More than a means to find out about financial crimes, Forensic accounting is the most thorough method of the due diligence process and is a way to ensure compliance. Smaller companies tend to overlook its importance. Here’s the reason why this is risky.
The word “forensic accounting” can bring up images of detective-like experts sifting through files and conducting interviews, as well as conducting background checks in order to uncover instances of financial crimes. While this is a part of the jobdescription, accounting forensic experts are also required to look into legitimate financial transactions and conduct due diligence reviews to assess possible mergers, investments, and acquisitions.
However, while many companies require regular due diligence but it’s not common for them to hire specialists in accounting to aid in the process, according to the expert in finance Margaryta Pugachova. She’s a member of the Toptal network since the year 2020. This is especially true for smaller and mid-sized businesses. “They don’t place a high enough value on the practice, which is quite expensive, so they try to get by just having their in-house team handle it,” she says. “But the internal teams generally lack the experience, knowledge, qualifications and broader perspective to carry out this task properly. This results in errors and bad investment decisions that cost more than the capital expense for due diligence investigations. .”
A forensic investigation could run into the thousands however due diligence plays a crucial role in determining how the value of a company is and whether its financial practices are in line with the laws. Accounting experts conduct this kind of analysis on companies which their clients are contemplating buying or merging with, as well as buying, but they as well conduct investigations within the company on behalf of clients who require more information about their own business operations.
Following the completion of an investment or purchase, accountants forensic conduct compliance checks to determine if all parties are adhering to all terms and conditions of the contracts and complying with rules and regulations. The two procedures are similar to each other, sometimes the same actions, however compliance reviews are generally more unstructured than due diligence reviews. If neither of them reveal the truth about financials the results could be disastrous.
How Does Forensic Accounting Work?
Forensic accounting is different in comparison to general accounting. While the latter is concerned with the conformity of financial statements to the rules referred to as Generally Accepted Accounting Principles (GAAP) The former focuses on whether the narrative being in the financial statements is reasonable and likely to be true.
Specialists in this particular type of accounting don’t only look at financial statements. They adopt an integrated approach that incorporates the analysis of statistics big data, interviews, machine learning and physical observation in order to determine the truth. This is just as essential in proper due-diligence as is in the criminal case.
If the probe is to ensure due diligence or compliance an accountant who is forensic will begin by examining the company’s financial statements, balance sheets or cash flow statements. They examine the data in these documents in time, and compare them to the numbers of their competitors and look at the company’s self-reported valuation and ensuring that it is logical, as well as comparing transactions against counterparties’ accounts and also examining the shares of ownership. The forensic accountant could utilize other strategies, including conducting interviews with customers and validating their claims as well as talking with suppliers, colleagues in the industry and the investor relations department visiting warehouses and offices and occasionally, reviewing camera footage to verify that there are production centers as well as activities, Pugachova says. They could employ AI software to find out if electronic documents were modified or falsified. They can also look through databases to determine whether executives have been being investigated for fraud. This work is carried out to verify or disprove the company’s assertions.
To evaluate these claims, forensic accountants typically have expertise in advanced valuation practices–particularly for high-tech, highly cyclical, and distressed assets, as well as other nontraditional assets like derivatives and those in emerging markets.
The field of forensic accounting has seen a steady increase in demand due to the rising rate of financial fraud and cybercrimes, including ransomware attacks. However it is also becoming more sought-after due to more stringent financial regulations and the fact that the majority of laws predate the advent of alternative assets such as crypto, and aren’t revised to address the corresponding taxes and reporting obligations and corporate procedures.
Growing fraud and cybercrime, tighter financial regulations, as well as the rising popularity of other assets such as cryptocurrency contribute to the growing forensic accounting industry size.
The most important applications of forensic accounting to the purpose of due diligence as well as compliance is the detection of bad investments, identifying undiscovered value, and identifying the best time to buy or sell stock. Let’s examine real cases of how this practice can be used to serve these functions.
Revealing Poor Investments
Some time back, financial specialist Carlos Salas had a client who was looking to invest in the private mobile e-commerce business Powa Technologies. The year 2015 was the last time Powa stated that its company was valued at $2.7 billion, and that over 1200 businesses were registered to use its product. It was the client who had brought Salas along with his staff to confirm the claims of these and other sources in order to get an accurate picture of the company’s finances.
“Our review of Powa encompassed fieldwork such as contacting suppliers, customers, and peers; visiting company headquarters; interviewing employees; and confirming international bank accounts,” claims Salas who has been who has been a part of the Toptal network since the year 2020. “We discovered irregularities, which included poor cost control and non-existent customers, offshore corporations that generated fictitious revenue, as well as unsavory past behaviour from their CEO. .”
Salas along with his staff wrote to more than 300 businesses that claimed to have agreed to sign contracts as Powa customers. Around 20% of them responded and stated that they hadn’t signed any contracts. Later, it was revealed that the majority of other companies listed also did not have contracts with Powa.
Salas noticed another red flag after he discovered Powa was operating from luxurious offices in the major cities all over the world. “As an early stage company one cannot afford to pay the same amount of rent, if you’re not even financially. In the beginning, when Google and Facebook began they were in a basement” Powa declares. “That didn’t add up.” It was apparent that Powa was using investors’ money to pay rent instead of expanding the company.
In the early months of 2016 Powa was into bankruptcy and was subsequently dissolved. If Salas’s customer had invested to the firm, the investors could be losing as much as $25 million. “That’s why it’s very important to always run forensic accounting reviews, but especially when it comes to early-stage businesses in private equity,” Salas states. “If you don’t and your customers end being a victim of fraud, they’ll be liable for everything. .”
Uncovering Hidden Value
The ability to prevent disasters is the most compelling reason to use investigating accounting, but it also plays crucially in finding gems hidden in the rough. While balance sheets are essential to determining the context of reported revenues and asset prices the company could provide them in ways which don’t reveal the true value of the business. However, accountants who investigate are able to expose this.
For instance, in the year the year 2019, Toptal finance expert Benjamin Ostrow was employed in the role of a senior associate at an office of the family, where he researched new companies that the company was considering purchasing or investing in. The financials of those companies were, as he observed, often were a mess of important data.
“Sometimes due to the way that bookkeeping is conducted and bookkeeping, they under-represent their companies. The industrial service firm I was researching for a portfolio company, and was interested in buying it. The company was accounting for the purchase of equipment rather than investing them in capital,” Ostrow says. “I visited the field together with our chief executive officer of our operating company and discovered millions of dollars worth of assets sitting in the back of the closet, not even in the balance sheets. .”
The company was treating these purchases as an expense that was advantageous for tax purposes in the short term. However, to prospective buyers and investors this made the company appear less profitable and with less assets than it actually had. Actually, these “expenses” were capital expenditures that were of great value.
“This discovery made the acquisition more attractive to us than it was at first glance,” Ostrow says. “Our efforts made us more confident about the purchase and assisted us in closing the deal more quickly and at a fair price for the buyer. .”
Forensic accountants look at both individuals and businesses’ reports of valuations, income and expenditures. They look over transactions that involve the use of fiat currencies (such such as US dollars) as well as cryptocurrency and debit and credit cards as also data from programs research, market research, and surveillance to create an accounting statement.
In other situations an organization’s financials could suggest it’s involved in fraud, however a more thorough inquiry reveals there’s no evidence to suggest that. In 2012 and 2013 Ostrow was an analyst in the field of investment looking into Ubiquiti which is a maker of networking equipment for his employer which was a hedge fund. The company was experiencing an abrupt decrease in sales, a substantial increase in accounts receivables as well as inventories, as well as a dramatic reduction in the price of its stock. The usual explanation for the case of this kind of situation could be that the business was channel-stuffed, inflating sales figures by soliciting resellers to purchase inventory, without selling it to the end-users.
The investigation of Ostrow’s revealed that this company had been not in breach. “Through additional research, I was able to validate that a contract manufacturer they were using in China had completely copied what they were doing,” Ostrow declares. “The problem wasn’t a lack of demand–there was an influx of counterfeit supply, and people couldn’t distinguish that from the authentic product.”
Ostrow could figure out the true story partly by analyzing the customers. He attended industry conferences that dealt with wireless internet providers, and spoke to over 100 people. “I went to several networks. And I saidto myself “The demand is there. Stuffing the channel with stuffing implies that there’s no demand, therefore this isn’t the issue.'” After that realization, he began to look at the claims about counterfeit products.
Detouring the counterfeiting helped Ostrow and his company to take the decision to make a bet in the company and earn the company millions of dollars. It was well worth the many months and several thousand dollars that they put in on accounting for forensic purposes.
Identifying the Right Moment
Salas often uses his investigative accounting expertise in short-selling stocks to clients. It’s dependent on timing. If you do not sell the stock, and then purchase back the stock at proper timings, you might lose money. One way to gain advantage is to conduct extensive due diligence of the company you’re planning to sell short on in order to determine the stock’s performance.
In the year 2018, Salas examined Wirecard the German payments firm. He initially noticed that the company’s shares were priced too high and later discovered that the financials of the company weren’t entirely authentic. Wirecard’s shares became highly volatile offering a tempting chance to sell the stock. The problem was that German authorities soon launched an inquiry, and stopped the short-selling process for two months.
“If we had taken an order to short the company in the early stages of our investigation, we’d suffered a significant loss since the price was increasing. Wirecard was a hot tech company that was adored from investors” Salas says. “However following the time that it was allowed to resume business evidence uncovered by authorities and regulators continued to pile on top of the company, and we knew it was a perfect moment to short the stock because the value of the stock was likely to plummet in the near future. We borrowed the stock and sold the stock at the time.” Salas was correct the price of Wirecard’s stock fell by more than 80%. The plunge was initiated shortly after the company’s former Chief Executive Officer Markus Braun was arrested–resulting in huge profits for Salas’s customer, who purchased the stock and then returned it to the broker following the collapse. In the following days, Wirecard became insolvent.
Salas’s investigation into forensics did not give him a clue on when to take a short position on the stock however, it helped him determine the company was one to be watching and ready to take action at the right moment.
Using Investigative Accounting Judiciously
Since forensic accountants are specialized in their expertise, even enterprises that have internal accounting departments can gain from their services to handle high-risk transactions, Pugachova says. “These professionals also bring the context of operations from other companies, so they have a strong sense of the norms and can provide a broader, more holistic view of a business’s financials–increasing the chances of identifying issues that may have been missed in-house.”
She also notes that there are a few reasons for a business to not choose to employ an investigation accountant. Forensic accounting is often linked to a plethora of alleged wrongdoings It is therefore essential to be aware of the impact on the business’s relationships with investors, other partners in mergers, or newly acquired partners. Because of the expense and risk of reputational damage, she suggests that companies review with their finance departments the deals in which investigation is needed and then discuss their alternatives with a risk-management specialist.
The bottom line is that the advantages are often greater than the risk, Pugachova says. “I haven’t seen any mistakes made by companies which have allocated the funds needed for this task to be completed thoroughly by experts from outside. However, I have heard of businesses that, like an equity private fund that were forced to write off their entire operation because they had bad investments because they failed to perform due diligence on all aspects. Quality is a matter of price.