How Financial Risk Analysis Can Be Boosted by Forensic Accounting

Companies need to boost their risk management game in a turbulent business climate. Before it's too late, forensic accounting can assist in identifying impending issues.

Neel Augusthy, a Toptal specialist in forensic accounting who has held regional and divisional CFO positions at Johnson & Johnson and Medtronic, was evaluating a company's performance a few years ago at the request of its owner, a conglomerate. He uses quantitative and qualitative techniques in his work, as is customary for forensic accounting experts, including discussions, behavioral observations, and site visits.

As he frequently does, Augusthy started that specific inquiry by looking at the audits of related businesses. He discovered that the business was significantly less profitable than similar businesses and that its profitability did not match its spending, both of which were warning signs. His next step was to spend a lot of time conversing with and listening to the company's vendors and personnel.

He claims that getting individuals to open up to you requires asking questions. "Explain to me how it works. You practically have to be asking that in an infantile way out of sheer ignorance. How does it all go together when you're telling me this and my other source over here is telling me that?

When Augusthy spoke with the company's suppliers, several of them complained about poor margins, which seemed odd considering how much the business claimed to be paying its suppliers. He thus invited the business' general manager to dinner under the guise of catching up and talking about future upgrades.

"When people talk and feel comfortable, they tell you a lot of things they probably shouldn't," adds August. "I questioned [the GM] as to why the suppliers were grumbling about the poor margins while we were paying them so much. Oh, these folks simply keep whining for no reason, he remarked. Other statements stated by the GM also struck Augusthy as odd: "He'd just bought this piece of land here" and "that one there." I then reflected, "This doesn't add up." He has a large sum of money to use for these purchases all of a sudden.

Then, according to Augusthy, "I realised he had been skimming from the company by taking money that was due to the vendors." The conglomerate fired the manager and enhanced checks and balances as a consequence of the probe to ensure it didn't happen again.

Forensic Accounting: What Is It?

Investigation of illegal activities is frequently connected with forensic accountants, sometimes known as investigative accountants, although that is not all they undertake. These specialized practitioners have specialized accounting knowledge and resources to go underneath financial statements and find additional hidden issues and hazards, such as those associated with:

Fraud is the loss of money as a result of dishonest or illegal deceit. Regulatory compliance: paying taxes or penalties for breaking the law. Loss of capital as a result of excessive debt and inadequate equity is known as liquidity. Investment: capital loss from funding a failed company. Credit: Capital loss resulting from a loan to a borrower who is unable to pay it back.

The Sarbanes-Oxley Act's inception more than 20 years ago was sparked by the scandals and failures of Enron and WorldCom, and since then, the corporate risk environment has grown more unpredictable and complicated. In addition to making it more difficult to predict financial risk, the speed of technology advancement, supply chain disruptions, and the impending climate catastrophe all make it easier for fraud.

Traditional approaches to financial risk analysis are useful for locating and managing numerous issues, but they can't always be relied upon to identify all forms of financial risk. According to Erik Stettler, chief economist at Toptal, there is a risky underutilization of forensic risk analysis and management in the current economic climate, particularly among small and medium-sized enterprises. He previously investigated the Great Recession-era failures and near-failures of a number of well-known US organizations for NERA Economic Consulting.

According to Stettler, many businesses attempt to cut costs by doing less thorough inspections with internal workers, but doing so is dangerous since employees can lack the requisite knowledge or might be too used to how things are done at the firm to recognize warning signs. According to him, the upfront capital investment for specialized investigative accounting, which normally runs from $30,000 to $50,000 for each project, is significantly less than the cost of failing to detect fraud, breaking the rules, or diminishing liquidity. In contrast, a survey of global corporations conducted in December 2017 discovered that the average yearly cost of noncompliance was close to $15 million.

Using Forensic Accounting to Assess Financial Risk

Accountants who conduct investigations look at more than just financial records. These experts use a comprehensive approach to investigations, including statistical analysis, market research, facility photos or visual inspections, interviews with human sources, and studies of the backgrounds, motivations, and psychology of people and organizations to learn the truth. Forensic accountants, for instance, may request real-time figures for the relevant time period in order to more closely investigate swings in a business's income or spending rather than merely looking at yearly or quarterly financials.

"It's crucial to take a more detailed look beyond traditional financials and also consult, in depth, other sources of information about a company when considering a loan, an investment, an M&A deal, or when conducting an audit," adds Stettler. Risk managers, however, cannot just send a forensic accountant on an investigation to see what they uncover. Due to the considerable expense involved, forensic accounting only works when there are particular claims or issues that need to be looked into.

An organized strategy for detecting, evaluating, and managing different forms of risk—including whether to hire a forensic accountant to do more research—can be given to businesses through a risk management framework. The framework may launch a forensic inquiry when it detects financial irregularities, such as abnormally high repayment activity by borrowers. Higher repayment rates reflect a significant rise in the borrower's income, which explains why. If that unexpected gain might be attributed to fraud, a forensic accountant would look into it. Let's examine how investigative accounting approaches may be used in three key risk areas in greater detail.

Criminal Justice and the Risk of Fraud

Just as a doctor may evaluate a patient's vitals while keeping a "normal" benchmark in mind, investigative accountants frequently ask themselves what they would expect to find if everything were normal while examining fraud-related questions. Then, according to Stettler, they determine statistically whether what the corporation is reporting corresponds.

Investigative accountants examine if specific transactions or financial statements are supported by convincing economic and financial rationale, much like August he did. The transaction may still be lawful in the literal meaning of the word if a financial record indicates that an asset was sold for 100 times more than similar transactions or an independent appraisal recommends, but it shows a suspiciously huge divergence from economic rationality. In that situation, not just one transaction but also others should be carefully examined to determine whether there is a trend.

A crucial step for investigative accountants using historical data is to seek for statistical structural discontinuities, such as adjustments to the asset's price or to the timing of cash flows or earnings. According to Stettler, this typically entails examining the correlation between financial or stock price performance and benchmarks to determine if there is a point at which the relationship changes or breaks down, indicating that financial activity within the company is now being driven by factors other than market factors.

Another strategy is to contrast past results with analyst consensus forecasts. Companies that frequently outperform the market by a tiny margin may have made sound judgments about depreciation or when to recognize revenue, but their performance may also be a sign that they are manipulating their results to generate financial statements that paint a more positive picture. In any case, according to Stettler, a constant margin might indicate that something deserves further investigation.

Regulatory Compliance and Forensic Accounting Risk

Companies confront a variety of risks when it comes to remaining fully compliant with governmental requirements, such as those connected to transparency, minimum-wage legislation, compulsory time off, and tariff and trade policy changes. When a corporation maintains a presence in more than one state or country, these dangers become very serious.

According to Toptal finance specialist and remote work expert John Lee, as remote work becomes more widely accepted, more and more businesses are confronted with major regulatory compliance problems related to work-from-anywhere agreements. Taxes, immigration, insurance, people management and benefits, data privacy and security, and other topics are all included in these compliance concerns, which have the potential to cause large financial losses.

Businesses are making better use of remote work talent pools outside of their immediate metro regions since the COVID-19 epidemic. However, Lee notes that the relevant tax laws are complicated and vary from state to state and country to country, so businesses that provide substantial remote work opportunities would be wise to enlist forensic accountants to assess and help mitigate the financial risks related to cross-border hiring and digital nomad workers.

For instance, if an employee remains in another nation or state for long enough to unintentionally establish residency there, the firm may be subject to increased corporation or income tax responsibilities. Furthermore, a worker's prolonged presence can even amount to a permanent installation of the company there. According to Lee, any corporation considering an investment in, a merger with, or an acquisition of a company with remote work rules should also consult one or more forensic accountants to make sure the companies are in compliance with tax and labor laws.

Risk experts use a remote work tax risk matrix to show the individual tax, corporate tax, Social Security, and employment law risks of actions like setting up a legal entity, hiring via an Employer of Record, hiring a contractor, and employing a worker on a digital nomad visa. This matrix helps companies with remote employees manage regulatory compliance.

According to Lee, forensic accountants are especially suited to identify possible tax pitfalls associated with remote labor and advise businesses on when they should seek the advice of a local tax expert. "Nobody is expected to overnight become an expert on taxes in every nation in the globe. However, if your CTO is hired by an Employer of Record or if your firm has 15 top salespeople who spend six months working in the south of France, you should, at the very least, indicate that this situation probably calls for tax knowledge.

Accounting Forensics and Liquidity Risk

According to Stettler, a sensible strategy to reduce liquidity risk is to have investigative accountants examine a company's accounts as a stress test, much like white-hat hackers try to break into corporate networks. After studying significant crises, disruptions, and private transactions for years, he has come to support such a proactive strategy. When one of these things happened, the company he worked for, NERA Economic Consulting, would investigate what had really transpired as opposed to what had ideally should have happened.

Stettler did a detailed analysis of the transaction portfolios of the firm, the risk levels its counterparties had taken, and the degree to which those counterparties were or should have been aware of the risk when he assisted in the investigation of a significant US bank that failed during the subprime mortgage crisis. Additionally, he examined whether the risks were consistent with the bank's declared principles for asset diversification and leverage.

"Our role in cases like the collapse of that bank was also to help the counterparties understand their exposure to the risk of fallout from the disaster," the author claims. "CEOs of some of the biggest financial institutions in the world were largely unaware of their degree of vulnerability." He adds that's because their portfolios and hedging tactics were so intricate and diverse that it was hard to appropriately account for them in the typical top-line financial statements.

Additionally, there were managerial choices that unintentionally led to vulnerabilities. In the instance of the aforementioned bank, which Stettler was looking into, a rigorous quarterly performance review process encouraged staff to set astronomically high goals, which caused unrecognized risk to amass below the surface. Nobody considered investigating if such an incentive structure may have an impact on all of the bank's activities and transactions. The bank's risk calculations contributed to the issue as well since they drastically overestimated the likelihood of a simultaneous and significant decline in house values. According to Stettler, those risk studies should have been carried out by independent specialists using alternative models to prevent disastrous blind spots for the best outcomes. By disclosing these risks, businesses would have been better equipped to handle them before they became issues.

He predicts that the International Financial Reporting Standards, or principles-based accounting, will likely overtake rules-based accounting in the future as businesses struggle to keep up with rapidly changing technology and regulations, as exemplified by the US approach known as Generally Accepted Accounting Principles (GAAP).

Financial risk analysis will undoubtedly demand more investigative accounting since the principles-based technique offers a more complex and flexible way to communicate underlying economic reality and requires deeper concerns than which boxes have been checked. And Stettler thinks that's a major factor in the rise in demand for these services, which he expects to continue.