Of Estimates, Errors & Fraud

fraud-warningThere was a local case of embezzlement in the news last week in which the suspected perpetrator claimed that a number of her seemingly fraudulent transactions, as identified by her company’s external auditors, were in reality ‘mistakes’ (mostly either accounting or estimating errors) or, in other cases, just simple missteps occasioned by ignorance of her company’s accounting policies. Somewhat surprisingly, this all too common defense seemed to cast some doubt, at least from the newspaper’s point of view, on the overall propriety of the entire prosecution. For me, the case brought to mind, on one hand, the differing roles of external auditors and forensic accountants and, on the other, the often critical role played in investigations by the introduction of the foggy elements of accounting estimates, simple errors and ignorance.

Unlike the external auditors in this case, the forensic accounting investigator’s concern is not limited to reaching a general opinion on financial statements taken as a whole, derived from reasonable efforts within a reasonable materiality boundary. Instead, the forensic accounting investigator’s concern is, at a much more granular level, with the detailed development of factual information—derived from both documentary evidence and testimonial evidence—about the who, what, when, where, how, and why of a specific, suspected or known impropriety.  In my opinion, it’s the lack of such investigative granularity in the follow-up to the simple discovery of the individual fraud by the auditors in this recent case that resulted in the ‘ambiguity’ expressed by the newspaper.

The auditors discovered the suspected fraud through their routine sampling procedures, which predication of the existence of an impropriety would have furnished the starting point for the work of a forensic accountant had one been called in. Think of it like the relationship between the accountant and the financial analyst.  The financial analyst’s work typically begins when that of the accountant ends; the audited financial statements are the foundation on which the work of the financial analyst rests.  So too do discoveries of improprieties by auditors often lead to a subsequent investigative hand off to forensic investigators.  The forensic investigator starts by seeking and examining all relevant evidence concerning the particular case made available, not only by the auditors, but by all the concerned parties.  Based on the investigative findings, the forensic accounting investigator then assesses and measures losses or other forms of damage to the organization and recommends and implements corrective actions, often including changes in accounting processes and policies and/or personnel actions. In addition, the forensic accounting investigator assists management in taking preventive actions to eliminate recurrence of the problem. In contrast to the external auditors, the forensic accounting investigator’s more complete findings and recommendations may form the basis of testimony in litigation proceedings or criminal actions against the perpetrators. They may also be used in testimony to government agencies such as the Securities and Exchange Commission in the United States or the Serious Fraud Office in the United Kingdom. Accordingly, the scope of the investigation and the evidence gathered and documented must be capable of withstanding challenges that may be brought by adversely affected parties on both sides of the prosecution or by skeptical regulators.

Clearly, there are many commonalities between auditing and forensic accounting which, at best , can support the formation of a close working partnership. Both rely on:

  • Knowledge of the industry and the company, including its business practices and processes;
  • Knowledge of the generally accepted accounting principles of the jurisdiction in question;
  • Interpretation of business documents and records;
  • Independence and objectivity—perhaps the most important commonality.

The foggy nature of estimates and errors arises in financial transactions and statements due to the continuous nature of business. Unlike a footrace that ends at the finish line or an athletic contest that ends with the final buzzer, a business and its transactions are continually in varying stages of completion. There are many items in a financial statement for which the final outcome is not known with precision. Given the complexity and continuity of business, it’s difficult to capture a clear snapshot of a company’s financial position and performance at a random point in time. As a general matter, estimates are most commonly made concerning the final amounts of cash that will be received or paid once assets or liabilities are finally converted into cash. Such estimates can encompass, for example, allowances for uncollectible customer receivables, estimates of liabilities for claims or lawsuits brought against a company, the amount of profit or loss on a long-term contract, and the salability of inventory that is past its prime. Most estimates are based on three types of information: past performance of the same or similar items, what is currently occurring, and what management perceives as the probable outcome. Further complicating matters, the weight to assign each type of information varies depending on the particular circumstances. But no matter how determined, unlike the score of a sporting contest, an estimate on the books or in financial statements is a prediction of what will happen, not the objective tally of what has already taken place.  For all these and a host of other reasons, the ACFE tells us that accounting estimates are always a fertile ground for every type of financial fraud.

What the forensic investigator brings into this mix is his or her informed, holistic approach (as outline above) to the detailed analysis of any specific, predicated fraud.   Legitimate assertion of managerial confidence in the business’s ability to achieve certain estimated results is one thing. A deceptive misinterpretation that is intended to generate a favorable estimate is another thing altogether and may pose a substantial investigative challenge well beyond the scope of most routine financial audits. Practicing forensic accounting investigators are trained to address the often vexing complexities and alternative rationales that may be offered to explain the difference between an estimate and an actual result. Given that estimates often constitute the cause of material differences in financial statement presentations, the ability to distinguish between the manipulatively self-serving and the merely incorrect is a critical element of many forensic investigations.

To get back to our newspaper case, U.S. auditing standards state that the main difference between fraud and error is intent. Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements. So, errors may involve:

  • Mistakes in gathering or processing data from which financial statements are prepared;
  • Unreasonable accounting estimates arising from oversight or misinterpretation of facts;
  • Mistakes in the application of accounting principles related to amount, classification, manner of presentation, or disclosure.

Fraud, on the other hand, is defined in SAS 99 as an intentional act that results in a material misstatement. The motive or intent of an individual in making accounting entries is not the primary focus of the external auditor’s procedures as it is of the forensic investigators. Auditors direct their efforts toward determining objectively measurable criteria regarding account balances and transactions by asking: Do the assets exist? How much was paid? What is the basis of the estimate? Is it reasonable? How much was collected? Were the goods shipped to the customer? By asking questions such as these and obtaining evidence to support the estimate where appropriate, auditors can be better positioned to ascertain that the amounts in the books are correct. Thus, given the focus of the auditor, intent is not uniformly relevant; evaluation of intent is a subjective as opposed to an objective evaluation, and ascertaining intent is a difficult exercise at which the trained forensic accountant is highly skilled.

For the foreseeable future, corporate fraud will continue to present substantial challenges and opportunities for fruitful partnership between auditors and forensic accounting investigators. However, it must be recognized that the complexities of the business world and the ingenuity of highly educated, white-collar criminals will always manage to produce schemes that unfortunately go undetected until they reach significant proportions. Forensic accounting investigators will investigate, prosecutors will convict, and regulators will react with new and more requirements … and, without question,  the fraudsters will always be with us.

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