How to Spot Fraud Using Forensic Accounting
Fraud is a serious problem companies need to prepare for.
It can have a devastating effect on a business and damage the company’s reputation and workers’ morale aside from the obvious financial damage.
So, what can companies do to detect fraud?
In this guide, I’ll be outlining one popular way to spotting fraud: use of forensic accounting.
What is forensic accounting and what is fraud all about?
I’ll provide an overview of the concepts along with the techniques and processes used by forensic accounting to identify whether fraud has occurred.
WHAT IS FORENSIC ACCOUNTING?
Let’s break down the term forensic accounting first.
According to Merriam-Webster, ‘forensic’ means, “relating to or dealing with the application of scientific knowledge to legal problems”.
Therefore, when we combine it with the word ‘accounting’, we have a scientific study of accounting and any possible legal breaches within it.
Essentially, the objective of forensic accounting is to analyze accounting procedures and findings and examine whether they are valid in the eyes of the law.
You can, perhaps, understand the field better when you consider when forensic accounting takes place. Not all accounting is forensic – forensic accountants are called upon when there is a litigation happening or when litigation is expected to take place.
Forensic accounting is most used to solve disputes and find answers – if things don’t add up in the accounting, for example.
It is used, therefore, to investigate and analyze the financial activities of an entity and determine if there has been malpractice, either intentional or not.
Forensic accounting is used to determine:
- How – The way in which the divergence has taken place.
- Where – At what point of the procedural chain has the divergence occurred.
- What – Is the divergence an intentional or not.
- Why – The motive or reason for the divergence, especially in terms of intentional divergence.
- Who – The person or other entity that is at fault.
Now, forensic accounting is useful for finding out whether fraud has taken place in the business.
However, forensic accounting doesn’t just deal with fraud, but it can also be used in other non-fraud situations to determine the full picture of the financial matters.
Whether forensic accounting finds fraud or is even supposed to look into possible fraud, the objective is to find and present evidence that could stand in front of the law.
The process is aimed at finding evidence that can be presented in court in order to debate and dispute a resolution – for example, convict a company or a person for fraud.
You can get more insight into forensic accounting by watching this short clip about a typical workday in the life of a forensic accountant:
WHERE CAN FRAUD OCCUR?
Fraud seems such a big word to use.
To most of us, the word is something distant and the event of fraud is something that happens to others and not us.
Since it seems such a drastic thing – fraud even sounds dramatic – it’s easy to think it wouldn’t happen in your business.
People in charge of small- or medium-sized businesses are especially shortsighted sometimes in terms of fraud.
The truth is, fraud can happen anywhere. Small, big, new, old, international, local, brick-and-mortar, or online-only; your company could be faced with fraud and you should be aware of it, rather than hide from it.
The nature of the fraud will depend on what your business does, as well as the kind of opportunities that are available to exploit.
However, there are a few common areas of fraud.
Fraud commonly takes place in situations of:
- Employees abusing their position.
It could be a matter of hiding or changing information in order to benefit from the situation. For example, an employee might claim they’ve conducted work on things they haven’t actually worked on.
- Third-party suppliers or other business partners taking advantage of their position.
The fraud can also be external – a supplier might lie about the number of products they are supplying, for example.
- Theft of confidential information that occurs either internally (someone in the organization stealing) or externally (an outsider steals information; an example could be hacking).
Sensitive information can be stolen by an employee or an outsider and then used to damage the business.
The above examples highlight the areas in which fraud often occurs.
Since the avenues for the possibility of fraud are rather varied, it’s important that companies take it seriously.
Creating business relationships that are built on trust is essential, but every company also needs proper checks and balances to limit the risk of fraud.
Simply thinking it would never happen for your business is not solid protection against fraud.
WHAT CONSTITUTES AS FRAUD?
While fraud can happen in any kind of business, it’s important to also understand what actually constitutes as a fraud. Merriam-Webster defines fraud as:
- “intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right”
- “an act of deceiving or misrepresenting”
From the above, two things point out in terms of what is fraud.
First, the act must be conscious and intentional – unwittingly writing an extra zero in the income bracket is not fraud; if you do it intentionally, it is.
The second point is about the act leading to a gain, which could be financial but it doesn’t have to be so.
The act must provide some kind of benefit to the person or entity doing it or infringe on the legal rights of someone else.
Now, the specific definition of fraud in the eyes of the law can vary from country to country. Nonetheless, those two points generally always appear in the legal definition in one form or another.
With all of that in mind, three core elements can help you understand whether something is fraudulent or not. These are:
- The law of the land will determine whether the act constitutes as fraud. This is always determined on a case-by-case basis and the available definitions and test cases will be set out by the regional or national court under which the business operations would fall into.
Forensic accounting would always use this legal definition of fraud as the basis for determining whether there has been fraud or not.
- The auditor cannot determine what constitutes as fraud. The forensic accounting team is not to make judgments or determine if fraud has taken place – it’s role is only to investigate and present evidence to the court of law, which makes the ultimate decision.
- Fraud always requires intention. In all events, fraud cannot take place without intention and part of the forensic accounting team’s job is to find if there is enough evidence to show there has been an intentional effort to change, tweak or other how mishandle the information.
WHEN CAN FORENSIC ACCOUNTING BE USED?
With all that in mind, when can forensic accounting be used to spot a fraud?
There are essentially two clear cases in which forensic accounting is the perfect tool for detecting fraud and presenting evidence that it might have happened.
Forensic accounting can be used in situations where there is a possibility of fraudulent accounting and reporting. This would occur if a company suspects that an employee or a third-party supplier has been doing something illegal.
The problem could be spotted by the accounting team within the company and reported to management.
The possibility of fraud can also be something spotted by an outside – for example, during a random audit or when annual taxes are being checked by the authorities.
Once a possibility of fraud has been established, the forensic accounting team is called in to investigate the situation.
As noted above, the forensic accountant won’t make a judgment on whether the fraud took place, so at this point, legal teams are involved in determining what happens with the evidence presented by the forensic accountant.
The other case for seeking help with a forensic account is when there has been a clear misappropriation of assets.
Again, this can be something directly spotted by the internal teams – accounting or likewise – or it can be noted by external entities. These are situations where the assets have been taken but the forensic accountant’s job is to find evidence to suggest or support the event has been fraudulent.
For example, the company might notice it is missing part of its income and the forensic accounting team will begin investigating whether there has been fraud or just another unintentional error in reporting.
THE PROCESS OF USING FORENSIC ACCOUNTING TO SPOT FRAUD
So, forensic accounting can be used when there’s a suspicion or strong possibility of fraud.
But what about the process?
How does forensic accounting go about finding evidence to support either argument?
Essentially, forensic accounting uses processes similar to a normal audit – it follows four specific steps in order to draw its conclusions.
Planning the investigation
First, the investigation must be planned.
Forensic accounting requires the use of forensic accountants, which have to be hired from outside of the firm to ensure partiality in the investigation.
Once the investigators have been found and hired, the forensic accounting team can start preparing for the investigation.
The team generally starts by laying out the objectives it wants to achieve. These are the how, what, where, when and why of the investigation, which I’ve already outlined above.
Forensic accounting will look at each objective and identify the different ways these can be achieved and how evidence can best be identified and gathered.
At this point, the team will create a schedule of operating and determine who is in charge of which part of the investigation (in case a bigger team is needed).
The second part of the investigation process is the most demanding and long-lasting.
It is about gathering the evidence to disprove or prove the action of fraud.
The focus at this point is on ensuring there is enough evidence for the courts to make a decision – the how, what, where, when and why are at the heart of this process, with each method and technique used to find information on these points.
There are a number of techniques forensic accounting can use to gather evidence.
The three most common techniques in terms of identifying fraud will be outlined in the next section.
But to give you an idea on what happens during the process, here are a few evidence gathering things forensic accountants might use:
- Using testing controls to identify weaknesses in the system and noticing how and why the fraud could have taken place.
- Utilizing analytical procedures to compare trends in the data and making comparisons between different areas of the business to spot deviations.
- Interviewing employees and other key members that could have information regarding the fraud.
- Taking advantage of computer assisted auditing software to identify issues of timing and other relevant data issues.
- Opting for substantive techniques, which include things such as cash or asset counts.
Reporting the findings
Once the forensic accounting team has been able to gather all the evidence, they will need to report the findings.
The report is often used for determining whether legal action shall be brought forward or if there is no evidence to suggest fraud has taken place.
The main function of the report is to summarize the evidence and to provide a conclusion whether the deviation or loss of assets was due to fraud or not. You will also be able to read an answer to the core questions – how the fraud took place and when it is suspected to have happened, for example.
The report is often also used for identifying possible recommendations for strengthening the accounting in the business and preventing future frauds.
Dealing with possible court proceedings
The fourth step in the process can technically be obsolete if the report doesn’t find any evidence to back up a claim of fraud.
However, if fraud is still suspected, the forensic accounting has to be prepared to deal with the possible court proceedings.
Team members will in most cases need to be part of those proceedings and they are often called to testify and explain the evidence to the jury and judge.
The forensic accounting team has to be able to provide and present the evidence in a way that is accessible to the wider audience – the judge and the jury might not have specialist knowledge of accounting and thus the evidence must be laid out in layman’s terms.
THREE FORENSIC ACCOUNTING TECHNIQUES TO DETECT FRAUD
When it comes to detecting fraud, there are three forensic accounting techniques used. These are data mining with computers, review of other documents using various methods and conducting interviews.
Data mining with computers
Data mining is about looking for anomalies, trends and patterns in the data relating to the business and its finances.
These could include the digital accounting files available or files and datasets relating to products, suppliers and so on.
As the world is increasingly moving from traditional paper filing to digital filing, data mining is becoming a more important tool for forensic accountants.
The data mining is often done with automated software that has been designed to notice anomalies or patterns. Occasionally, a person reviews the data and the forensic accounting team studies any noticeable differences further.
A big part of the data mining involves around the concept of Metadata. This is the information related to the organization’s computer programs and the specific files used. Metadata is used to identify things like:
- The date when the file was created and whether it had been modified.
- The location of the file and whether it has changed.
- The identity of the person who has modified and changed information or the location.
Finding and understanding the trail of the digital files is important because it can reveal fraud.
For example, if the financial figures are wrong, data mining can identify whether they have been wrong since the start (i.e. possibly as a result of a typing mistake) or if they have been tampered with later (i.e. changed to create stronger income figures and thus pointing to a fraudulent and intentional action).
Aside from the metadata, forensic accounting also uses data mining to review the information in the file and the patterns revealed by data.
Forensic accountants can spot fraud by data mining with actions like:
- Evaluating the frequency of payments and consistency of financial figures.
- Finding gaps in ledgers or missing data files or information.
- Examining the vendor and supplier information, including addresses.
Data mining also utilizes different mathematical formulas for spotting fraud. Among the most popular is the Benford’s Law. The technique is explained further in the video below:
Data mining is performed on any computer or another device that is used by the organization and which could include information that might help the forensic accounting team.
These include things like personal computers, network servers, answering machines, digital cameras, fax machines, printers, GPS systems and so on.
Reviewing other documents
Of course, information isn’t always in digital format and forensic accounting has to use document reviewing strategies to spot fraud. Reviewing physical documents can be tricky for the forensic team because they need to ensure they follow the right legal procedures in accessing, storing and managing these files.
For example, they can’t illegally obtain business documents and then use them to accuse the business of fraud – everything has to follow the correct and legal route.
Generally, when the forensic team receives an invitation to perform the investigation, a legal contract is formed that issues the forensic accounting team with the rights and responsibilities regarding the documents.
In certain instances, the contract also has to deal with the proceedings for digital documents and any documents that might be accessed on employee premises.
Interestingly, a big part of the document review is identifying the carbon copy of these documents. This means checking whether the documents have been modified after the date they are meant to have formed or simply added in later.
Let’s say an employee would try to tamper with sales numbers, he or she might re-print the invoices with different figures.
The review of other documents uses similar techniques to above in finding trends and patterns.
Reviewing will be more laborious if it has to be done manually but forensic accounting teams often scan and create digital data files of the documents to allow data mining.
But forensic accounting doesn’t just have to rely on data. Talking to employees and other key parties is another crucial technique to help identify data.
For example, by interviewing the organization and the supplier, different stories of the invoicing procedure might come up and point to the system being fraudulent. Indeed, sometimes the fear of the investigation can make people talk and admit fraud – helping the forensic team to find the answers to the questions they might have.
Again, it’s crucial to ensure the interviews are conducted professionally and within the legal boundaries of the country.
The process must be coordinated with the legal teams and generally, there has to be some kind of record of the interview (this can be used in the court as evidence, rather than have a situation of ‘he said, she said’). The purpose of the interview is to identify the following things, which could point out a possibility of fraud:
- Knowledge of the information being examined.
- Opportunities to change, swap or manipulate data.
- Understanding of the procedures being used in the organization.
The forensic accounting team has to be good at communicating with people and use a logical approach to getting to the bottom of things.
It’s important to realize that you might not receive a pure admission of guilt – the person’s unusual behavior might be a sign there is something suspicious going on that needs to be investigated.
Fraud is not just something that occurs in big, popular companies. It can happen to small or big businesses in all industries.
Detecting it can be difficult but forensic accounting provides quite a good number of solutions to identifying whether a fraudulent activity has taken place.
It uses modern technology in the form of data mining to notice anomalies and patterns in data.
But it also helps spot fraud by focusing on the people involved in the situation – using documents and interviews to see whether things are out of the ordinary.
It is essentially picking the pieces apart and seeing whether putting them back together leads to the same results or if things are out of the ordinary.
In San Jose (CA), we meet CEO and Co-Founder of MapR, John Schroeder. John talks about his story how …