This is the first of two articles comparing the roles of the auditor and the forensic accountant, specifically their differing objectives, responsibilities, professional standards, and engagement terms. This article, which focuses on fraud investigations conducted by forensic accountants, also discusses how each professional approaches risk assessment, the concept of materiality, and building teams. Gathering information and reporting will be examined in the second article.
Introduction
There is a popular misconception that audits of financial statements are conducted with the primary objective of detecting fraud. Since the collapse of Enron, independent external financial statement auditors have made great strides in communicating the true objective of an audit and who holds the responsibility for detecting fraud. But auditors must continue to battle the misconception and need to continue to reinforce the fact that a financial statement audit is not a forensic accounting fraud investigation.
Auditing is a process of determining whether a company’s reported financial position and performance are fairly represented and in accordance with certain standards. A forensic investigation is an examination of specific records and information to help determine facts related to a suspicion or allegation of fraud.
Audits and forensic investigations are different services that are planned and performed to accomplish unique objectives. While both have a responsibility to detect fraud, the degree of that responsibility is substantially different.
This is the first of two articles comparing the roles of the auditor and the forensic accountant, specifically their differing objectives, responsibilities, professional standards, and engagement terms. This article, which focuses on fraud investigations conducted by forensic accountants, also discusses how each professional approaches risk assessment, the concept of materiality, and building teams. Gathering information and reporting will be examined in the second article.
Different Objectives and Responsibilities
Auditors help provide confidence in the world’s financial system by performing audits of financial statements to provide reasonable assurance that company management is presenting a “true and fair” view of a company’s financial position and performance.
Forensic accountants assist entities in investigating by providing their expertise, from the initial allegation or suspicion of fraud to resolution, whether the end result is restitution, litigation, an insurance claim, or a referral to a law enforcement agency.
The overall objective of an audit is to obtain reasonable assurance about whether financial statements are free from material misstatement, whether due to fraud or error. This enables the auditor to express an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework; and to report on the financial statements and communicate as required by generally accepted auditing standards (GAAS), in accordance with the auditor’s findings.[i]
A forensic investigation is performed to assist an entity in gathering sufficient relevant data to help a trier of fact determine whether fraud was committed. The forensic investigation’s objectives include gathering evidence to identify the type of fraud, quantifying the amount of loss; determining who was involved, when it began, why it was able to be perpetrated, and how it was concealed; and reporting the findings verbally or in a written report along with supporting evidence.
“Forensic,” as defined by Black’s Law Dictionary, is something used in or suitable for use in courts of law or public debate. Therefore, a forensic investigation requires a very high standard of support that can sustain the scrutiny of a court of law. “Fraud” is defined by Black’s Law Dictionary as the knowing misrepresentation of the truth or the concealment of a material fact to induce another to act to his or her detriment. Forensic accountants should avoid opinions on whether “fraud” exists, as they cannot opine on someone’s “intent” and are not the trier of fact.
The forensic accountant’s role in litigation is to report on legally obtained evidence objectively, succinctly, and with a sufficiently explained foundation. For matters in litigation, there must be evidence provided to the trier of fact—beyond a reasonable doubt in criminal cases, and by a preponderance of the evidence in civil cases.
An auditor owes primary allegiance to the investing public, and the objective is general in nature. A forensic accountant is not concerned with reaching a general opinion on the financial statements as a whole. A forensic accountant’s objective is more specific in nature as defined by the scope of services in the engagement letter, and the work is typically directed through counsel and, therefore, privileged and confidential. In addition, the forensic accountant may be asked by the company to advise on internal controls that can be implemented to prevent a fraud that has been discovered from recurring.
Professional Standards
Auditors and forensic accountants adhere to different sets of professional standards in performing their work. Forensic investigations differ fundamentally from the auditor’s function of attesting to the assertions of other parties. In an attest service, the practitioner expresses a conclusion about the reliability of a written assertion that is the responsibility of another party, such as company management. In a forensic investigation, the practitioner develops findings, conclusions, and recommendations based on the evidence discovered during a forensic investigation. In addition to SSFS No. 1, a forensic investigation may be subject to requirements of the U.S. Department of Justice, the U.S. Securities and Exchange Commission, or other regulators. If the forensic investigation becomes subject to litigation, the forensic accountant may be subject to further requirements, such as the Federal Rules of Civil Procedure, as well as state court and other jurisdiction and venue requirements.
Engagement
Auditors and forensic accountants must develop a clear understanding with their clients about the nature and extent of the professional services to be performed, including the scope and limitations.
An auditor must adhere to applicable auditing standards and include prescribed engagement terms. For example, an auditor should include a statement that because of the inherent limitations of an audit, together with the inherent limitations of internal control, an unavoidable risk exists that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with GAAS.[ii]
A forensic accountant is typically hired by counsel on behalf of a client to maintain the privilege of communications and to adhere to less restrictive engagement terms than those of an auditor. The forensic accountant’s engagement terms should be customized to define the client, limit assistance to specific issues, establish the boundaries of the investigation and the applicable standards, and describe the roles and responsibilities of the parties. A forensic investigation cannot describe expected results or make any guarantees regarding the findings or outcomes of a forensic investigation. The trier of fact determines guilt, innocence, or liability, so a forensic accountant should avoid opinions regarding guilt, innocence, or liability of any party involved in the forensic investigation.[iii]
Other Notable Differences
- Timing: Audits are planned periodically and on a recurring basis. Forensic investigations are unforeseen and nonrecurring.
- Predication: A forensic investigation begins with an allegation or suspicion of fraud. The allegation or suspicion of fraud is not the basis of an audit.
- Obligatory: Forensic investigations are typically conducted voluntarily because a company has a suspicion or allegation of fraud. An audit is an obligatory engagement for which a company must hire an auditor to provide an opinion on the truthfulness and fairness of its financial statements.
- Performance: An audit is performed by auditors who are certified public accountants (CPAs). A forensic investigation is typically performed by a multidisciplinary team of experts that often includes CPAs.
- Appointment: The appointment of an auditor is made by the shareholders of the company. A forensic accountant is appointed by the owner/management or a third party.
Materiality and Team Building
The execution of an audit and a forensic investigation is similar in that both types of inquiries include planning, gathering evidence, a review process, and a report to the client. As part of planning and developing an overall strategy, both should gain an understanding of the business and assemble the most appropriate team for the task. As knowledge and evidence are accumulated, both the auditor and the forensic accountant will revisit their plan and revise procedures to achieve their respective objectives.
To be in accordance with professional standards, an auditor should identify the client’s risks of material misstatement by gaining an understanding of the client and its internal control over financial reporting. The auditor should assess the risks and design audit procedures to address those risks. The auditor should understand the client’s business, the business environment, the industry in which it operates, how it makes money, the products or services it sells, who its customers are, what the competitive advantages are (i.e., low cost, superior product, unique business model), and the performance measures, among other business risks. The auditor should also obtain an understanding of the client’s internal control over financial reporting and determine if control processes have been adequately designed and implemented, and operate effectively. The auditor’s objective is to identify and appropriately assess the risks of material misstatement, and design and implement audit procedures that will uniquely mitigate the risks identified.
An auditor does not, and cannot, test every transaction. Instead, the auditor sets a “materiality” threshold. This threshold is subject to the professional judgment of the auditor. The U.S. Supreme Court has noted that an auditor’s determination of materiality requires “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him.”[iv] In interpreting federal securities laws, the Supreme Court has held that a fact is material if there is “a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ on information made available.”[v]
Like the auditor, the forensic accountant should gain an overall understanding of the company, its environment, and the internal control procedures over financial reporting. In planning and developing an overall strategy, the forensic accountant is not constrained by the concept of materiality. The forensic accountant’s objective is to understand what information is available to develop investigative procedures focused on an alleged fraud.
Building the Right Team
The audit engagement partner and other key members of the audit engagement team should be involved with planning the audit, including selecting members with appropriate capabilities and competence, allocating team members’ responsibilities, assisting in the coordination of work done by a specialist, and ensuring quality control procedures. The auditor should determine whether any specialists with expertise outside the field of accounting or auditing are necessary. Specialists may include valuation experts, appraisers, actuaries, or tax and IT professionals.
A forensic investigation team may consist of different experts, depending on the nature of the alleged fraud. Forensic accountants are specialized in the field of accounting, and use a combination of accounting, auditing, and investigative skills. Depending on the nature of the allegations, available information, and the client’s business, the forensic accountant determines the skills, knowledge, and experience required to conduct the forensic investigation efficiently, effectively, and competently. The type of experts on the team will depend on the facts and circumstances of the case, and may include experts in cyber investigations, computer forensics, data analytics, business intelligence analysts, former prosecutors, former law enforcement, former C-suite executives, regulatory specialists, and other subject matter experts as deemed necessary. The forensic investigation team should understand the circumstances surrounding the engagement, in that the client may want the forensic investigation conducted discreetly.
Conclusion
Audits and forensic investigations are unique services. The forensic accountant is not constrained by the auditor’s concept of materiality, and a forensic investigation team is composed of experts in differing aspects of a forensic investigation. To choose which team is right for an engagement—whether for financial statement analyses or to detect suspected fraud—it is essential to understand the different objectives and responsibilities of an auditor versus a forensic accountant/investigator.
This article was previously published in J.S. Held Insights and is republished here by permission.
[i] AICPA AU-C Section 200.12.
[ii] AICPA AU-C Section 210.10.
[iii] AICPA Forensic and Valuation Services Practice Aid – Forensic Accounting – Forensic Investigations.
[iv] TSC Industries v Northway Inc., 426 US 450 (1976).
[v] TSC Industries v Northway Inc., 426 US 438, 449 (1976). See also Basic Inc. v Levinson, 485 US 224 (1988).
Erik Ringoen, CPA, ABV, CFF, is an Executive Vice President in J.S. Held’s Economic Damages and Valuations practice. He joined J.S. Held in January of 2024 as part of J.S. Held’s acquisition of Forensic Resolutions, Inc. He has more than 30 years of experience assisting clients on matters including financial investigations, litigation and dispute consulting, financial auditing, tax, and economic damages. Mr. Ringoen has led multi-disciplined teams performing fraud and financial investigations, due diligence, Foreign Corrupt Practices Act (FCPA) investigations, bankruptcy, and claims management services, domestically and internationally.
Mr. Ringoen may be contacted at (856) 433-6059 or by e-mail to erik.ringoen@jsheld.com.
