Forensic Accounting: Boost Your Financial Risk Analysis

A few years ago, Neel Augusthy — a forensic accounting expert at Toptal who has held regional and divisional finance director positions at Medtronic and Johnson & Johnson—examined the performance of a company at the request of its owner, a conglomerate. As is typical of forensic accounting professionals, he combines both quantitative methods and qualitative tools in his work, such as conversations, behavioral observations and site visits.

Augusty began this particular investigation, as he often does, by examining Audits of similar companies. He noted that the company was much less profitable than others, and its profitability did not match expenses — both red flags. His next step was to spend a lot of time talking and listening to the company’s employees and suppliers.

Asking questions is key to getting people to open up to you, he says. “You must be almost childish and, out of pure ignorance, ask‘ ‘can you explain to me how this works? You tell me that and my other source here tells me that, so how does it all fit together?’”

When Augusty spoke to the company’s sales people, many complained about low margins, which made no sense considering the amount the company claimed to be paying them. So he took the general director of the company to dinner under the pretext of catching up and discussing possible improvements.

What is forensic accounting?

Forensic accountants, also known as investigative accountants, are often associated with the investigation of delinquent activities, but that’s not all they do. These specialized practitioners are equipped with specific accounting skills and tools to determine what lies below the financial statements and discover other hidden problems and risks, including those related to:

Bluff: capital loss due to unlawful or delinquent deception.

Regulatory compliance: taxes or fines due to non-compliance with laws.

Liquidity: Capital loss due to excessive debt and insufficient equity.

Investment: capital loss due to an investment in a company in difficulty.

Credit: capital loss due to the loan to a borrower who cannot repay.

In the more than 20 years since the scandals and collapses of Enron and WorldCom catalyzed the introduction of the Sarbanes-Oxley Law, the corporate risk environment has become more volatile and complex. The speed of technological innovation, the disruption of supply chains and the impending climate crisis not only make it difficult to anticipate financial risks, but the increased volatility also offers fertile ground for bluff.

Forensics and the risk of bluff

When investigating bluff matters, investigative accountants usually wonder what to expect if everything goes well, just as a doctor might check a patient’s vital signs with a “normal” scale in mind. Then they statistically evaluate whether what the company is reporting matches, says Stettler.

Like Augusty, investigative accountants also check whether certain transactions or financial statements are based on convincing economic and financial logic. If a financial file indicates that an asset has been sold for 100 times more than comparable transactions or if an independent evaluation suggests it, the transaction may still be valid in the strict sense of the term—but represents a strangely significant deviation from economic logic. In this matter, not only does this transaction need to be verified, but others also need to be checked to see if there is a pattern.

When investigative accountants have historical data, another important step is to examine breaks in statistical structure, such as changes in the way an asset was valued or how cash flows or income occurred. “This usually involves looking at the correlation between financial or stock market performance and benchmarks and determining if there is a moment when the relationship collapses or changes, which means that financial activity within the company is now governed by something other than market factors,” says Stettler.

Comparing the earnings history to the consensus expectations of analysts is another tactic. If companies consistently exceed consensus by a small margin, this success may reflect legitimate decisions regarding depreciation or revenue recognition, but it may also indicate that they are managing their profits to create financial statements that reflect a rosier picture. Regardless, Stettler says, a constant margin like this may signal a need to take a closer look.