Neel Aughhy, a forensic accountant at Toptal who previously held CFO positions at Medtronic, Johnson & Johnson, and regional divisions, was reviewing a business’s performance a few years back at the owner of that company, a large conglomerate. He uses both qualitative and quantitative tools in his work, such as site visits, conversations and behavioral […]

Neel Aughhy, a forensic accountant at Toptal who previously held CFO positions at Medtronic, Johnson & Johnson, and regional divisions, was reviewing a business’s performance a few years back at the owner of that company, a large conglomerate. He uses both qualitative and quantitative tools in his work, such as site visits, conversations and behavioral observations.

Augusthy started this particular investigation by examining audits from similar companies, which he does often. Augusthy found out that this company’s profitability was lower than other companies of similar size and did not match its expenditures. Both were red flags. He spent a lot of time listening and talking to the employees of the business.

He says that asking questions will help you open people up. You almost need to act childlike and ask out of sheer ignorance, “Can you tell me how this works?” How do you explain it? You tell me one thing, but my source here says another.

Augusthy spoke to vendors of the company and many expressed concern about the low profit margins. This was strange, considering how much they claimed the company paid them. He invited the general manager of the company to dinner under the pretext that he wanted to catch up with him and discuss potential improvements.

Augusthy says that when people feel at ease, they will say things that they shouldn’t. I asked [the GM] what the problem was with vendors complaining that their margins were so low, when we paid them so much. He replied, ‘Oh these guys keep complaining without reason.’ He suddenly has a large amount of cash to spend on these items.

Augusthy says, “I realized that he was skimming money from the company by taking it away from vendors.” The conglomerate fired the manager after the investigation and implemented new checks to ensure that it wouldn’t happen again.

What is Forensic Accounting?

These forensic accountants are also known as investigative accountants. But they don’t just investigate criminal activities. They are skilled in accounting and have the tools and skills to uncover hidden risks and problems, such as those relating to:

  • Fraud Loss of Capital due to Wrongful or Criminal Deception.
  • Compliance with regulations: Taxes or fines if you fail to comply with laws.
  • Loss of Capital due to excess debt and inadequate equity:
  • Loss of Capital: A loss in capital caused by investing into a struggling business.
  • Loss in capital due to a loan to an unable-to-repay borrower.

The corporate risk climate has grown more complex and volatile in the past 20 years, since Enron’s scandals and the collapse of WorldCom sparked the Sarbanes-Oxley Act. In addition to the increasing volatility, technological innovations, disruptions in supply chains and the climate crisis make it difficult for companies to predict financial risks.

Fraud has a wide range of negative effects on businesses. A study conducted in 150 firms across three industries shows this.

Traditional financial risk assessment methods are effective at identifying problems and mitigating them, but they don’t always uncover every type of risk. Erik Stettler, Toptal’s Chief Economist, believes that, given the current business climate, forensic risk management and analysis is underutilized, particularly by small- to medium-sized businesses. He studied for NERA Economic Consulting the near-failures and failures of several prominent US institutions in the Great Recession.

Stettler warns that many companies attempt to cut costs by relying on their own staff to perform less rigorous checks. However, this can be risky, as staffers might not have enough experience, or they may become so used to how the business operates that they are unable to detect red flags. He says that failing to detect fraud, breaking regulations or shrinking cash flow costs a business far more than an initial capital investment for investigative accounting. This typically runs between $30,000 and $50,000. A December 2017 survey of multinational companies found that non-compliance costs an average of $15 million per year.

Forensic Accounting for Financial Risk Analysis

Investigation accountants are more than just financial statement examiners. They use a holistic approach to investigate, including statistical analysis, interviews with sources and human resources, visual or photographic inspections of buildings, photos of the facilities and conversations, as well as studies on individuals and businesses’ pasts, behavior and psychology. To examine the income and expenses of a company, for example, instead of just looking at quarterly or annual financials, they may request real-time figures for that time period to be able to see fluctuations more clearly.

Stettler explains that it is important to consult other information sources about the company when evaluating a loan or investment or M&A transaction, as well as conducting an audit. Risk managers cannot send a forensic accounting team on an investigation to find out what information they can uncover. It is expensive to hire a forensic accountant and there must be specific concerns or claims that need investigating.

Risk management frameworks can help companies identify, assess, and mitigate various risks, as well as determine whether they need to hire forensic accountants to do further investigation. A forensic audit may be initiated when the framework flags unusual repayment patterns by borrowers. This is because higher repayment numbers indicate an increase in income for the borrower. An accountant who specializes in forensic accounting would look into whether the sudden windfall was due to fraud. We’ll examine how accounting investigative techniques are used in three key risk areas.

Forensic accounting and fraud risk

Investigative accountants often ask what they expect to find if everything is normal. This is similar to a doctor reviewing a patient’s vitals while keeping in mind a benchmark. Stettler says that they then assess whether the information provided by the company matches their expectations.

Investigative accountants, like Augusthy, also examine whether financial or economic logic is behind certain financial transactions and statements. A financial statement that reports an asset sold at 100 times the price of comparable transactions, or what an independent appraisal suggests may be valid. However, it is a large deviation from economic logic. If this is the case, it’s important to examine other transactions as well, in order to determine if there are any patterns.

If the accountants are able to access historical data, they should also look for statistical breaks. These include changes in cash flow or earnings, or even in pricing. Stettler says that this involves examining the correlation between financial performance or stock prices and benchmarks, to see if the relationship changes or breaks. This means financial activity in the company now is driven by factors other than the market.

Another tactic is to compare earnings against the consensus of analysts. If companies are consistently beating consensus expectations by a tiny margin, this may be due to legitimate decisions made about depreciation and when to recognize revenues, or it could indicate that the company is managing its earnings in order to present a more rosy picture. Stettler says that a margin of this size can be a sign to take a deeper look.

Forensic accounting and Regulatory Compliance risk

Companies face many risks when it comes to complying with all government regulations. These include disclosure laws, time-off mandates, tariff and trade policies, as well as minimum wage laws. The risks become more acute when companies have a presence across multiple states or countries.

John Lee, Toptal’s finance expert and remote-work specialist, says that with the increasing acceptance of work-from anywhere arrangements, companies are facing significant compliance risks. The compliance risks that can lead to significant financial losses are spread across a variety of fields, such as taxes, immigration and insurance, talent management, benefits and data security.

Businesses are increasingly utilizing remote talent outside their metro areas since the COVID-19 outbreak. Lee says that tax laws vary from state to state and country to country. Companies offering remote work should hire forensic accountants who can assess the financial risk associated with hiring digital nomads and cross-border workers.

A company may be subject to additional income or corporate tax if, for example, an employee stays long enough in a foreign country or state that they establish residence in the area. A company’s permanent presence in a particular area may be deemed to have been established by an employee who stays for a long time. Lee advises that any company interested in investing in, merging with or acquiring a business with remote working policies, should hire one or two forensic accountants in order to make sure the firms are compliant with employment and tax regulations.

Risk professionals can use a matrix of remote tax risks to help manage compliance for companies that have remote workers. This matrix shows individual and corporate tax rates, as well as Social Security and Employment Law risk, of various activities. These include setting up an employer of record, hiring contractors, or employing digital nomads.

Lee says that forensic accountants have a unique ability to identify potential tax risks associated with remote working and to advise businesses when to consult an expert in taxation for a specific country. Nobody is suddenly expected to be an expert on taxation in all countries. If your company employs 15 salespeople who spend six months in France or you have a CTO working for an Employer of Record then it is important to flag this as requiring tax knowledge.

Forensic accounting and Liquidity risk

Stettler believes that having accountants perform a stress-test on a firm’s accounts, much like white-hat hackers do to break into corporate networks, is a good way to reduce liquidity risks. Stettler has become a proponent of such proactive measures after years spent analyzing crises, disruptions and other major events in securities markets. NERA Economic Consulting was the company he worked at. They would examine what actually happened and what should have been done.

Stettler investigated a US bank during the subprime crisis. He examined the transaction portfolios of that company, as well as the risks their counterparties accepted and whether or not they were aware of those risks. Stettler also investigated whether or not the risk taken was in accordance with the stated frameworks of the bank for asset diversification and leverage.

He says that in situations like the bank’s collapse, his role was to also help counterparties to understand the risks of the fallout of the disaster. He explains that “CEOs from some of the largest financial institutions in the world had no idea of their vulnerability” because the portfolios and hedge strategies of these financial institutions were too complex to be adequately accounted for by the top-line financial reports.

Inadvertently, there were management decisions which created weaknesses. The intense performance evaluation process used by the bank Stettler investigated encouraged employees to achieve extraordinarily high goals, which allowed risk to build up below the surface. The incentive structure was not examined to see if it could have ripple effects on the entire bank. Bank risk formulae were also a part of the issue, as they underestimated the likelihood of housing prices falling together at a large scale. Stettler says that for the best possible results, these risk analyses would have needed to be conducted by experts outside of the bank using different models in order to avoid blind spots. By exposing these risks, companies could have addressed them prior to becoming a major problem.

He says that as businesses struggle to stay up-to-date with technology and regulations, the International Financial Reporting Standards (IFRS) or principles-based approach will likely dominate the rules-based method of accounting. This is reflected in the US approach known as Generally Accepted Accountability Principles (GAAP).

Financial risk analysis may require more investigational accounting, since the principles-based approach is more adaptable and sophisticated in conveying economic truths. It also involves more questions that go beyond whether boxes are checked. Stettler says that this is one of the main reasons why the demand for financial risk analysis services has increased, and he believes it will continue to increase.