arthur Anderson-Accounting (2002), Parmalat-Food (2003), Refco-Brokering (2005) and of course the securities scam by Harshad Mehta and Ketan Parekh, C.R. Bhansali, Home Trade fraud, M/s Satyam Computer Services Ltd and many more.

Some of the Companies which were in news in recent past for the wrong reasons-

1) Vakrangee – no one knows whats wrong with the Company

2) Manpasand – Alleged Tax credit claim fraud (Fake invoices exchanged in grey market)

3) LEEL – It is alleged that Promoters just took out the money after selling a business unit

4) Gitanjali – Fake letter of credit

5) Eros, Cox and kings – It was alleged that Despite having cash company defaulted on NCD

6) DHFL – It is alleged that borrowed funds were used to lend to shell companies owned by operator

7) IL&FS – Huge bonuses and dividend payouts to promoters were alleged

8) Yes bank – Alleged Non disclosure of provisions is been the issue and power of centered in the hand of one man knew and he was asked by regulators to leave

9) HEG– A 20 million USD bonus was given to the CEO when shareholders lost more than 80% of value

10) CG Power – It is alleged that billion dollars taken out via transactions

11) TATA Sons-The Board aligned to the majority shareholder, gave Cyrus Mistry a glowing performance review only to sack him a few months later

12) Infosys-The Board first played supplicant to Chief Executive Officer Vishal Sikka, then to former promoter NR Narayan Murthy. Investors paid the price for unstable leadership. And even today, investigations into acquisitions have not been shared with all the stakeholders.

13) Axis Bank-The Board seemed unquestioning of Managing Director and Chief Executive Officer Shikha Sharma. But the regulator wanted her go.

14) ICICI Bank-The Board appeared like a deer in the headlights, dazed by the celebrity of MD & CEO Chanda Kochhar, allowing her continued presence in the company, even as she was being investigated for alleged nepotism.

15) Fortis-Promoters held sway, the board turned a blind eye to many suspicious transactions, and finally shareholders booted them out

Statutory Provisions covering the reporting of Fraud

SA 240- prescribed auditing standard as per Sec 143(10) of the Companies Act 2013 Communication of fraud/ fraudulent matters to management

The auditor is concerned with fraud that causes a material misstatement in the financial statements.

Sec 143(12) of Companies Act 2013 Reporting to the Central Government/ Audit committee as the case may be, if an offence involving fraud is being or has been committed against the company by officers/ employees of the company.
Rule 13 of Companies (Audit & Auditors) Rules 2014 Specifies the manner for reporting the fraud to the Central Government/ Audit Committee as the case may be

A fraud, which involves or is expected to involve individually an amount of rupees one crore or above, is being or has been committed against the company by its officers or employees, the auditor shall report the matter to the Central Government.

A Fraud involving lesser than the amount specified above- the auditor shall report the matter to Audit Committee constituted under section 177 or to the Board immediately but not later than two days of his knowledge of the fraud 

Form ADT 4 Format and information to be included in such report.

 WHAT IS FRAUD?

With the advent of definition of fraud in the Companies Act 2013, the concept of Forensic Auditing as a practice and methodology has gained immense importance and relevance in addition to the regular auditing techniques already in place.

The explanation given in Sec 447 of the Companies Act 2013  says that-

“fraud” in relation to affairs of a company or any body corporate, includes any act, omission, concealment of any fact or abuse of position committed by any person or any other person with the connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss; 

A Forensic Audit is a comprehensive and systematic process involving a series of activities and tasks undertaken for establishing the accuracy and authenticity of the transactions under review.

It may include-

  • investigative techniques with an understanding of accounting principles,
  • review of financial statements to determine if they are accurate and lawful,
  • application of accounting methods to the tracking and collection of forensic evidence
  • examination of legalities
 Propriety Audit   Investigative Audit 
Regularity Audit  Financial Audit

Why Are Forensic Audits required?

  • to find out whether or not true business value has been reflected in the financial statements
  • to find whether any fraud has taken place
  • to determine if there are suspicious practices hiding beneath company or individual financial records and statements.

Various international laws and legislations such as Foreign Corrupt Practices Act 1977, Sarbanes-Oxley Act 2002, Public Companies Accounting Oversight Board (PCAOB) etc also depicts the importance of Forensic Auditing in the recent corporate scenario.

When Are Forensic Audits required?

  • wherever an entity’s finances present a legal concern,
  • in cases of suspected embezzlement or fraud,
  • to determine tax liability,
  • to investigate allegations of bribery,
  • to strengthen a company’s already good business practices,
  • to either determine the lost income as a result of a fraudulent financial/ operational report,
  • or to determine the damage that falsified reports caused to shareholders, clients or employees.

Types of Frauds detected by Forensic Auditors

Forensic Auditors being the professionals carrying high degree of skepticism, effective probing techniques, highly analytical and well versed I documentation and evaluation usually detects the following types of frauds in the financial statements-

1. Frauds related to Revenue and Sales- such as showing fictitious sales revenue(inflated/ deflated)

2. Frauds with respect to falsifying the market position of the company by either showing false results or deceiving the shareholders by showing inflated share prices and consequently lower debts.

3. Other frauds may also consist of various deceptive sale practices being undertaken by the company itself in order to capture market share or sustaining the present market position. This is generally done by selling defective parts or even re-imbruing the expenses which have not been actually incurred / covered in the policies.

4. Various third party frauds may also comprise of recording of deceptive allowances from vendors in order to falsify the revenue(inflated/ deflated) and even sometimes underachievement to vendors is also reported.

5. Fraudulent acts of providing mis-statement in the financial statements by the directors such as no violation of law has taken place or Internal Financial Controls are in place etc.

6. Frauds related to tampering of bank records and taking the monetary advantage thereof.

7. Theft of competitor secrets or third party intellectual property rights may also amount to fraudulent act which also comes under the purview of forensic auditors.

8. Various other frauds may also include-

9. Showing financial statements as these are in line with the standards set or budgeted tasks.

10. Falsifying the value of the business

11. Using business resources for personal purposes

12. Accepting bribes form the customers/ dealers/ vendors in order to facilitate business to them

13. Representation of dummy workers/employees in the manpower sheets and consequently higher wage cost/ employee cost.

14. Fictitious expenses and inflated incomes

15. Showing dummy suppliers/ vendors and payments thereof

16. Representing excess recoverable/ payables in the financials

Constituents of Forensic Audits-

1. Assessment of fraud risk factors and evaluating internal controls and standards

2. Comparison and contrast of various fraud schemes to devise the appropriate internal controls

3. Developing off-setting internal controls that would limit or prevent these fraud schemes

4. Using data analysis techniques to identify high-risk transactions for further review and investigation

5. Evaluating internal controls and identifying ways to plan audits to take advantage of available information systems resources

6. Evaluating financial and program risk for potential fraud

7. Applying various evidence-gathering techniques used to detect fraud

8. Justifying the auditor’s conclusion of fraud by providing the evidence needed to support legal and investigative staff

9. Documenting the evidence and data-gathering process

10. Sharing the findings with the agency and advise them on how to avoid the fraud in the future

Distinction between Forensic Auditing and Financial Auditing

  Financial Auditing Forensic Auditing
1. Examination of the financial statements in accordance with the applicable standards and norms. Identifying and analyzing the possibility of fraudulent financial reporting and misappropriation of assets.
2. The techniques mainly comprises of compliance and substantive testing of eth transactions. The techniques usually comprises of scrutiny and in-depth review of specific transactions.
3. Audit opinion is on the whole set of the financial statements being audited. The main concern is on heightening of the awareness of the specific irregularities reported
4. Audit is in the nature of public interest Audit is conducted considering the interest of specific persons who have hired them.
5. Auditor’s  work  stands  on  its  own  Forensic  Auditor’s  work  supports  the work of the legal counsel or the board
6. The financial auditor only expresses the opinion In addition to the opinion , the forensic auditor also identifies the causes of the irregularities and may also recommend requisite changes.
7. Management representations for valuation of stock, bank accounts etc are used. The auditor gathers each single evidence on its own during the whole examination.
8. Auditors are concerned with errors and irregularities forensic accountants are concerned with distinction between errors of judgement & deliberate misrepresentations
9. Working without indemnification work usually has both indemnification and hold-harmless protections
10. Auditor determines the nature,  scope,  and extent of the audit Client determines the nature,  scope,  and extent of the audit

How are frauds detected in the Forensic Audit?

In this type of audit, the forensic auditor specifically looks for the financial misconduct taken place in the financial records and statements of the entity. As against the regular review or audit of financial statements, it focuses on the gathering of the evidence to be produced in the court of law during the proceedings taking place.

Various detecting techniques used by Forensic Auditors may include the investigation, pro-active detection, identifying the absence of moral rules in the organization, weaknesses in the line of defense  such as ineffective internal control/ audit, other tests can be conducted such as tests of reasonableness, historical comparisons of eth entity’s key performance indicators, evaluating other off-balance sheet transactions etc.

Internal Audit and Internal Control- A line of defense

According to the Business Dictionary, Internal Control are systematic measures, such as reviews, checks and balances, methods and procedures instituted by an organization to conduct its business in an orderly and efficient manner, safeguard its assets and resources, deter and detect errors, fraud and theft, ensure accuracy and completeness of its accounting data, produce reliable and timely financial and management information and ensure adherence to its policies and plans.

In order to achieve all these objectives, an organization must have an effective Internal Audit system in place. In the recent scenario, when the scope of the term Internal Control has been extended to Internal financial Controls, the functionality of the internal Auditor of the company has also changed. The responsibility of detecting the fraud has increased and measures for preventing and mitigating such recurrences needs to be identified by the professionals. The governing forces behind the effective and efficient Internal Audit and control review can be summarized as below-

 Control Environment

(Physical or Documentary)

 Control Activities

(Operational or Financial)

 Risk Assessment

(All types of risks) 

Information and Communication

(Effective and Efficient)

Conclusion

In the present scenario of revival of corporate law and norms being made stringent, there is an ample space for the overall recognition of such an important technique for identifying frauds. The technique altogether different from the traditional auditing approach has also got its significance where the  concept of due diligence has to be applied. Forensic Auditing  not only identifies the factors/ reasons adversely affecting the trust in mechanism of trade, finance and investment but also helps in recognizing the destabilizing effect on commercial institutions and corporate houses directly affecting the national progress and putting strain on national resources.

Author Bio

Qualification: CA in Job / Business
Company: M/s SML Isuzu Ltd
Location: Chandigarh, Chandigarh, IN
Member Since: 10 May 2017 | Total Posts: 43
CA Rubneet Anand B.Com, M.Com(Finance& Taxation), MBA(Finance & International Business- IMT Ghaziabad) [email protected] Deputy Manager (Internal Audit & Indirect Taxation)-M/s SML Isuzu Ltd Facebook Page- Corporate Prism-Consultation in Accounting & Corporate Managemen View Full Profile

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