A Comprehensive Look into Forensic Accounting:
Empirical Evidence from a Big Four in Mexico City
Student: Carlos A. Rodriguez Ortiz
Student Number: 10825428
Word Count: 14,512
Program: MSc Accountancy and Control - Control Track
Supervisor: Professor Ron van Loon
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Statement of Originality
This document is written by student Carlos A. Rodriguez Ortiz who declares
to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original
and that no sources other than those mentioned in the text and its references
have been used in creating it.
The Faculty of Economics and Business is responsible solely for the
supervision of completion of the work, not for the contents.
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ABSTRACT
This study focuses on providing a comprehensive view of forensic accounting and its contrast against the audit practice. Through the development of the main elements of the practice with a literature review, a thorough understanding of the history and underlying elements of forensic accounting is achieved. The researcher conducted a qualitative empirical study in the form of interviews to current practitioners of forensic accounting in a Big Four in Mexico setting, in order to account for the differences between forensic accounting and the audit practice. Findings suggest the differences lay on the scope, purpose and procedure of the services. Other elements discussed in the findings include forensic accounting litigation risk, necessary skills and abilities for forensic accountants and the role of IT in forensic accounting as advised by current practitioners.
Keywords: forensic accounting, audit, fraud, anticorruption, forensic investigations, fraud examination, forensic accounting education, computer forensics, litigation risk
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TABLE OF CONTENTS
1. Introduction ... 4
1.1 Background and Overview ... 4
1.2 Scope and Motivation ... 7
2. Literature Review ... 9
2.1 Historical Perspective of Auditing and Forensic Accounting ... 9
2. 2 Fraud, Fraud Examination and Forensic Accounting ... 11
Figure 1. The Fraud Triangle ... 12
2.3 Forensic Accounting Engagement Description ... 14
2.4 Academic View of Forensic Accounting ... 15
2.5 Forensic Accounting and Corporate Governance ... 16
2.6 Litigation Risk Literature as related to Audit Services ... 17
2.7 The Forensic Accountant Skill-set ... 20
2.8 Forensic Accounting and IT ... 22
3. Research Methodology ... 24
4. Case Context ... 26
5. Analysis and Results ... 27
5.1 Forensic Accounting and the Audit Practice ... 27
5.1.1 Scope and Engagement Description of Forensic Accounting versus
Audit ... 27
5.1.1 Provision of Forensic Accounting and Audit Services Simultaneously
to the Same Client ... 31
5.2 Skills and Education for Forensic Investigators ... 33
5.3 Litigation Risk for Forensic Accounting Firms ... 35
5.4 Role of IT in Forensic Accounting ... 37
6. Discussion and Conclusion ... 38
References ... 40
Appendix A. Interview Guide ... 43
Appendix B. Interviewee Details ... 44
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1. Introduction
Today´s business world is becoming more complex and dynamic than ever. New technologies have had an enormous effect on how business is conducted and managed, and more importantly, on how companies are controlled. Ineffective control of an organization leads to internal and external operating issues, which may increase the possibility of fraud being committed by internal and external parties.
A basic definition of fraud is ―to create a misjudgment or maintain an existing misjudgment to induce somebody to make a contract‖ (Arzova, 2003), on an organizational setting, a definition of fraud is to enrich oneself by intentionally reducing the worth of an asset. In many cases, human error in the operation of organizations may provoke unintentional losses, and thus fault is an important term encountered when reviewing the concept of fraud. Fault refers to an unconscious error and stems from the deficiencies originated from the person or the environment in which he or she performs his/her duties, thus showing that intention is what distinguishes fraud from fault (Ozkul & Pamukcu, 2012).
According to the Association of Certified Fraud Examiners‘ Report to the Nations (2012), the cost of fraud to the US organizations is 5 percent of annual revenues, despite increased emphasis on anti-fraud controls and recent legislation to combat fraud. Black (2010) stated that financial statement fraud was a contributing factor to the recent financial crisis and it threatened the efficiency, liquidity and safety of both debt and capital markets. In addition, it has increased uncertainty and volatility in financial markets, thus reducing the creditability of financial information that investors use in their decisions (Rezaee & Kedia, 2012).
1.1 Background and Overview
In the early 2000s, the unveiling of huge fraud schemes such as Enron and WorldCom provoked increased attention to the prevention of these types of schemes due to their negative economic and social impact (Smith, 2012; Warshavsky et al., 2013; Houck et al., 2006; Pearson et al., 2008). Fraudulent financial reporting can
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have harsh consequences for the organization and all its stakeholders. According to a COSO Report (2010) periodic high-profile cases of fraudulent financial reporting raise concerns about the credibility of the U.S. financial reporting process and thus call into question the roles of management, auditors, regulators, and analysts. Moreover, a world-wide study of organizations conducted by Murphy and Dacin (2011) found that 30 percent of companies were victims of fraud in 2010 alone.
In general, schemes such as employee and management fraud, theft, embezzlement, and other crimes were found to be augmenting and thus accounting and auditing personnel must have training and skills to recognize the associated red flags (Houck et al., 2006). An ACFE survey found that whistle-blowing is the single most common method of fraud detection (Robinson & Robertson, 2012). In this manner, if there are no whistleblowers within a company, the detection of fraud and/or inappropriate proves to be a hard task even for the more experienced employees of the firm and even more to internal or external auditors. As a means to control wrongdoing in the corporate world, certain specialized professional services have been developed in order to prevent and deter different kinds of fraud; these services are most commonly known as forensic investigation services (Pearson et al., 2008).
Forensic investigation have become more important and widely known since the creation of the Sarbanes Oxley Act and are now offered as a professional service by more and more accounting firms around the globe (Charles et al., 2010). The increased regulation by governmental and private bodies posed as the main support for the expansion of preventive and reactive investigation services. It is important to assert that forensic investigations include a range of services that are complementary in an investigation, such as forensic accounting (also known as forensic audits), business intelligence and computer forensic services. Within the scope of forensic investigations, Smith (2012) defines forensic accounting as a comprehensive view of a fraud investigation, which encompasses the audit of accounting records to interpret whether a fraud has occurred and who is involved. Smith (2012) asserted that in some cases the forensic accountant is required to serve as an expert witness in court. Forensic accounting knowledge thus affects the accounting profession on a daily basis, since there is a continuous need to identify fraud schemes and illegal sources of money at all levels within an organization (Houck et al., 2006).
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Forensic accounting in practice, unlike general audits, regardless of their type (financial, compliance or internal control), takes a more focused standpoint into analyzing day-to-day documentation and the gathering of qualitative and quantitative data to provide an objective and unbiased opinion on specific (or even broader) allegations (Warshavsky, 2013). Throughout the engagement, the forensic accountants have access to confidential data and the final deliverables may or may not be used in court depending on how the company chooses to proceed, internally or legally (Warshavsky, 2013). These follow-up procedures may therefore cause forensic audit engagements to be considerably high-risk from a litigious perspective for the firms that provide the services, due to the intrinsic nature of the services and the intended use of the deliverables. The litigious perspective on the provision of forensic services will be a topic of importance during this study as no prior research on litigation risk for forensic services was identified.
In general, the academic literature related to forensic accounting is limited and to an extent repetitive. As such, the ambiguity and inexistence of prior literature that encompasses a comprehensive overview of the forensic accounting field set the motivation for this study. This study aims to provide a clear picture of the issues faced by practitioners of forensic accounting and how they are addressed in order to understand how the field practically works. On a more specific context, the purpose of this empirical study is to provide an insightful view on the importance of forensic investigations and its contrast against the audit practice. Special attention will be paid to the identification of the skills, training and background education that are perceived necessary to practice forensic investigations (forensic accounting included), the litigation risk from the firm‘s perspective and the role that IT plays in these services. Based on the previous statements, the main research question for this study is as follows:
What are the most relevant elements of the Forensic Accounting practice and how and to which extent does it differ from the Audit practice in a Big Four setting?
The literature review will provide background on relevant aspects of forensic accounting and how it is related to the audit practice in order to provide a better and deeper understanding of the subject.
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This study aims to provide a more thorough understanding of the forensic accounting subject in practice, as theory may differ substantially from practice in this delicate field. In order to achieve this objective, this interpretive study was conducted in a qualitative fashion. The information was obtained first-hand in a series of phone interviews with forensic accounting practitioners in a Big Four located in Mexico City. The academic background and position of the interviewees varies and provides a rich perspective for the study, so as to take into account some positions have more knowledge in the day-to-day operations and others have a higher knowledge in the general strategy of the department.
The standpoint of this study is exploratory, and seeks to provide an easy-to-understand and practical approach to the main elements of forensic investigations and the field. This study thus intends to focus on the real life aspects of how the skills and background education have an effect on actual forensic investigations, how litigation risk is actually perceived and how IT affects this field in a corporate setting.
1.2 Scope and Motivation
Forensic accounting is gaining relevance in the business world, and as such it is important to provide a comprehensive practical view of the different aspects of the field. There is limited research on the relevant aspects of forensic accounting, more specifically on the difference with the audit practice, the skills and education required by forensic accounting practitioners, types of engagements, litigation risk perception and role of IT in the field.
The academic research for forensic accounting at large is U.S. centric and is largely focused on the skill-set required by forensic accountants and its relation to previous education (Heitger & Heitger, 2008; Smith, 2012; Warshavsky; 2013; Digabriele, 2008). No prior academic research was identified on litigation risk as related to forensic accounting services, and no prior academic research was identified in a American setting. This resulted interesting as it is widely known that Latin-American countries have a higher corruption rate and thus are more prone to fraud in private and public bodies. In addition, few articles on how IT has an effect on forensic accounting investigations were identified (Garfinkel, 2013; Pearson &
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Singleton, 2008), which provide a very limited and theoretical scope of the usefulness of IT.
The contribution of this study then lies in filling the gap of a comprehensive empirical view of different relevant elements for the forensic accounting field in a Big Four setting in Mexico, and its comparison to the audit practice in the same setting. To the extent of my literature review, this is the first qualitative study of its kind, and by interviewing current practitioners a clear and up-to-date set of information can be retrieved. In addition to the empirical knowledge contribution of the contrast with audit, the litigation risk perception and the usefulness of IT, the contribution of the present study as related to the identification of relevant skills of forensic accountants in a Big Four setting in Mexico provides useful insight on the current topic researched by forensic accounting academics about the necessary education courses and skills required to be a proficient forensic accountant. It will aid to analyze if the correct skill-set results from a traditional accounting education or if further specialization is needed in the accounting curricula. Thus, the identification of specific relevant skills of forensic accountants in the results of this study contributes forensic accounting education literature by identifying certain abilities that need to be included with course content.
The remainder of the paper is structured as follows: first, literature review on different identifiable elements of forensic accounting will be provided for the reader to develop a basic yet important understanding of the subject. Second, the methodology and assumptions will be presented. Lastly, the results and analysis will be presented, followed by a conclusion.
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2. Literature Review
2.1 Historical Perspective of Auditing and Forensic Accounting
Gray and Mousalli (2006) point out forensic accounting has been defined differently throughout the years, but in the end, different terms such as fraud auditing, forensic accounting, litigation support, investigative accounting and even valuation analysis are used interchangeably to refer to the same practice. Moreover, forensic investigations may be grounded in different fields, such as accounting and engineering. In this stuy forensic accounting will be addressed as related to forensic investigations, which are performed to detect, measure and deter fraud.As for forensic accounting, it focuses on an examination of evidence regarding an assertion to determine its correspondence to established criteria suitable for a court. In relation to this, Okoye and Akamobi (2009) stated that forensic accounting is the practice of utilizing accounting, auditing and investigative skills to assist in legal matters. Thus, forensic accounting is a special practice area of accounting that describes engagements that result from actual or anticipated disputes or litigation (Enofe, 2013) unlike general auditing, which is not historically defined as a service designed to be utilized on legal disputes.
Forensic accounting, while apparently a new practice created to deter and identify fraud at all levels within companies and institutions, has actually been around for more than just a few years. Gray and Mousalli (2006) provide a very useful and insightful historical perspective on forensic accounting where they identify the first instances of the relation between auditors and fraud examination, and the stages that the practice has evolved through in time. They further state that several years ago auditors were responsible for detecting fraud at any given engagement. They quote Robert Mongomery, one of the founders of the American accounting profession, who stated that ―the detection of fraud is a most important portion of the auditor´s duties, and there will be no disputing the contention that the auditor who is able to detect fraud is – other things being equal – a better man than the auditor who cannot‖. However, regardless of the original expectation that auditors were responsible for
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identifying fraud, audit firms denied primary responsibility over the detection of fraud.
Gray and Mousalli (2006) pointed out that regardless of the auditors`stance, the general public still expected them to be able to identify fraud schemes. Furthermore, in most cases, it was identified that fraud was perpetrated by trusted people within the companies, specially those in higher positions in the accounting, finance and IT functions, which complicates the auditor´s job and the detection of fraud since concealment is often easier to conduct when the employee has more power in the organization (Pearson et al., 2008). The gap between expectations and actual performance of auditors still exists, now more than ever auditors are expected to at least conduct a fraud risk assessment under certain rules when the organizations are governed by regulators and laws, i.e. Sarbanes-Oxley Act of 2002. Gray and Mousalli (2006) advise that the accounting profession continued to teach auditors that identifying fraud was an incidental part of the audit practice, not a responsibility. In this manner, the fraud investigation field and more in-depth review of allegations was relegated to forensic accountants, who are better suited and trained for the task.
Gray and Mousalli (2006) further state that in the past thirty years several efforts were made to strengthen fraud awareness, i.e. the Treadway Commission was set to study different accounting bodies (in the United States of America), where they concluded that the ability of the independent public accountant to detect fraudulent financial reporting is related directly to the quality of the audit, furthermore, the Treadway Commission created audit standards related specifically to fraud detection. But it was not until major scandals occurred (Enron, Tyco, Worldcom, HealthSouth) that it was asserted that auditors were not focusing enough in identifying fraud, which led to a reassessment of the audit profession, and the creation of the Sarbanes-Oxley Act of 2002, an act that made fraud discovery a priority of auditors once again.
According to Albrecht et al. (2008), the Sarbanes-Oxley Act had broad implications for both auditors and companies. In an effort to improve fraud detection the Act established the Public Company Accounting Oversight Board in the U.S. The public generally agrees that SOX has helped strenghten corporate governance and decrease the incidence of fraud, however, the frequency of financial statement fraud has not seemed to decline since the passage of the Sarbanes-Oxley Act (Bhasin, 2013).
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2. 2 Fraud, Fraud Examination and Forensic Accounting
The terminology in the forensic field can sometimes be used interchangeably but on other occasions it may provoke confusion as similar terms are not necessarily the same. In this section definitions, examples and relevant information on different terms important to this paper will be provided, such as fraud, the different fraud stages and the key difference between the concepts of fraud examination and forensic accounting as identified in prior literature.
Fraud is a very broad term and is defined differently by different field researchers. Houck et al. (2006) define fraud or fraudulent act as the means human ingenuity can devise to get an advantage by false suggestions or suppression of the truth. Furthermore, in relation to fraud terms, they define occupational fraud (more relevant to this study) as the use of one's occupation for personal enrichment through the deliberate misuse of the employing organization's resources or assets; and corruption as the "paying off" of public or private in order to receive preferential treatment. Arzova (2003) defines fraud as the creation of a misjudgment or maintaining an existing misjudgment. Ozkul & Pamukcu (2012) suggest fraud refers to enriching oneself by intentionally reducing the value of an asset. They also state fault is an important term related to fraud, as there may be misstatements or misjudgments that arise from wrong actions but unintentionally due to deficiencies from the persons and the systems overseeing them. Thus, the most important differences between fault and fraud are the intention of the person and the objective of material gain. In general, it is claimed that accounting fraud occurs due to different integrated factors, such as lack of auditor independence, weak law enforcement, dishonest management, poor internal controls and weak corporate governance (Bhasin, 2013).
There are two general types of fraud identified by Ozkul & Pamukcu (2012): the personal use of business resources (money embezzlement, tampering bank records, document forgery, fake payments) and drawing false financial statements (largely corporate fraud to mislead investors, debt issuers, and the market).
Ozkul & Pamukcu (2012) further discuss that fraud detection has increased in the past years due to the increasing number of fraud events. They advise that fraud
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detection begins with the identification of red flags in the business´ operations, so that employees and managers concern about losses in assets. In general, the ways in which fraud can be detected vary and in general include detection by chance, whistleblowing by an employee or detection by conducting a preventive review. Ozkul & Pamukcu (2012) assert that people who are exposed to fraud in the organization usually are aware that some kind of fraud is being committed, but could not bring it to light either because they are unwilling to blame someone directly or are unsure of how to go about reporting the inappropriate actions, in addition, employees may also be afraid of being labeled as a whistleblower. It is important to point out that whistleblowing is the most important and effective way of detecting fraud. Ozkul & Pamukcu (2012) describe that the most successful effort to identify fraud is to set anonymous hotlines within the organization or outsource them to independent organizations. Although this is a very effective approach, there is always a risk involved of receiving false reports by unhappy employees and thus the company must evaluate which reports should and should not be investigated.
Fraud identification and detection is of utmost importance for organizations, but they must be aware of why fraud is committed in the first place in order to avoid it. According to Albrecht et al (2008), fraud researchers identified three elements common to all frauds. These three elements together are known to create the concept of the fraud triangle, and these elements are: perceived pressure, perceived opportunity, and some way to rationalize the fraud as ethically acceptable. The following figure summarizes the fraud triangle concept:
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Source: Albrecht et al., 2008
After a fraud scheme is identified, a fraud examination is usually the best next step to follow. Smith (2012) states that the fraud general theory consists of four elements: facts, assumptions, rationale, and conclusion. He also describes fraud examination as the process of identifying and determining whether fraud has occurred. This process usually includes collecting and analyzing documentary evidence, interviewing key personnel within an organization and suspects of fraud, reporting on observations, and testifying on conclusions. Smith (2012) further advises that in a fraud examination the client and fraud examiner initially discuss the reasons why a fraud may have occurred, conduct an analysis of relevant documents, direct inquiries are made in the form of interviews and collection of transactional records and document support. A similar approach is suggested by Ozkul & Pamukcu (2012), who states the first stage raises fraud consciousness and fraud risk assessment (in a risky environment, fraudulent events are doomed to occur). The second stage is the investigation stage, where all security procedures and internal control are included. The larger part of the investigation is conducted by interviewing and examining documents and it is important to point out that the investigation may not lead to a final decision but is usually costly and time-consuming. Ozkul & Pamukcu (2012) assert that there are four possible decision actions at this time: do nothing, fire the fraudster, transfer the fraudster to another department, or fire the fraudster and start legal proceeding. The third stage then proceeds in implementing the chosen course of action, and in the final stage the file is closed and new controls are applied.
Smith (2012) and Ozkul & Pamukcu (2012) advise that forensic accounting and fraud examination are related terms, but differ based on the underlying reason of each service. For instance, forensic accounting work is done by accountants in anticipation of litigation and can involve different fields such as fraud and valuation. Fraud examinations refer to either preventively or reactively treating fraud and can be conducted by either accountants or non-accountants. A fraud examination refers solely to antifraud matters. Forensic accounting uses accounting, auditing, and investigative skills to conduct investigations into theft and fraud. Different types of
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schemes and situations provide for different assignments required by clients, forensic assignments include corporate investigations, litigation support, criminal matters, insurance claims and governmental issues, and thus forensic accounting is considered the intersection between accounting, investigation and the law (Houck et al., 2006). In addition, forensic accountants are of assistance in legal disputes such as shareholder/partner disputes, matrimonial dissolutions, breach of contract, white-collar criminal investigations and bankruptcy (Warshavsky, 2013).
2.3 Forensic Accounting Engagement Description
According to Renick (2007) and Warshavsky (2013) a forensic accounting engagement may contain different phases depending on its core purpose, such as providing the service solely for a corporation´s internal review or providing the service to use the deliverables for litigation purposes. Renick (2007) advises that in general, all engagements are divided in an exploration and evaluation phase and then, if a cause of action is determined and supportable a scope expansion phase is followed. During the exploration and evaluation phase the forensic accountants define the issues involved and the scope of the engagement, the interviews and document review is limited to readily accessible information, and the conclusion is a report of preliminary findings. A determination is made at this point of whether the investigation should be expanded if there is enough evidence that a fraud is being committed and that further findings will strengthen the case. Warshavsky (2013) advises a similar approach, describing the following steps: foundational, in this stage the forensic accountants provide assistance in the case´s initial development and in the identification of relevant courses of action and the financial framework; interpersonal, during this phase forensic accountants plan and conduct interviews to collect case data and find new lines of investigation; data collection and analysis, where document and interview data is combined and analyzed in different ways to evaluate if the fraud allegation/theory is true from an objective standpoint; and expert report, all conclusions from the analysis are aggregated into a summarized expert report which may or may not be used in trial depending on the agreed scope of the investigation.
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2.4 Academic View of Forensic Accounting
First of all, it is important to point out that the literature identified for the academic view and academic support of forensic accounting is limited and U.S. centric. Forensic accounting has been analyzed from an academic formation standpoint more thoroughly since the major scandals in the beginning of the century, given that historically, the accounting academic curricula does not usually include forensic accounting courses (Heitger, 2008). Forensic accounting is academically defined in a study as ―the practice of rigorous data collection and analysis in the areas of litigation support, consulting, expert witnessing, and fraud examination‖ (Rezaee et al., 2004). By comparing the forensic accounting practice to the accounting profession curricula a clear gap was identified, since forensic accountancy is currently considered a secure career track for accountants, but only a limited number of accounting programs (in the U.S.) offer forensic-related courses. The study conducted by Rezaee et al. (2004), in which they surveyed academicians and practitioners in the U.S. to determine the importance and relevance of forensic accounting education, reveals that the demand for and interest in forensic accounting is expected to increase, that more universities plan to provide forensic accounting education, that respondents viewed forensic accounting education as relevant and beneficial to accounting students and the business community, and that there is a general consesus that forensic accounting topics are important in the academic accounting curricula.
In addition to the previous study, Peterson (2013) identified two possible main reasons for the limited inclusion of fraud topics in the accounting curricula. First, a reason why fraud education is not included is that educators are not aware of the magnitude of the fraud issues in the business environment. In the past years, several researchers have performed surveys of different sizes to monitor fraud and its main effects on business and society, these findings are alarming, especially considering that fraud statistics are estimates, since not all frauds are discovered and not all frauds are reported to an external entity. Two examples of these surveys include the ACFE (Association of Certified Fraud Examiners), that reviewed 662 fraud cases that were investigated in 2002 and aggregated seven billion USD in losses. The second example is the survey conducted by Ernst&Young, one of the leading consultancy firms worldwide, which identified that more than two thirds of the respondents suffered some type of fraud in the past year, and hat 82% of frauds were committed by employees. The second reason for the limited amount of fraud education is that
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there is little room for an additional course in the accounting curriculum, taking into account that some accounting courses are more important to the base curriculum than more specialized courses, such as a forensic accounting course. It is expected that courses in accounting principles, intermediate accounting, advanced accounting, accounting information systems, auditing, tax, cost accounting, and governmental accounting are of utmost importance and necessary, and cannot be eliminated from the accounting base curriculum.
2.5 Forensic Accounting and Corporate Governance
Corporate governance is one of the most important elements of an organization and thus it is interesting to discourse the importance of forensic accounting as related to corporate governance. Bhasin (2013) addressed that the effectiveness of corporate governance mechanisms will deter fraud at all levels, especially higher levels (most common for fraudulent financial reporting) which can have significant consequences for an organization, but also to its stakeholders and the public at large.
Bhasin (2013) further discusses that the interests of investors and stakeholders are usually protected by its corporate governance system, which is specifically directed toward enforcing company policies, achieving company objectives, monitoring company performance, and ensuring adequate disclosure of the company‗s activities. The main issues of a corporate governance code that could lead to fraud are: lack of a well-developed corporate governance policy, lack of honesty in reporting and inefficient and ineffective internal control system. According to Bhasin (2013), the forensic accountant should be skilled in financial accounting, internal control systems, law, investigative proficiency, and interpersonal skills, so organizations can rely on these skills for developing a consistent corporate governance system. The main features the forensic accounting field can develop and strengthen in a corporate governance system include designing the correct channels to transfer information within and outside the company, ensuring that governance policies and objectives are considered into the internal control system, setting up fraud prevention systems, and investigating any allegations of fraud at any level.
In addition, Bhasin (2013) advised that as part of the corporate governance committee, forensic accountants can make a significant contribution in areas such as:
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comprehensive corporate governance policy that include dependent and independent directors and management, the prevention of fraud by establishing an ethical reporting code and ensuring a revision of relevant transactions and procedural control, creating a positive work environment, establishing effective lines of communication, conducting constant monitoring at all levels, establishing clear consequences for incorrect behavior and deterring fraud by proactively conducting fraud examinations.
2.6 Litigation Risk Literature as related to Audit Services
One of the main risks that consultants face when providing professional services is the risk of litigation from existing or prior clients. As mentioned in the beginning of this study, no prior literature on forensic accounting litigation risk was identified and this study attempts to fill the gap in that regard. In order to obtain a comparable base of litigation risk history, the most relevant litigation risk academic research articles in the audit literature were reviewed. The audit business environment is close in nature to the environment of forensic accounting, which was my main reasoning for reviewing audit literature to present a general overview of the litigation risk topic.
Mong & Roebuck (2005) recognize that auditor litigation risk is a principal concern to auditors and that it is difficult to ascertain with any degree of certainty before the engagement. It is also recognized that the issue has been ongoing for many years and is one of the main concern0073 for the audit profession. According to Krishnan (1997), the incidence of litigation against audit firms has increased dramatically in the past years. Other researchers also measured litigation incidence; Free (1999) found that litigation costs in the U.S. accounted for 14 per cent of gross fees in 1992, while Pratt and Stice (1994) found that the level of litigation against auditors increased 300 per cent approximately between 1985 and 1994. Palmrose (1988) states that litigation against auditors typically involves a process, from initial discovery of potentially false or misleading statements, to filing of lawsuits, and eventual resolution of such suits. Throughout the years there have been a variety of studies that look into different aspects of litigation risk.
The main issues involved in previous litigation risk literature in the audit field include auditor independence, audit fees and the issuance of specific opinions depending on the clients. Schmidt (2012) states that ―there is a longstanding view that
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auditor independence is threatened by the economic dependence of an auditor on client fees and that ―additional fees obtained through the provision of nonaudit services (NAS) increase an auditor‘s economic dependence on a client, and thus have been perceived by regulators to threaten auditor independence‖. Blay (2005) conducted a study to investigate whether litigation risk and auditor independence threats influence auditor´s evaluation of information. Blay (2005) results suggest that the greater the independence threat, the less auditors decreased their predictions that the firm would survive; as for litigation risk, the greater it is, the more auditors decreased final survival probability assesment. Prior research also provides evidence that client fees impair perceived auditor independence but it is unclear whether particular types of fees result in impairment (Schmidt, 2012). Most prior studies measure perceived auditor independence by examining the costs to clients instead than to auditors. For instance, the study conducted by Schmidt (2012) examines the initiation and resolution of audit restatement-related litigation to provide evidence on whether fee dependence impairs perceived auditor independence. This study ultimately concludes that more severe restatements, as well as those that involve revenue-recognition failures are more likely to end in audit litigation. Another interesting factor involving litigation risk is how audit firms price different engagements based on a number of characteristics. Audit fees play an important role in the litigation risk setting. Simunic (1980) defined the audit process as the calculation of the cost of the accounting system, the cost of the external audit, and expected losses from litigation. Litigation costs for auditors include delisting, bankruptcy and lawsuits (Beaty,1993). There have been numerous studies that focus on how audit fees are affected by litigation risk. For example, Taylor and Simon (1999) analyzed the extent to which fees are determined by micro and macro-economic and other environmental factors across countries. In this study, it is pointed out how the effect of excessive litigation and regulation increases the price of accounting services. Another recent study conducted by Elliot et al. (2013) found that succesor auditors charge higher fees to their clients that previously reported disagreements and other reportable events, which lead to higher litigation risk. Minutti-Meza (2014) provides rich and insightful information on the review of Badertscher et al. (2014), where it is stated that litigation risk is expected to be a strong incentive for auditors to deliver high-quality audits and an important determinant of audit fees, although determining the impact of litigation risk is hard to measure since it is complicated to examine variation in litigation risk for different
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scensarios. Prior studies reach conclusions similar to the one stated previously. For instance, Simunic and Stein (1996) examined audit fees for a sample of public and private U.S. firms in a litigation risk setting, where they found that public clients pay higher fees than private clients do, and that the auditors appear to respond to higher client-specific litigation risk by putting more effort into the audit rather than charging a higher premium. Venkataraman et al. (2008) stated that audit fees are usually related to auditor exposure to losses from legal liability; moreover, they state that the expectation that audit fees should reflect differences across litigation regimes (different countries) has an effect on audit quality. A study conducted by Dye (1993) confirms the relation between audit fees, audit quality and litigation risk exposure. Another study by Choi et al. (2009) concludes that auditors charge comparatively higher fees for firms that are cross-listed in countries with strong legal regimes. As for the issuance of specific audit opinions, the study performed by Mong & Roebuck (2005) examined whether the issuance of an audit opinion with a going concern paragraph disclosure has any effect on higher or lower litigation risk for the auditor. The study concludes that the issuance of a modified opinion can significantly reduce the likelihood of auditors facing legal action from its clients, although the effect of work practices disclosure was not deemed significant. Kaplan et al. (2013) conducted another study in similar grounds, their motivation states that auditors ―may be able to reduce their exposure to litigation when auditing a financially stressed client by issuing a going concern report.‖ Other studies that consider litigation risk relation to going concern decisions include Blay (2005), Krishnan and Krishnan (1996) and Kida (1980).
In addition to litigation risk derived from a failed financial audit, auditors are required to design audit procedures to identify fraud risks as part of the audit in some regimes, such as defined by the AICPA in the U.S. Litigation exposure is an important and delicate topic, in fact, according to Reffett (2010) there is a practice aide that advises auditors against documenting the specific fraud risks identified during the required fraud-related brainstorming sessions since doing it may cause litigation exposure. Moreover, Reffett (2010) also states that a forensic accounting guide published by a Big Four partner suggests that enhancing audit procedures to improve fraud detection may raise the risk of litigation. In the same study, he cites Coffee (2004) who stated that auditor´s best defense in cases of undetected fraud is ignorance, so that in this case there is an incentive to not conduct a thorough audit.
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Reffett (2010) conducted a study based on counterfactual theory to empirically test if investigating fraud risks increase auditors´liability when fraud goes undetected. The study concludes that ―evaluators in a between participants environment experience more intense thoughts of what the auditors could have done differently to detect the fraud and are more likely to hold auditors liable for plaintiff losses when the auditors performed audit procedures to investigate for the fraud, relative to when the auditors did not investigate for the fraud.‖ This conclusion suggests that evaluators lack an understanding of what auditors should be held responsible and thus makes increasing the quality of the audit a counterproductive measure.
It is the purpose of this exploratory study to identify if some of the litigation risk elements presented are to an extent transferable to forensic accounting services, and if it represents such an important hindrance in forensic accounting as it does in the audit environment.
2.7 The Forensic Accountant Skill-set
Ozkul & Pamukcu (2012) defined that forensic accountants, also referred to as forensic or investigative auditors, have different duties and responsibilities throughout their engagements, and thus their skill set is quite dynamic. Forensic accountants must have a very broad skill set as the nature of their job requires flexibility and sly thinking. In general, forensic accountants utilize an understanding of holistic business information and financial reporting systems, accounting and auditing standards and procedures, a thorough understanding of fraud schemes, the ability to comprehend the internal control systems of corporations and to set-up control systems, proficiency in computer and network systems‘ knowledge, command of basic criminal and civil law, evidence gathering and investigative techniques, and litigation processes and procedures (Ozkul & Pamukcu, 2012; Bhasin, 2013). Furthermore, they also state that forensic accountants may be required to give expert evidence at a trial, playing a proactive role in risk reduction by designing extended procedures as part of statutory audit, acting as advisers to audit committees and fraud deterrence services. In addition, forensic accountants must have a skeptical mindset. In contrast with a financial auditor, what turns a well-trained and experienced accounting professional into a good forensic investigator is the knowledge of human behavior and the ability
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to detect red flags intuitively and then being able to find evidence that proves this theory (Ozkul & Pamukcu, 2012; Bhasin, 2013). Ozkul & Pamukcu (2012) also assert that the skeptical mindset of the forensic accountant should raise questions about the reasonableness of all transactions and the underlying evidence.
On the academic side of the skill set of forensic accountants, Digabriele (2008) conducted a very interesting study in which he surveyed a large sample of practitioners and academics in the accounting field (U.S. centric) to analyze what the necessary skill set of the forensic accountant is. The results indicate that practitioners and academics agree on the importance of forensic accountants´ holistic technique to an investigation, where the forensic accountant has to maintain an open-mind in the different people involved in the investigation and the related accounting transactions. Moreover, practitioners and academics also agree that being able to solve a financial puzzle with an incomplete set of pieces is an extremely important characteristic for forensic accountants. Other abilities that are also important and were strongly agreed by the participants were: oral communication to participate in expert testimony, effective communication in writing to clearly communicate the findings of an examination, general although working knowledge of the legal process and the evidence rules used in court when required by the engagement and maintaining composure during an engagement, more specifically during expert witnessing. In summary, Digabriele‘s (2008) findings pose that practitioners and academics agree that critical thinking, unstructured problem solving, investigative flexibility, analytical proficiency, and legal knowledge are important skills of forensic accountants.
Certification-wise, Ozkul & Pamukcu (2012) advise that the ACFE (Association of Certified Fraud Examiners) provides an antifraud international certification called the CFE (Certified Fraud Examiner), to professionals with at least 2 years of professional experience in a field either directly or indirectly related to the detection or deterrence of fraud. The areas that the ACFE recognizes as important for qualified antifraud professional experience are: accounting, auditing, criminology, fraud investigation, law as related to fraud.
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2.8 Forensic Accounting and IT
The role of IT has grown exponentially in organizations of all industries and sizes. The shift from physical information to digital information has had an effect on how fraud is committed, detected and investigated in a corporate setting. Pearson and Singleton (2008) advise that an understanding of digital tools and techniques is necessary to deter fraudulent acts. Furthermore, they state that the role of technologies and digital data is growing significantly in fraud detection and thus IT and forensic accounting are interrelated in various ways. Pearson & Singleton (2008) also state that knowledge and application of technology has become essential and effective in forensic accounting and anti-fraud programs. Businesses now, regardless of their size or industry, use computers and networks where all transactions are recorded and thus leave a trace. From an audit perspective, such as internal or external audit, several firms purchase analytic software to conduct analysis of huge amounts of data to search for red flags, this process is called data analytics and data mining. In general, according to Pearson & Singleton (2008), IT has influenced forensic accounting in the following ways: increased usage of IT in fraud detection, since auditors now have the tools to play a proactive role on the detection of fraud and protection of privileged information; increased usage of IT by those who commit frauds, since the growth and accessibility of the Internet and digital technologies offers more opportunities to the criminal mind; prevention and deterrence, since IT systems can be breached and circumvented; digital evidence, since special knowledge and skills are necessary to present and preserve digital evidence; detection and investigation, since data extraction and analysis can be performed in a variety of ways and some are more effective than others under specific circumstances.
Furthermore, Pearson and Singleton (2008) state that the current importance of IT is derived from the fact that for crimes committed in the past years only digital evidence exists. For instance, cyber-crime is only traceable through digital sources, so that wrongdoers are able to conceal their acts and misappropriate assets without auditors and law enforcements being able to persecute them. According to Garfinkel (2013), these issues gave rise to digital forensics, which encompass different actions such as the uncovering and examination of evidence located on all devices with electronical storage, such as computers, cell-phones and even networks. Garfinkel (2013) further discuss that digital forensics researchers and practitioners continually face challenges in their work environment such as analyzing huge amounts of data,
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language processing, data visualization and cyber-security. Moreover, Garfinkel (2013) states that ―digital forensics is powerful because computer systems are windows into the past. Many retain vast quantities of information—either intentionally, in the form of log files or archives, or inadvertently, as a result of software that does not cleanly erase memory and files.‖ Due to this fact, investigators can recover old emails messages, chat logs and other kinds of data that were created weeks, months or even years before, and thus can provide missing pieces of information during an investigation.
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3. Research Methodology
Due to the nature of the study and in order to obtain a practical in-depth understanding of the topic at hand a interpretive qualitative approach will be utilized to conduct the research case. According to Bryman (2008) interpretive research stresses on the understanding of the social world through the interpretation of the world by its participants. Moreover, a case study provides the opportunity to better answer the how and why of the research question in more detail (Yin, 2009).
The main objective of this case study will be to provide a comprehensive picture of the most relevant elements and issues of the forensic accounting practice. There are a number of subtopics that will also be specifically regarded during the case study, such as is to investigate the extent to which forensic accounting differs with the audit practice, if forensic accounting services can be provided simultaneously with audit services by the same firm to the same client, the litigation risk perceived on the field, the education and skills necessary for proficient forensic accountants and the role of IT in the forensic accounting field.
The study will be exploratory as there is limited related prior research and the intention of this study is to provide a base for the forensic accounting field literature. The instrument used in this study was the qualitative interview. Theoretically speaking, the qualitative research interview seeks to describe and the meanings of central themes in the life world of the subjects and the main task in interviewing is to understand the meaning of what the interviewees say (Kvale,1996). A qualitative research interview seeks to cover both the facts and meanings (Kvale, 1996); which is useful in this type of study due to its exploratory nature. Interviews are particularly useful for getting the story behind a participant‘s experiences. Moreover, the interviewer can pursue in-depth information around the topic by asking follow up questions.
The interviews were semi-structured, leaving room for the practitioners to elaborate on broader topics regarding forensic accounting. According to Bernard (1988), semi-structured interviews should be used when there are few chances to interview people and thus the best information possible has to be obtained in one interview. Semi-structured interviews are usually preceded by observation and prior review of the topic in order to develop a keen understanding before conducting the
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interview. The semi-structured interview guide provides a clear set of questions for interviewers, which creates more reliable and comparable data, but each respondent was able to elaborate on different topics based on their knowledge and experience.
The case study was performed at a Big Four firm located in Mexico. Access was granted by the partners as the researcher had a prior working relationship with one of the main partners of the practice. In total, eight current practitioners were interviewed as it was complicated to interview more since employees in this field are constantly traveling or are located at the client´s office and unavailable to contact. Appendix A provides a summary of the interview guide. Appendix B provides a summary of the interviewee records, including their gender and position. These employees had a minimum of three years of experience in the field and up to 26 years for the main partner. Different positions and experience provide for a rich background of information as different level employees have different activities and thus different working knowledge.
An initial interview guide was developed to cover the main topics described in previous sections, but as the interviews progressed other topics of interest were covered. Interview duration averaged 24 minutes and interviews were conducted in an anonymous manner. Although all respondents were bilingual, all interviews were conducted in Spanish to better capture the essence of their knowledge and experience. All interviews were conducted via conference call, they were recorded digitally and are stored in an electronic file, all interviews were transcribed into Word Documents totaling 41 pages of transcribed interviews. Respondent validation was obtained from all interviewees except the two partners whom were unavailable due to high workload.
Data analysis was conducted utilizing the software ―Atlas TI‖ for qualitative analysis. The initial coding of the final transcripts was performed and then a second-cycle coding was conducted, in which several codes were merged and others erased to provide a clearer picture of the analysis. Several quotes were selected during the first coding analysis but the second cycle provided a better approach to deciding which quotes to utilize for the final results. Appendix C shows the final codes, categories and concepts that resulted from the final analysis, and which were used to develop the analysis and results of the study.
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4. Case Context
As previously stated, the case study was conducted on a Big Four context located in Mexico City. The department within the Big Four is called Forensic and Dispute Services and encompasses a variety of services that are complementary during an investigation project. The different service lines are: forensic accounting, which serves the review of transactional records and direct inquiries to an organization‘s employees, the review and investigation of fraud allegations and the creation of expert reports to assist litigation related to fraud and anticorruption matters; business intelligence, which serves the investigation of individuals and/or organizations in the form of background checks, these checks include the review of legal private and public databases for criminal records, lawsuit records, private property ownership, participation in public or governmental positions, investment trading and ownership of businesses i.e. public incorporation acts; antimoney laundering, which serves the niche of antimoney laundering preventive and reactive services for private and public financial institutions; and computer forensics, which includes the data copying, data mining and eDiscovery services, these services provide organizations the availability to make an exact copy of a digital storage device (PC hard drive, cellphone, USB flashdrive) in order to analyze it thoroughly and find information that could aid an investigation. These four service lines may or may not be used in a complementary manner, but according to most of the interviewees it is common for clients to utilize forensic accounting, business intelligence and computer forensics simultaneously.
Another important issue for the context of the case is that several of the higher level employees have a wider view of the forensic investigation services as opposed to a narrow forensic accounting view. This is reflected in how they answered some of the questions during the interview; whenever possible it was requested from them to provide more detail for the forensic accounting section in order to obtain a better understanding of the subject.
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. Analysis and Results
The analysis and results will be subdivided in four different sections to provide a clear-cut set of information.
5.1 Forensic Accounting and the Audit Practice
The focus of the comparison between forensic accounting and auditing lies on the scope of the service and the procedures performed during an engagement. These were the major topics discussed during the interviews, but a third topic arose related to the possibility of providing both forensic accounting services and auditing services simultaneously by the same firm (different lines of service) to the same client. The results in this section will then be organized in two major subtopics: scope and engagement description of forensic accounting versus audit and provision of forensic accounting and audit services simultaneously.
5.1.1 Scope and Engagement Description of Forensic Accounting versus Audit
First of all, it is important to point out that the interviewees have a broader view of forensic accounting that includes the interrelation of different services provided by the department. These services include forensic accounting, background checks, computer forensics and antimoney laundering and all are provided individually or in a complementary manner and thus the interviewees sometimes took a step back to clarify that forensic accounting was not the same as forensic investigations, as has been identified in some academic literature. According to the partners:
The department in which we work is generally known as forensic investigations, within an investigation there can be different components depending on the size of the engagement and the procedures that must be performed. Forensic accounting refers to a section where you are focused on the analysis of accounting information or historical records. In a broader context, an investigation can include computer forensics, background checks and if necessary antimoney laundering services, these elements are utilized together depending on the requirements (I1, partner).
In our case (the department), the projects related to fraud investigation, anticorruption and largely all projects that derive from the investigation of conducts that lead to a violation
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of internal and external laws, preventive assessments for fraud and compliance. For (forensic) accounting, to serve the requirements of organizations that have suffered damage in their assets derived from a financial crime performed by their employees or a third-party (I2, partner).
As a starting point, it is important to provide the description of forensic accounting and its scope as narrowed down by the coding procedures performed to the different interviewees. Main descriptions are:
The focus of forensic accounting is performing an in-depth analysis of specific transactions or historical records that permit a better understanding and clarity about the reasonableness of certain operations that may have arisen doubts or inconsistencies. Forensic accounting is commonly used to investigate an allegation of possible deviation of funds, conflict of interests or other related topics (I1, partner).
The forensic accounting service focuses on specific topics, normally there is a preexisting allegation of bad practices within an organization that could be related to fraud or corruption. The services provided are to review the statements and accounting information, uniquely related to the original allegation, this allegation is usually made by an employee (I5, manager).
In the case of forensic accounting normally they are projects that derive from an anonymous allegation of inappropriate conducts, or suspicion of the latter, it is a reactive service usually and it is usually provided when there is an existing situation that the organizations are concerned about and wish to take action (I2, partner).
The main focus of forensic accounting is to detect/measure fraud or possible violations to anticorruption laws and antimoney laundering (I8, senior associate).
From the previous quotes, it is noticeable that in practice in the Mexico setting the scope of forensic accounting is similar to the one presented on the literature review, in which it is explained that the scope of a forensic accounting engagement is specific and narrow, but a major difference with the literature is that it can be inferred that not all forensic accounting engagements are started in anticipation of litigation (Enofe, 2013). Some engagements of forensic accounting may only provide information that will be used internally by the client, without necessarily engaging in legal action. Four interviewees stated this fact as part of their description of usual activities. According to a senior associate:
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Forensic accounting is a specialized practice focusing in fraud and corruption topics, and this may or may not end in a legal dispute or litigation (I7, senior associate).
Another finding is that most common way of starting a forensic accounting engagement is by an anonymous allegation made by an employee of the firm, whom notices misbehavior and reports it through the available communication channels. All interviewees agreed on this and this finding is in line with the literature review.
As for the focus between forensic accounting and audit services, the qualitative analysis‘ main finding is that the differences between these services are their core purposes and procedures, they are fundamentally different and thus auditors cannot provide forensic accounting services since it falls out of the scope of their expertise, which is of performing an overview and measure of the reasonableness of financial statements, internal controls or other topics depending on the focus of the audit, but ultimately does not follow the detailed review that has to be performed in a forensic accounting engagement. All interviewees have at least two years of audit experience and all agreed on the main differences between forensic accounting and audit services. Extracts from the interviews follow:
The purposes and procedures performed of each service are different, while in an audit of financial statements (or other type) the purpose is to verify that the financial statements meet certain regulations and criteria, such as completeness, the forensic audit focuses on a particular situation, in other words, to validate or reject any evidence that an allegation is true. This allegation could be fraud, or any other related topic, but it is narrowed down and goes beyond the review of an accounting record, it implicated the in-depth understanding of the transaction or group of transactions and the process it followed, the systems used, descriptive methodologies, how operations were conducted and how communication flowed as they occurred (I1, partner).
Well, firstly, lets clarify that a ―normal‖ audit is focused on compliance with existing legislation, either national or international which is a very different line of service (from forensic audit). A forensic audit is (in simple words) a supporting service provided to a client to prove or disprove an issue, in a forensic audit no opinions are provided to the client as it is done in a traditional audit by the auditors, since the opinion provided will be used by third parties (I8, senior associate).
In general, the audit is designed to provide an opinion on the financial information (of a company), but a detailed analysis of all transactions or operations on the focus of the audit is not performed, only a determined group of transactions or a percentage of them is used as a
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sample. In a forensic audit there is more attention to detail on specific details and in some situations there may be a legal dispute or litigation (I7, senior associate).
As stated by Gray and Mousalli (2006) in the historical perspective of audit and fraud investigation, the audit practice has largely maintained itself separated from fraud identification responsibilities and focused more on the overall review of controls and financial information. The qualitative results confirm this statement to an extent, as forensic accounting practitioners recognize the difference in scope of the audit procedures versus the forensic accounting procedure. This in turn reflects that auditors are not practically obligated to detect and investigate fraud issues during their engagements, thus leaving this more specific and detailed reviews to the forensic accounting line of service. A director added:
Normally, we are contacted (by potential clients) when there are already existing (fraud) issues (within the company), most likely a lawyer has been hired already and there are suspicions of fraud, of any kind really, embezzlement, asset misappropriations, collusion with clients, etc. We start with forensic accounting procedures to identify how thing happened, what impact they have on the accounting system (reporting) and determine the material monetary amount that was lost by the company, in this manner we are able to correct controls and have a clear idea of the economic loss (I3, director).
While audits usually follow a sampling procedure to ensure that protocols are being followed, and conduct a review of current policies and procedures to ensure there are no deviations in the day-to-day operations, forensic accounting conducts a more detailed set of steps into specific allegations. All of the interviewees have previous working knowledge in the audit practice and thus are able to put in context the differences between the procedures followed in one service as opposed to the other. According to a partner:
The starting point is to understand the situation of the client very well, taking into account all the problems and requirements, the next step is to design a work plan that will provide a solution to the issues that were discussed. Normally there is an agreement with the client on what the scope of our services will be, this scope may be very limited and only focuses on the specific issues that were discussed, but it is very common that after we identified fraud and reviewed all the damage clients request an additional review with a larger scope to find out if other deviations could have occurred. So, the first stage is understanding
