Forensic accounting is a specialized branch of accounting. It involves the investigation of financial data so that committed frauds can be identified and probable frauds are prevented.
In this article, we will be focusing on the basics of forensic accounting and the methodologies used in the branch.
Table of Contents
- What is forensic accounting?
- Areas of operations
- Job responsibilities of forensic accountants
- Methodologies used
What is forensic accounting?
Forensic accounting is used for investigating financial documents to find evidence related to financial misconduct or frauds. It is a branch of accounting that uses audit, law and accounting for discerning any financial crime. Forensic professionals such as CPAs prepare reports to provide their detailed analysis of the investigation.
Areas of Operation for Forensic Accounting
Forensic Accountants have the following areas of operation:
- Claim investigation: The investment industry requires forensic accountants to verify the genuity behind a claim. Along with that, they also quantify financial damage in a case. For this purpose, they use a combination of current conditions, historical data, and future predictions for calculating the damage. Based on this analysis, accountants recommend the claim amount possible.
- Business interruption claims: It is the loss that is sustained by a business due to any incidents that are not under control. These result in the inability to carry out business functions. This compels businesses to seek coverage through various insurance policies. Forensic accountants identify and analyze frauds in such claims and explain consideration by insurance carriers while hiring external accountants. They also analyze and compare the company’s financial statement before and after such business interruption.
- Breach of contract: This occurs when a contract is not properly followed by parties that are legally bounded by it. Forensic accountants quantify the financial losses that arise from such contractual disputes. These professionals analyze the entire contract and assess the breach to help parties achieve an appropriate settlement.
- Diversion of funds: Forensic accounting is also useful in determining whether allocated funds are used for any other purpose than expected. They examine the books of accounting, banking and financial statements, among other documents, to identify fraud.
- Tax evasion: Forensic accountants help identify methods and the amount of tax evasion committed. To investigate tax fraud, they analyze financial data and prepare reports to explain the fraud. They also provide documentary evidence as an expert witness in tax legal proceedings.
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Job Responsibilities of Forensic Accountants
The job responsibilities of forensic accountants is to identify the following:
- Manipulation of the accounting books
- Misrepresentation of financials and business operations
- Siphoning off of the company funds by stakeholders and key management persons
- Impairment of the investments in subsidiaries, associates, and potential related-party transactions.
- Performing forensic research for tracing funds and identifying assets for recovery
- Providing litigation support as eye witness
Methodologies and Tools Used in Forensic Accounting
The professionals in forensic accounting use two methods for conducting their investigation:
- Direct Methods: This is also known as the transaction method, where accountants examine cancelled cheques, invoices, public records, contracts and agreements.
- Indirect methods: It has the following three methods:
- Cash T Method: It involves the comparison of received cash with the amount of cash that has been spent. This method investigates whether a company or financial entity has an understated income. Another similar method is the source and application of funds that examine the amount spent on lifestyle versus assets and investments.
- Net Worth Method: In this method, accounting professionals calculate the total assets and deduct them from the total liabilities of a company. This results in the net worth, which is then compared to reported income over several accounting periods. If any unreconciled differences are identified, the investigation is conducted.
- Bank deposit method: Here, total annual deposits are analyzed and compared with total expenses. Any transfers between accounts and the redeposited cheques are deducted from the total annual deposit to assess the net deposit. Then, total cash expenditures in a year are added to et deposits to find total receipts in a year. This number is compared to the funds from known sources so that unknown sources of funds can be identified. Once the unknown sources are identified, they are investigated.
- Forensic Accounting Software: There are many accounting software that are useful for forensic accountants. These software help in the following manner:
- extracting bank statement transactions
- automating quality control
- finding undisclosed or hidden assets
- identifying any fraudulent transfers and preference payments
- visualizing the flow of funds from list of sources into accounts or legal entities
- monitoring the progress of the data set in the real-time
- Benford’s Law: This law states that in a naturally occurring set of numbers, smaller digits more often appear disproportionally than leading digits. With the increase in the digit, the frequency of occurrence goes down. Since there is a disparity between distribution stated in Benford’s law and what uniform distribution indicates, this disparity helps in locating instances of fraud.
- Data mining: Forensic accountants also use data mining for examining metadata and data sets. This is done to identify anamolies, patterns, and trends to provide predictive value for the future. Companies may build models using different algorithms for identifying transactions that are associated with purchasing fraud.
- Computer Assisted Auditing Tools (CAATs): These tools are used for searching irregularities in a given data. This tool helps auditors and accountant to provide analytical results.
Forensic accounting is an important branch of accounting since financial frauds can cripple any business completely. With the help of methodologies used in this branch, businesses can prevent themselves from becoming victims of such frauds. Forensic accountants can even help in preventing businesses from doing anything that may not be in the interest of our legal system.
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