Forensic Audit Meaning
A forensic audit is a structured examination of the financial records of a business entity in an investigative manner to find out the evidence that can be used for legal proceedings in court. It is one step ahead of an internal audit and the person who conducts such an audit should know the law and legal frameworks and have expert knowledge of accounting and auditing.
Reasons for Conducting Forensic Audit
#1 – Conflict of Interest
When an employee misuses their position for personal gains and causes the company to incur a loss, a forensic audit comes into the picture.
For instance, a manager approving the excess/unwanted expenses of an employee due to personal relations will get some leverage over the employee on a personal level. In this case, the manager will not benefit financially from this activity.
#2 – Bribe
An organization offering money or giving expensive gifts to get things done or making the situation in its favor is a bribe.
For example, the head of the purchase department approves purchases from a vendor that will supply the material at a higher cost or cost less than other vendors. Although the quality of the product is not good, the head is getting some personal compensation from that vendor.
#3 – Misappropriation of Assets
It is the most prevalent type of fraud where employees misuse the assets of the company for their benefit.
For example, an employee submitting a fake bill for using the company stationery or showing the damaged or expired inventory (primarily in FMCG companies) and receiving funds.
#4 – Misrepresentation of Financial Statement
This type of fraud generally happens at a higher level of the company by showing the better business performance against the actual performance. Thus, investors will not hesitate to invest in the company, and lenders can easily offer loans at lower interest rates. Top management will also benefit by getting bonuses or incentives based on the company performance. Misrepresentation can be done by showing less provision against accrued expensesAccrued ExpensesAn accrued expense is the expenses which is incurred by the company over one accounting period but not paid in the same accounting period. In the books of accounts it is recorded in a way that the expense account is debited and the accrued expense account is credited. or debtors, hiding any contingent liabilityContingent LiabilityContingent Liabilities are the potential liabilities of the company that may arise at some future date as a result of a contingent event that is beyond the company's control. , not giving the proper disclosure about the information which can influence investors or lenders.
Steps of Forensic Audit
There are four steps of forensic audit:
- Planning the investigation
- Collecting evidence
- Court Proceedings
#1 – Planning the Investigation
Auditors will plan the investigation to leave nothing out and to achieve the objective of an auditObjective Of An AuditThe primary objective of an audit is to obtain reasonable assurance regarding the financial statements being free from any misstatement either by error or fraud. Another objective is to report the findings of the independent examination so performed.. Below are some points which auditors keep in mind:
- Identifying the fraud being carried out
- The period during which fraud has been carried out
- Reason or root cause of fraud
- Find out employees involved in the fraud
- The loss suffered by the company because of the fraud, whether it is financial or non-financial
- Establishing evidence collection by copying in court proceedings.
- Suggesting actions for preventing these types of frauds in future
#2 – Collecting Evidence
It is an essential part of forensic audits. After identifying the fraud, the auditor will collect the evidence, which can be substantiated and accepted in the court. These documents must reflect how the fraud has happened, who has done it, and what amount of loss the company has suffered.
For example, a vendor has finalized the purchase of raw material. If it suspects that some malicious things happened in that finalization, the auditor will examine the below things:
- Who has approved the vendor
- Whether company policy was followed at the time of finalizing
- Quotation from other 3-4 vendors has been taken or not
- If taken, whether all these quotations were compared with each other in terms of pricing and quality
- After finalizing, whether the vendor provided the same quality of material, which it has shown at the time of selection
#3 – Reporting
After completing the above process, a forensic auditor will prepare a report that summarizes the audit and present it to the management/client. The report contains below points:
- Observation/finding during the audit
- Evidence gathered which will substantiate the fraud
- How much loss the company has suffered
- How the fraud has been conducted
- What steps should be taken to stop this type of fraud
Based on the report, the management can decide whether they should go for legal proceedings or not.
#4 – Court Proceedings
Suppose management decides to go for legal action based on the forensic audit report. In that case, the auditor should also be present at the court to explain how the fraud has been done and how the evidence will support the statement. The forensic auditor will also simplify the accounting fraud in simple language so that everyone can understand it.
Forensic Audit vs. Internal Audit
- A forensic audit is done to find the fraud happened in the company, whereas an internal auditInternal AuditInternal audit refers to the inspection conducted to assess and enhance the company's risk management efficacy, evaluate the different internal controls, and ensure that the company adheres to all the regulations. It helps the management and board of directors to identify and rectify the loopholes before the external audit. is done to find the lapse in accounting or company policies.
- Forensic auditors must have expert knowledge of the law, whereas this is not compulsory for internal auditors.
- Forensic audits can be used for legal proceedings, whereas evidence gathered in an internal audit will not be acceptable in legal proceedings.
- A forensic audit is required when there is suspicion that an employee has intentionally committed fraud for personal gain. In contrast, an internal audit is done regularly to check whether all accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level. and accounting standards have been followed, but mistakes have not been made.
A forensic audit is required for a specific purpose like finding the fraud or any misrepresentation of a financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. by examining the past transaction and collecting evidence that will prove that some fraud has happened and can be used in court for legal proceedings. Whereas internal audit is focused on compliance, policies, accounting standards, and other controls that companies need to follow for their operation.
This article has been a guide to Forensic Audit and its meaning. Here we discuss steps for conducting a forensic audit, along with its example, reasons, and differences from internal audit. You may learn more about financing from the following articles –