Virtually all businesses are at risk of fraud, and an allegation of fraud can pose a serious threat to a business. A business facing an allegation of fraud must deal with potential costs that include not only direct losses if fraud is confirmed, but also costs related to an investigation, public relations, fines and penalties, among other costs. Further, there are nonfinancial impacts for a business as well, such as loss of customer confidence and decline in employee morale.
Allegations of fraud can arise from a variety of circumstances. In a recent news article, the Securities and Exchange Commission discussed the formation of a Financial Reporting and Audit Task Force and its belief that it needs to focus on identifying accounting fraud. The article noted that the task force was receiving whistleblower tips and was investigating several cases referred to it by whistleblowers. Fraud allegations also can arise as a result of financial information discrepancies, internal and external audit procedures, customer complaints and anonymous tips.
Regardless of how a fraud allegation arises, an investigation is typically required to address the allegation. The focus of the investigation is to identify information that either supports or disproves the fraud allegation. Because of the serious nature of these allegations and the complexity of the work, these types of investigations often bring together individuals from various disciplines, including law, accounting, regulatory and business management. The intersection of these disciplines results in their reliance on financial information.
Financial information provides a history of the business's performance and is the roadmap for what a company has done. Financial information is important in fraud investigations because it can be analyzed and used to identify red flags. Red flags are circumstances that are unusual in nature and are a departure from normal business activity. Identification of red flags can expose areas that require further analysis and provide direction in an investigation.
A business's financial statements represent the highest level of summarization of a business's financial information. There are typically four main statements, as detailed below:
• The income statement reflects the financial performance of the entity over a period of time and includes the revenues/sales, expenses and income of a business.
• The balance sheet summarizes a business's assets, liabilities and owner's equity over time.
• The statement of owner's equity outlines the changes in retained earnings (sometimes called statement of retained earnings).
• The cash flow statement aggregates data regarding all cash inflows a business receives from both its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given period.
Trends And Patterns
Most businesses prepare financial statements at the end of a period (i.e., monthly, quarterly and/or annually). Analysis at the financial-statement level may involve comparing the data over multiple periods or converting the data to percentages and comparing the percentages for multiple periods. For example, the income statement line items may be expressed as a percent of revenues for multiple periods. Conversion to percentages "common sizes" the data and can facilitate comparison between periods and companies.
The results of these types of comparisons can provide information about financial performance changes over time, and highlight accounts as well as trends and patterns that should be investigated further. Examples of red flags that may be indentified through these analyses include unexpected growth in revenue, expense and/or profit. Often, analysis performed on summary-level data will direct the more detailed analyses undertaken in the investigation. For example, if analysis of the income statement identifies that the cost of raw materials purchased has significantly increased in recent years, but overall sales have not increased, analysis of the raw material purchase transaction detail may be identified as an additional investigative procedure.
Because financial statements represent a summary of transactions, it is important to understand the process of recording and summarizing individual transactions. Key issues to consider are when, where, why and how the transactions were recorded.
In many businesses, daily transactions are summarized into ledgers by account. Often, a chart of accounts is maintained, which facilitates the review and analysis of the ledgers. These documents summarize the financial transactions into more manageable parts and allow a business to control its financial data more efficiently.
An important concept of ledger accounting is that it creates a central system for the recording of transactions. This is a business's permanent track record of the history of its financial transactions. This data can be utilized to find the origin of a transaction, and to analyze the other entries related to the transaction. There is a direct relationship between the detail transaction data and a business's financial statements.
Another key area to consider is the internal control environment of the business. Internal controls are processes and procedures that a business utilizes to achieve its objectives. These objectives are often focused on compliance with laws and regulations, the preparation of reliable financial data and the safeguarding of assets. Examples include segregation of duties, proper authorization of transactions, maintenance of appropriate documentation and physical security of assets. An analysis of the internal control environment is essential to identify and analyze red flags, such as management override ability and lack of segregation between key business functions. Identification of weaknesses in internal controls also provides direction in an investigation and identifies areas for further analysis.
Difficult To Detect
The fraud investigation process is frequently complex and may require analysis of significant levels of detail. At the center of the investigation are the financial data and the financial systems of the company. The financial data can be paper or digital and originate from multiple sources. Although how the financial information is utilized depends on the nature of the fraud allegation and the scope of the investigation, obtaining an understanding of the financial systems and the data they contain, as well as the internal control environment, is important across all investigations. Fraud can be difficult to detect in many circumstances, thus, understanding the systems provides key information to direct the investigation, as well as context in which to evaluate the findings.
It should also be noted that financial data analyzed during an investigation is not limited to the business's books and records. It can include data produced from external sources, such as bank statements, canceled checks, vendor invoices and purchasing records, among others. The amount and type of documentation examined depends on the scope of the investigation.
There are also many tools that can be used in the investigation, both computerized and manual. Regardless of the tools used or the specific role an individual plays in the investigation, it is likely that each individual involved will need, at a minimum, to understand the financial data that underlies the investigation. In many cases, these individuals will most likely to be required to discuss, explain, question and summarize that data. Gaining a better understanding of accounting systems and processes and how transactions are recorded will assist with determining the scope of the investigation, identifying red flags and meeting the overall objectives of the investigation. •