Forensic Audit Guide

What is a Forensic Audit?

A forensic audit is an in-depth examination of financial records to uncover fraud, embezzlement, or other illegal financial activities, often for legal or regulatory purposes.It goes beyond being just a financial requirement for the organization.

There are other types of audits that an organization can undergo as well. All these help the third party understand the organization's health and position in the market.

A company or organization can undergo multiple audits at once. These will result in different results that will help understand the organization better.

A forensic audit is a review of the forensic accounts of a company to check for evidence of fraud or misconduct to present in a court of law. This is a specialization within the field of accountancy.

Many organizations have a forensic audit department. This audit requires knowledge of accountancy and auditing and their proceedings. It also needs an expert understanding of the legal framework.

It involves many investigative activities, such as examining financial records and interviewing relevant parties. For example, it may be conducted to prosecute a party for fraud or any other financial crime.

During the audit, an auditor can be called to check the ongoing proceedings and the various activities. These proceedings include checking fraudulent activities and other situations such as bankruptcy, filing documents, disputes, etc.

Procedure for a Forensic Audit Investigation

Forensic and financial audits have many things in common, from the first step of an audit, Planning, to the last step, reporting.

The only difference between the two is that a forensic audit involves an additional step of possible court appearance, where the audit findings and reports are submitted in front of a court of law.

1. Planning the Investigation

Planning is the first step in any auditing. Here, the objectives are determined, and plans are made to achieve them. These objectives include:

• The auditor must first plan their course of action to identify the fraud being carried on.
• They must study all the evidence to determine the fraud period
• One important objective for the auditor is to sum up the fraud by explaining how it is being conducted
• They must also unveil the true identity of the people involved in the fraud
• They must also uncover the monetary value of the fraud
• The main objective is to uncover and document evidence of fraud, which may be presented in front of a court of law
• While fraud prevention is important, the main objective of a forensic audit is to uncover and document evidence of fraud

2. Collecting Evidence

At the end of an audit, the forensic auditor must submit the findings of the possible fraud at a court of law. The evidence must be complete enough to name the fraudster(s), the scheme behind the fraud, how it was conducted, and documents supporting the value involved in the fraud. 

The forensic auditor has to ensure the documents are authentic and not altered by anyone.

There are various techniques that an auditor can adopt to collect this evidence.

• Substantive technique: This audit procedure goes through a company's financial statements to check for errors or fraud. There are many substantive techniques that an auditor can implement
• Analytical procedures: Analytical procedures involve comparing various sets of financial information to conclude by analyzing the comparison
• Computer-Assisted Audit Techniques(CAATs): This involves collecting audit evidence via the computer. Various programs help the auditor collect evidence
• Understanding the internal control and examining them: Every Company has its internal control system that checks the data before an external audit, the evidence collected by them is tested, and true evidence is recorded

3. Reporting

The auditor must prepare a written report to be submitted to the client to carry on legal proceedings as per their wish. An audit report must contain the following:

• All the evidence the auditor thinks is necessary to explain the fraud.
• They must sort all this evidence and present it in a way that will provide a summary of the fraud.
• The auditor must also explain how they carried out the fraud.
• The final part of the report must suggest ways to prevent such fraud.

4. Court Proceedings

The case doesn't need to go to court, but the auditor must be present if it doesn't. His/Her main task there will be to explain the fraud to the people in the court, who may or may not understand accounting and auditing. 

Therefore, an auditor will assist in simplifying such hard-to-understand concepts in the court of law.

Why is a forensic audit conducted?

A forensic audit is conducted for various reasons, including but not limited to identifying ongoing fraud in the company. There are different manners the company can exploit to conduct fraud, some of which are listed below.

1. Corruption or Fraud

During a forensic audit trial, an auditor will be on the lookout for

• Conflict of interest: When a person who is to commit fraud uses his/her influence for personal gain from the company. They might not be the personal beneficiaries of such acts
• Bribery: This is an act of influencing someone to do the wrong deed in exchange for money
• Extortion: When a person uses his power to threaten or uses force to get things done, it is an act of extortion

2. Misappropriation of assets

Asset misappropriation refers to the theft or misuse of company assets, rather than falsifying records to show non-existent assets. Instead, they have been altered to showcase more profit and manipulate the financial records.

3. Financial misstatement

This type of fraud occurs when a company's financial records are presented as false to show that companies perform better than the actual performance. 

Such a type of fraud aims to show a better position in the market, earn extra profit, and collect money from the public via investors.

Limitations of Forensic Auditing

Many reasons act as a limitation for conducting forensic auditing. While forensic audits are typically conducted independently, auditors may seek assistance from workers within the organization to gather necessary information, which is standard practice.

This leads to manipulating the results, and the fraud goes undetected. For example, suppose a company is committing fraud, and the auditor asks for information from the people involved during the audit. In that case, they will not provide true information.

This is also called audit dependency, one of the major fallouts of an audit. Due to such limitations, a forensic audit cannot be considered a foolproof system to detect and identify fraud in an organization. 

Here are a few more limitations of forensic auditing:

• Forensic auditing is expensive in nature
• There are situations where there is no relevant data for forensic auditing to be conducted
• It is very time-consuming for a company
• It distracts the company from its actual work and focuses only on auditing
• Data received can be limited or inconsistent by third parties
• This can affect employee morale

The choice between a traditional audit and a forensic audit depends on the specific circumstances and objectives of the audit, rather than a blanket preference for either approach.

Example of a Forensic Audit Case

Let us say a hypothetical company, Skylights, is in the business of producing light bulbs. It gets into a contract with another company, Elite Lights, on the recommendation of the BOD.

Elite Lights supplies raw materials for light bulb production.

The company has its license revoked due to some past allegations by the court, but the BOD, even after knowing that Elite Lights has its license revoked, gets into the contract as the BOD of Elite Lights offers them something in return. This is an example of Corruption/fraud.

Let us see another example. ABC Pvt. Ltd. has an annual profit of $400000. Still, when audited, the auditor found evidence that the company had showcased a profit that was not in existence. Still, a manipulation of assets has led the company to this false profit.

In all the above cases, fraud can be identified with the help of forensic auditing. This can also help the company provide the necessary details of how, when, where, and what the fraud was and ways for prevention.

There are many case studies that show real-life incidents of fraud that have taken place in the past. Learning about fraud can help one understand it. You can find some cases in Forensic Audit Case Studies.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Audit Legal Implications
• Evidence in an Audit
• Financial Accounting Theory
• Fraud in Audits
• Prorated