How Forensic Accounting Functions

The term "forensic" might remind you of criminal investigations in TV shows, where detectives use DNA samples, fingerprints, bloodstains, photographs, and various clues. But how does the term "forensic" tie into accounting? After all, accountants aren't usually seen working alongside detectives at a crime scene.

Forensic simply means "pertaining to the application of scientific knowledge to legal matters" or "usable in court." Most crimes, like those depicted in shows such as "CSI," fall under "crimes against the person." Forensic accounting blends financial analysis with investigative techniques to uncover financial wrongdoings.

What Makes Accounting Forensic?

Forensic accountants investigate "crimes against property," such as financial fraud, and often serve as expert witnesses in court cases. They may also be involved in civil litigation. These professionals go by various titles, including fraud investigators, investigative accountants, forensic auditors, and fraud auditors.

Though forensic accounting might not seem as glamorous as other types of investigative work, these professionals play a crucial role in high-profile financial crimes, especially those involving large corporations like the Enron and Adelphia Communications scandals in 2001 and 2002.

The federal government relies on objective forensic accountants to uncover the full scope of fraud and other accounting discrepancies carried out by executives and their affiliated accounting firms.

Forensic Accounting Essentials

Forensic accountants are not merely number crunchers involved in criminal or civil cases. They need to perform investigations, be skilled in using various computer programs, and possess strong communication abilities.

Certain forensic accountants focus on industries that are highly vulnerable to fraud, such as insurance and banking, and acquire expertise in the business practices unique to those sectors.

Given that the reputation of individuals and corporations is on the line, forensic accountants must exercise utmost discretion during their investigations. They must remain impartial, thoroughly evaluating both financial documents and employee behavior.

Unlike traditional accountants, forensic accountants actively search for signs of fraud while conducting audits. Alongside scrutinizing financial statements for accuracy and completeness, they may explore internal databases and court records. Since fraudsters hide the evidence of their crimes, forensic accountants must go beyond the numbers and anticipate potential criminal activities.

Whether dealing with criminal or civil cases, forensic accountants adhere to the same fundamental principles when carrying out their investigations.

Financial Investigations

Initially, they consult with a government official, attorney, or client to understand the details of the alleged fraud. Then, they begin their preliminary research and develop a strategy for the investigation. The next phase involves reviewing records — bank statements, credit reports, journals, ledgers, databases, e-mails, and memos — anything that might provide a clearer picture of the financial situation.

After collecting the records, forensic accountants often conduct interviews with the accused and other relevant individuals to gather personal accounts of the irregularities.

Forensic accountants must be keen observers, able to detect subtle signs or suspicious behavior that may eventually point them to the wrongdoer. These signs might include new cars, frequent vacations, and the initiation of new businesses without obvious sources of funding.

How far will forensic accountants go to gather information? It depends on the specifics of the case. In criminal matters, they typically collaborate with law enforcement and the district attorney's office. Just like in other types of investigations, the prosecution must secure search warrants and subpoenas to access financial data and compel relevant individuals to provide interviews about the case.

In civil cases, forensic accountants are authorized by the client, who is generally either part of the company under investigation or holds agreements that allow for accounting audits.

Once all the information is collected, the forensic accountant begins analyzing the data. They may trace the company's assets, calculate the total financial loss, and determine how it occurred, while also summarizing various transactions.

The final step (unless the accountant is required to testify in court) is preparing a detailed report outlining the investigation's methods and findings. This report might include graphs, charts, spreadsheets, and other visual aids to explain the case.

Litigation Support

In addition to conducting investigations, forensic accountants often offer litigation support. Lawyers hire forensic accountants to analyze existing records and testimonies, helping to clarify their financial implications.

A forensic accountant can advise the attorney on what additional information is necessary to strengthen the case and suggest pertinent questions for witnesses. They may also evaluate damage reports and assess whether these reports are accurate and align with the case.

Forensic Accounting Cases

While the fundamental approach remains consistent, the specific types of cases requiring forensic accountants' expertise can vary widely.

An independent consultant may be hired by a small business owner suspecting their bookkeeper of embezzlement, or an accountant working for a government entity might be tasked with proving that a corporation has been laundering profits. Financial institutions and insurance companies also seek the expertise of forensic accountants for fraud investigations.

Finding case studies of forensic accounting in action can be challenging because most companies prefer to keep financial misconduct details private. Nevertheless, there are a few notable examples where forensic accounting has played a crucial role.

The Orinda-Moraga Disposal Services Case

In 1996, a city manager in Contra Costa County, California, became suspicious when a local disposal company, Orinda-Moraga Disposal Services, requested assistance to stay in business. They wanted to increase rates for their customers and sought approval from the Contra Costa Sanitation District, despite previously stating a desire to reduce rates. The cautious city manager enlisted forensic accountant Dan Ray to investigate further.

Upon reviewing Orinda-Moraga’s financial records, Ray uncovered that the company had issued checks to fictitious individuals at fake companies with fabricated addresses. The company owner was funneling the checks into his personal account, using these fake businesses to siphon funds from Orinda-Moraga and artificially inflate its operating costs to justify the proposed rate hike.

In the end, both the owner of Orinda-Moraga and his business partner were found liable in both civil and criminal cases.

The Sunbeam Scandal

In 1997, Sunbeam, a manufacturer of household appliances, engaged in a controversial practice known as 'bill and hold.' This method allowed the company to record sales as profits for the current quarter, even though the products were not yet shipped, only recognizing them as actual sales when delivered.

Sunbeam made large volume sales to other companies at discounted rates but kept the goods stored in warehouses. While it appeared that the company was experiencing robust sales on paper, its warehouses were filled with unsold stock. This deceptive practice was exposed by a financial analyst at Paine Webber, who subsequently downgraded Sunbeam's stock value.

Although 'bill and hold' itself isn't illegal, shareholders of Sunbeam felt misled and filed lawsuits against the company. Sunbeam's accounting firm, Arthur Andersen, which later became infamous due to its involvement in the Enron scandal, conducted an audit and confirmed that the company's financial records complied with federal guidelines.

Dissatisfied with the findings, the board enlisted Deloitte & Touche to reassess Arthur Andersen's audit. This secondary review revealed evidence that the financial numbers had been manipulated.

The Securities and Exchange Commission launched an investigation into Sunbeam, which led to the dismissal of its CEO, Albert Dunlap. He was also required to pay millions in settlement for investment-related lawsuits. Dunlap paid a fine of $500,000 and was prohibited from holding any executive role in a public company.

Becoming a Forensic Accountant

Forensic accounting offers a rewarding career with many potential employers ranging from law enforcement to financial institutions. Like all accountants, forensic accountants must possess a deep understanding of Generally Accepted Accounting Principles (GAAP), business practices, and relevant laws.

In the United States, most forensic accountants hold at least a bachelor's degree in accounting and have several years of experience in the field.

The next milestone in becoming a forensic accountant is passing the Uniform Certified Public Accountant Examination to earn the title of Certified Public Accountant (CPA). This exam, designed by the American Institute of Certified Public Accountants, is a mandatory requirement for many firms, alongside other state and federal qualifications.

To maintain CPA certification, continuing education is essential. Many aspiring forensic accountants pursue graduate studies to meet this requirement, while also deepening their knowledge in the field and enhancing their marketability. Numerous universities offer master's programs in forensic accounting or business administration with a specialization in forensic accounting.

Forensic accountants often take courses in:

Several organizations offer specialized training and certification for forensic accountants. The American College of Forensic Examiners International (ACFEI) introduced the Certified Forensic Accountant (Cr.FA) credential in 2001.

The Association of Certified Fraud Examiners (ACFE) offers the Certified Fraud Examiner (CFE) designation, while the Association of Certified Fraud Specialists (ACFS) provides the title of Certified Fraud Specialist (CFS).

These professional organizations require their members to meet specific educational and experience qualifications, in addition to passing further exams. Holding these certifications signifies that a forensic accountant has expertise, training, and professional experience that surpasses that of a typical accountant.

Forensic Accounting Origins

The term 'forensic accounting' was first coined in 1946 by Maurice E. Peloubet, a partner in a New York accounting firm. He discussed the role of accounting in courtroom proceedings, specifically as a form of testimony, and recognized that investigations were becoming a more frequent task for accountants due to the rise of government regulation in financial practices.

Articles about the intersection of law and accounting began appearing in journals. In 1953, Max Lourie, a lawyer from New York, claimed to have coined the term 'forensic accounting,' although Peloubet had written about it earlier. Lourie emphasized the need for literature and education on forensic accounting.