What is a Forensic Audit? Understanding How Forensic Audits Help Businesses

In an era of increasing corporate scandals, financial frauds, and complex business transactions, ensuring the integrity and transparency of financial records has become paramount for organizations worldwide. To combat these threats and safeguard their financial well-being, businesses are turning to a powerful tool known as forensic auditing.

But what does the word “forensic audit” even mean? And how can it help small business owners properly care for their financial records?

Forensic Audits vs. Financial Audits

Financial audits are independent evaluations of a company’s financial statements. They are commonplace in the business world, with many companies conducting financial audits on an annual basis. In fact, publicly traded companies must submit audited financial statements every year as part of their filings to the U.S. Securities and Exchange Commission. Private companies, while not legally required to audit their finances, also frequently choose to do so for various reasons. For example, a bank or other lender may require the submission of audited financial statements as part of its loan approval process. A private company planning for a future sale or anticipating going public may also choose to undergo a financial audit.

Forensic audits are less common but no less necessary. Like financial audits, forensic audits involve hiring an outside party to examine a company’s financial records. However, forensic audits differ from financial audits in several essential ways.

First, a forensic audit is typically much more targeted than a financial audit. Forensic audits are often conducted on a particular department or set of transactions. Additionally, forensic audits are typically conducted for investigative purposes. This type of audit is usually performed when a company has reason to suspect that financial fraud or theft has occurred or when it needs to produce evidence for a legal proceeding or an insurance claim.

Types of Forensic Audits

Fraud Investigation

Business fraud is a broad term that can be used to describe several different scenarios. Still, at a basic level, it involves an individual misusing their position in the company for financial gain. Business fraud can be as simple as altering timesheets or involve more intricate schemes like money laundering or bribery. Regardless of the specifics, fraud is an all-too-common occurrence in business.

When a business suspects fraud has occurred, a forensic audit can help uncover that fraud. Forensic accountants are trained to examine internal documents, accounts, and records for evidence of misappropriation or embezzlement. In addition to finding fraud, a forensic audit can also point to internal systems or controls that could be strengthened or tightened to prevent future instances of fraud.    

Bankruptcy and Insolvency Audits

Corporate bankruptcy filings are often complicated affairs. Significant sums of money can be at stake, and all parties involved, from the company doing the filing to its creditors to the bankruptcy judge, have an interest in making accurate financial appraisals of the situation.

A forensic audit is helpful for all of these parties. For companies facing insolvency, a forensic audit can assist in determining the causes of the financial difficulty while also helping to provide accurate valuations of remaining assets. Creditors and bankruptcy judges will also be interested in ensuring all claims made during bankruptcy are error-free and above board. 

Insurance Claims Audits

Some insurance claims are open-and-shut cases; one party incurs damage or financial loss, and an insurer compensates to make that party whole. However, not all insurance claim situations are that simple. They can involve complex calculations about financial losses, future earnings, and revenue projections, among other factors. 

A forensic audit can help to determine everything that needs to be considered during a complicated insurance claim while also developing systematic ways to estimate or track losses and valuations. For example, if a liability claim requires quantifying lost revenue due to a covered event, a forensic audit can provide a sound methodology for estimating that loss. And because the conclusions of a forensic accountant are based on a systematic approach to the available evidence, these findings will be sound enough to hold up should the insurance claim require litigation.

Royalty Audits

Royalty payments are amounts paid to intellectual property, copyright, or patent owners for the use of their assets. For instance, a musician would receive royalty payments when a third-party licensee, like a radio station or a television show, played one of their songs. Similarly, an inventor or software developer might receive royalty payments each time a company sells a product that contains their intellectual property. While the specific setup of these payments might vary across industries, a royalty contract is a document that spells out the agreement between the intellectual property owner and the licensee.

Royalty contracts are often complex, and misinterpretations, miscalculations, or intentional fraud can lead to disagreements about payments from licensees to owners. A royalty audit is an efficient way of resolving such disputes. Forensic accountants have the expertise to interpret contracts, examine accounting records, and uncover instances of intentional malfeasance. 

Forensic Audit Process

1. Planning and Preparation

The first step in conducting a forensic audit is to hire a forensic accountant. While this may seem so obvious as not to need to be stated, it’s worth noting because one of the significant benefits of the process is that the auditor is an independent party, not beholden to any particular stakeholder in the process. The auditor’s conclusions will be based solely on the evidence available.

The planning stage will help determine exactly what evidence the forensic auditor will examine. To make this determination, they will need to understand some key details, including the overall objective of the audit, the involved parties, and the potential scope of the available evidence. For example, suppose a forensic audit involves missing funds and suspected embezzlement. In that case, the auditor may determine they need to see detailed transaction records for every payment going back over the years. For a forensic audit of an insurance claim involving lost revenues, the auditor may need to examine past sales numbers and future forecasts.

2. Data Collection and Analysis

Once the auditor has determined the scope of the process, the next step is to gather and analyze the available data. This may include critical financial data, account records, internal and external communications, and other documents. The data collection stage may also include interviews with involved parties, depending on the exact nature of the audit.

Data analysis can also take multiple forms. A forensic accountant may use software programs to detect anomalies in financial data or other records. They might also do detailed reconciliations of financial statements for specific periods or use comparative analysis techniques to compare and contrast financial trends over time. Generally speaking, a forensic auditor’s goal throughout this process is to ensure that the data collected and the analysis performed would be strong enough to hold up in a court of law or other legal proceedings.

3. Identification and Testing of Controls

In fraud cases mainly, forensic auditors will do thorough testing of a company’s systems and procedures to help determine how the fraud occurred. Nearly every company has internal controls designed to minimize fraud risks, whether separating functions between different team members, user authentication for sensitive systems, or pre-numbered accounting forms. A forensic auditor will identify these internal controls and test whether they work as intended.

4. Reporting and Recommendations

The final step in a forensic audit is to produce a report of the findings. In a case of suspected fraud or embezzlement, this report would include findings about whether the fraud occurred, who was responsible, how much financial loss the company suffered, and how the fraud occurred. A forensic audit report will also include recommendations about implementing policies and procedures that will prevent future instances of fraud.

Regardless of the exact type of audit, the forensic auditor’s report will be thorough enough to use in subsequent legal proceedings, should that be necessary. Many forensic auditors can also be called expert witnesses to present their findings.

How a Certified Forensic Accountant Can Help

If you are in the unfortunate situation of suspecting that fraud or misconduct may have occurred at your company, a forensic audit can help you get answers. Remote Quality Bookkeeping is an experienced forensic bookkeeping firm that can analyze your books, investigate potential occurrences of fraud or embezzlement, and help you ensure your internal controls are sufficient to prevent future misconduct. Contact us today if you think your business would benefit from a forensic audit or other forensic accounting services.