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ARTICLES

A. INTRODUCTION – ACCOUNTING – OVERVIEW:

A.1: Accounts – Sum of Actual and Estimation:

Financial statements, compiled on accrual basis, represent the following:

• actual receipts & payments, collected and summarized (cash basis),
• recognition of certain items of expenditure or income on accrual basis, in accordance with the applicable statements, e.g., recognition of sale may be either on appropriation of goods for delivery or on actual delivery, both methods in accordance with standards but as suited to the needs of the entity,
• estimates of provisions and bad/irrecoverable debts, or write back of creditors (due to law of limitation),
• provisions for various intangible items, like foreign currency fluctuations, retirement benefits based on actuarial valuation or any other basis,
• adjustments, on account of prior period transactions.

Thus any financial statement cannot be said to present exactly the position of financial affairs. The true and fair presentation is an attribute to the methods adopted in compiling such financial statements.

A.2: Accounting Standards:

Accounting Standards are only guiding tools in preparation and submission of financial statements. Accounting Standards are epitome of various conventions, concepts, principles and practices to be followed in presentation of financial affairs to reflect true and fair view.

Most of the Accounting Standards are mandatory. These Accounting Standards may broadly be classified into:

• Accounting specific, like inventory valuation, revenue recognition, provision for employees’ retirement benefits, valuation of investments, etc.
• Reporting and disclosure specific, like related party transactions, contingents & events occurring after balance sheet date, amalgamation & mergers (mainly basis of valuation), treatment of assets acquired out of grants, etc.

A.3: Accounting Practices:

Normative Accounting: Financial statements are drawn on historical cost basis, complying with respective Accounting Standards. However the impact analysis on presentation of vital facts and legalities thereof are not analysed.

Inventive Accounting: Imaginative part of accounting for a transaction in a structured manner to produce the desired outcome is known as Inventive Accounting. The judgmental freedom, to record a transaction in any manner without breaking the basic rule, but against the spirit of it, is the tool for inventive accounting. Under this method, focus is on circumventing some of the accounting standards, which have effect on the working results and the financial position. Practically, window dressing is resorted to by manipulating, revenue recognition method (and not policies), inventory valuation methods, prior period adjustments, etc. without effecting any changes in the significant accounting policies. In the cash flow statement, effect of such window-dressing gets subsumed in investment and/or financing activities. However, the analysis shall, in such cases, be focused in absolute increase in cash in hand (with the aid of forensic audit).

Forensic Accounting: Under this concept, effort is to record each transaction for the true value of it, by analyzing legal implications reflected in such accounting. Further, forensic accounting relies on proper and legally tenable documentation for each and every aspect of accounting entry or treatment of an item/transaction in the accounts. Gathering of hard-core evidence or proof or information which strengthens financial assertions and disclosures would be the realm of Forensic Accounting. In times to come, this may emerge as a separate managerial and specialist function and provide checks and balances before finalization of entity’s financial report.

B. Financial Reporting and Frauds:

Accounts may be falsified to conceal:

(a) absolute theft of money or money’s value (mainly relating to employees frauds).

(b) true results of operations, or financial position of the entity with a view to prevent timely detection of corporate frauds.

‘Fraud’ refers to an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. Fraudulent financial reporting involves intentional misstatements, in any one or more ways as stated below:

1. Deception such as manipulation, falsification or alteration of accounting records or supporting documents.
2. Misrepresentation in, or intentional omission from the financial statements, significant events, transactions or other information.
3. Intentional, wrong application of accounting principles relating to measurement, recognition, classification, presentation, or disclosure of material transactions.
    

B.1: Motives for Fraudulent Financial Reporting by the Management:

1. Management is under pressure, from sources outside or inside the entity, to achieve an expected (and perhaps unrealistic) target, where consequences of failure are significant.
    
2. To increase the entity’s stock price or earnings trend.
    
3. To keep the results attuned to forecasts/commitment made, knowingly unrealistic/non-achievable, to creditors and lenders.
    
4. Tax-motivated reasons.
    
5. (e) To raise capital either by further issue of shares at a premium and/or through borrowings
    

Corporate frauds are results of manipulation of accounting jugglery designed to deceive others for wrongful gains.

C: CORPORATE FRAUDS:

While lack of or inadequate internal control/check points manifest in employee’s frauds, same cannot be said of the management frauds. The management frauds assume greater dimensions & varieties. The distinction between individual frauds and management frauds might be evident from the intention, though in either case, ultimate aim is to derive a benefit by dishonest means.
 

D: Forensic Auditing: This term has not been defined anywhere. However, since the object is to relate the findings of audit by gathering legally tenable evidence and in doing so, the corporate veil may be lifted (in case of corporate entities) to prosecute the persons responsible for fraud (a criminal offence), if any committed. This concept may be defined as “a concentrated audit of transactions, pertaining to financing or any other specified activity, and without any limitation to time period, with a view to find the fact and obtaining legally tenable evidence, as to a ‘right or wrong’ elements of such transaction(s). In doing so, the veil of separate entity is pierced to establish the intentions of person(s) behind such transaction(s)”.

Forensic auditing aims at legal determination of whether fraud has actually occurred. In the process, it also aims at naming the person(s) involved (with a view to take legal action).

D.1: Distinction between Statutory Audit and Forensic Audit:

D.2: Audit Plan:

In Forensic Auditing, the first step is to analyze the financial statements, records, other related documents, etc. to list out the indicators of fraud. This is an essential step to formulate Audit plan and the period of coverage. The indicators may be one or more of the following:

1. Even though the entity has been reporting profits (earnings/earnings growth), actual cash flow exhibits shortage in working capital.
    

2. Non-compliance with prescribed Accounting Standards, especially for material items, like revenue recognition, inventory valuation.
    

3. Ineffective accounting practices, or internal audit.
    

4. Estimation of assets, liabilities, revenues, or expenses, to a significant extent, on unusually subjective judgements or uncertainties and not supported by physical existence.
    

5. Significant related party transactions especially those not in the ordinary course of business.
    

6. A poor or deteriorating financial position when management or holding company has personally guaranteed significant debts of entity.
    

7. Inadequate record keeping for assets (mainly current assets) susceptible to misappropriation.
    

8. Frequent changes in the significant accounting policies or basis of accounting like cash to accrual and/ or accrual to cash, for major revenue/expenditure transactions.
    

9. Frequent withdrawals/deposits of money or unusual treasury operations, etc. as evidenced from cash flow statements.
    

10. Acquisition or disposal of shares in group companies, with significant variations in value with that of book value/market value.
     

11. Frequent engagement of consultants / valuers in valuation of business assets.

D.3: Detection Techniques:-

Forensic auditing, to be effective, shall focus on very significant transactions – both as reflected in financial statements and off balance sheet items (these are discussed later). The techniques mainly are critical point auditing and propriety auditing.

(1) Critical Point Auditing

Critical point auditing technique aims at filtering out the symptoms of fraud from regular and normal transactions in which they are mixed or concealed. For this purpose, financial statements, books, records, etc. are analyzed mainly to find out:

1. trend-analysis by tabulating significant financial parameters.
    

2. unusual debits/credits in accounts normally closing to credits/debits respectively.
    

3. account/inventory discrepancies as evidenced from the unrecognized balance between financial records and corresponding subsidiary records (like physical verification statement, priced stores ledgers, personal ledgers, etc.)
   (iv) accumulations of debit balances in loosely controlled accounts (like deferred revenue expenditure accounts, mandatory spares account – capitalized as addition to respective machinery item, etc.)
   (v) false credits to boost sales with corresponding debits to non-existent personal accounts, and
   (vi) cross debits and credits and inter-account transfers.
   (vii) weaknesses/inadequacies in internal control/check systems, like delayed/non-preparation of bank reconciliation statements, etc.

(2) Propriety Audit:

Propriety audit is conducted by Supreme Audit Institutions (SAI) to report on whether Govt. accounts, i.e., all expenditure sanctioned & incurred are need-based and all revenues due to Government have been realized in time and credited to the Govt. account. In conducting the propriety audit, the core focus is on “Value for Money audits” aimed at lending assurance that economy, efficiency and efficacy have been achieved in the transactions for which expenditure has been incurred or revenue collected. The same analogy, with modifications to the principles of propriety of public finance, applies in forensic audit to establish fraudulent intentions if any, on the part of the management. Financial frauds are results of wasteful, unwarranted and unfruitful expenditure from the monies available to the entity.

Mainly the examination methods are:
(a) Tests of reasonableness:

1. Check weaknesses in internal controls

2. Identify questionable transactions – indicating wide fluctuations from the normal ones and not, in general, related to main objectives.

3. Review questionable transaction documents for peculiarities, like improper account, classifications, pricing, invoicing, or claims, etc.

(b) Historical Comparisons:

1. Generally develop a profile of the entity under investigation, its personnel and beneficiaries, using available information.

2. Identify questionable accounts, account balances, and relationships between accounts, for finding out variances from current expectations and past relationships.

3. Gather and preserve evidence corroborating asset losses, fraudulent transactions, and financial misstatements.

D.4: Off-Balance Sheet Transactions:

There are certain transactions not prima facie discussed in the financial statements and/or suitable disclosures/auditors made qualifications thereon. Statutory auditors may satisfy themselves as to sanction, authority and compliance to legalities. However, statutory auditors may not be probing certain aspects of a financial statement in detail. These may encompass:

1. Employment of relatives at a very high pay.

2. Purchase / sale contracts as proprietary items from related parties / group companies, not disclosed as such.

3. Excess consumption pattern of major raw materials/ components.

4. Over / under-invoicing for capital goods, raw-materials/components, services, etc. as compared to normal arms’ length prices for the same.

5. Alteration (amendment & deletion) of contractual terms, to pass on otherwise accrued benefit, to holding/group companies.

6.  Diversion of funds through group companies and setting off such debits as expenditure in accounts, before closure of accounts to avoid detection.

7. Cost over – runs in major capital expenditure without corresponding benefit or convincing reasons.

E: TOOLS AND SKILL SET:

E.1: Detailed Examination:

Above are a few techniques which can be beneficially employed in Forensic Auditing. The selected critical aspects shall be subjected to in-depth (vertical) audit and also across the entities (horizontal) to keep trail of the transactions. This calls for more patience and perseverance on the part of the personnel employed for the purpose.


E.2: Aspects to be Covered:

Forensic auditing is one of the tools in finding out whether or not a fraud has taken place. Forensic auditor may in the process have to examine voluminous and in totality, records and witnesses, if permitted by law. Proper documentation is vital in substantiating the findings. The outcome shall focus on the following, in case of frauds:

• Proving the loss

• Proving the responsibility for the loss

• Proving the method/motive

• Establishing guilty knowledge

• Identifying other beneficiaries.

E.3: Skill Set: The personnel detailed for Forensic audit shall have:

1. Knowledge of entity’s business and legal environment.

2. Awareness of computer assisted audit procedures.

3. Innovative approach and skeptic of routine audit practices.
    

E.4: Application:

Forensic accounting and audit may be applied in the following areas besides fraud detection:

1. Conducting due-diligence (especially for segment wise profitability analysis)

2. Business valuation

3. Management auditing

4. Assessing loss before settling insurance claims

Conclusion:

Forensic auditing combines legalities alongside the techniques of propriety (VFM audit), regularity, investigative, and financial audits. The main aim is to find out whether or not true business value has been reflected in the financial statements and whether any fraud has taken place. It differs, altogether, in form and content from the statutory audits of financial statements. It may beneficially be applied in other areas where due diligence exercise is required to be carried out.

BIBLIOGRAPHY:

1. BALANCE SHEETS – PRACTICAL METHODS OF WINDOW DRESSING (C R RAO)
2. CORORATE FRAUD – M J COMER
3. FRAUD IN ACCOUNTS (1919) – ACCOUNTANTS’ LIBRARY
4. DETECTION OF FRAUDS – PROFESSIONAL DEVELOPMENT SERIES – INST OF CHARTERED ACCOUNTANTS OF INDIA