A few years ago, forensic accountant Neel Augusthy, a specialist at Toptal with a background in CFO roles at companies like Medtronic and Johnson & Johnson, was tasked with investigating a company’s performance for its owner, a large conglomerate. As part of his thorough approach, Augusthy combined both quantitative analysis and qualitative methods, such as employee interviews, behavioral observations, and on-site visits, to uncover underlying financial risks.
Augusthy’s investigation began with a review of audits from similar companies. He quickly noted that this particular company had much lower profitability compared to its peers, and the profit margins did not align with its expenditures, which immediately raised red flags. To dive deeper, he spent considerable time speaking with employees and vendors, asking probing questions to better understand the company’s financial picture.
“Being inquisitive, almost childlike, is essential,” says Augusthy. “You need to ask, ‘Can you explain this to me? How does this all fit together?'”
During his conversations with the company’s vendors, many expressed concerns about low margins, which seemed contradictory to the high payments the company claimed to be making. This discrepancy led Augusthy to take the general manager (GM) out for dinner under the pretext of discussing potential improvements. Over the meal, the GM made some offhand comments that raised further suspicion—particularly about recent land acquisitions, which seemed unusual for someone in his position.
That’s when Augusthy realized that the GM had been diverting funds from the company by withholding payments meant for the vendors. His investigative work led to the GM’s removal, and the company implemented more rigorous checks and balances to prevent similar fraudulent behavior.
What Is Forensic Accounting?
Forensic accounting, often associated with uncovering criminal activity, is much more than that. Forensic accountants are trained to look beneath the surface of financial statements and identify hidden problems and risks that traditional accounting methods might miss. These risks include:
- Fraud: Financial loss due to deception or criminal activity.
- Regulatory Compliance: Risks from failing to comply with laws and regulations, leading to penalties.
- Liquidity: Risks from excessive debt or insufficient equity, which can lead to financial instability.
- Investment: Risks from investing in troubled businesses that might not be able to recover.
- Credit: Risks from lending to borrowers who are unable to repay.
The corporate risk environment has grown more complex over the years, especially with the rise of technology, disruptions in supply chains, and the ongoing global challenges posed by climate change. As a result, there is a significant risk of fraud, and traditional financial risk analysis may not be enough to uncover all potential threats.
Forensic Accounting for Financial Risk Analysis
Forensic accountants do not just review financial statements—they take a holistic approach to investigating financial irregularities. This involves combining traditional analysis with statistical techniques, market research, visual inspections, and even behavioral analysis of individuals involved in the company. For example, instead of simply reviewing an annual or quarterly report, forensic accountants may request real-time financial data to observe fluctuations in income or expenses more closely.
“When considering investments, loans, M&A deals, or audits, it’s essential to look beyond financials and consult multiple sources of information to get a full picture,” says Stettler. However, forensic accounting requires a structured approach, which means it should only be engaged when specific concerns or red flags are identified within a risk management framework. For instance, if there are unusual fluctuations in borrower repayment activity, it may signal a need for forensic investigation to determine if the sudden spike in revenue could be linked to fraudulent activities.
How Forensic Accounting Tackles Key Risk Areas
Forensic Accounting and Fraud Risk
When investigating fraud, forensic accountants approach the task much like a physician reviewing a patient’s vital signs. They assess whether financial data aligns with economic and financial logic. For example, if an asset is sold for 100 times more than its comparable market value, this discrepancy would prompt a deeper investigation. Even though the transaction may be legitimate in a strict sense, the unusual disparity suggests it warrants scrutiny.
Forensic accountants also examine historical data for “structural breaks”—sudden changes in asset pricing or cash flows that are not aligned with market factors. By identifying these breaks, they can uncover patterns of fraudulent or inappropriate financial activity.
Conclusion
Forensic accounting provides a robust and comprehensive tool for financial risk analysis, going beyond traditional methods to uncover hidden issues like fraud, regulatory noncompliance, and liquidity concerns. By utilizing a blend of quantitative analysis and qualitative research, forensic accountants can identify red flags early, helping businesses avoid costly mistakes and enhance their financial risk management strategies. For companies seeking to navigate today’s complex financial environment, investing in forensic accounting expertise is a prudent decision to safeguard against potential risks and ensure long-term success.
