Insights
While we traditionally think of forensic accounting as the specialized area of accounting that focuses primarily on the investigation of financial crimes, forensic accountants are also well equipped to help companies untangle financial records when a company suspects financial records are not properly reflected due to errors. Regardless of the nature of the engagement, the use of analytics can help the forensic accounting professional identify areas to investigate and can provide an indication of the reasonableness of the financial results.
In this article, we utilized a case study to explore how forensic accountants used analytics to identify discrepancies in financial records and support financial investigations.
We were recently retained by a firm in the professional services sector (the “Firm”) that had been advised by a third party to switch from accrual to cash basis of accounting in 2023.
The Firm’s primary source of revenue was from insurance cash settlements, which were split between the Firm, its clients, and third-party vendors. When settlements were received, the Firm recorded a liability (“Client Liability”) pending review of contract terms before recording revenue for the Firm and issuing payments to its clients and third-party vendors.
The owner of the Firm anticipated a significant decrease in revenue from 2022 to 2023 because the Firm had a one-time, outlier event (the “Outlier”) that generated USD14 million in revenue in 2022. When financial statements were prepared for 2022 and 2023, revenue for 2023 was USD2 million lower than 2022. The owner believed the change in accounting method created duplication of revenue in 2023.
We were asked to determine if the switch in accounting method led to this potential revenue overstatement.
High-level analytics were a good place to start to determine if overall results were in line with expectations. According to the general ledger, the Firm experienced significant growth from 2014 to 2019, with year-over-year growth ranging from 17% to 56%. There was revenue reduction during the COVID pandemic in 2020, but the Firm rebounded in 2021 with growth of 19%. Without taking into consideration the 2022 Outlier, revenue growth for 2023, as reflected in the general ledger, was approximately 37%. This was high compared to 2022 growth, but not when compared to pre-pandemic growth. Financial statements for 2024 had not been finalized as of the date of this article.
To understand if business activity could have contributed to 37% growth, we requested settlement counts for 2022 and 2023, excluding the Outlier. Settlement information indicated that the number of settlements grew by approximately 1,000 from 2022 to 2023, with an average income per client increasing from USD8,850 to USD9,300 from 2022 to 2023. The increase in both the number of settlements and the average revenue per settlement may account for an increase of approximately USD11 million in 2023 compared to 2022, offset by the Outlier of USD14 million, for an estimated net decrease in revenue of approximately USD3 million. This calculation suggests that the USD2 million decrease in revenue from 2022 to 2023, as reported, is not as unexpected as the owner suspected.
Another form of high-level analysis performed was a review of the financial statements. While we were engaged to determine if the change in accounting method caused revenue to be overstated, a review of the financial statements showed accrued expenses totaling more than USD1 million for 2023 in the balance sheets for accrued payroll related expenses. These accruals are not consistent with cash basis of accounting.
High-level analytics were a helpful starting point; however, a deep dive was still needed to determine if there were areas in the financial records that required further review. Whether sifting through thousands or hundreds of thousands of records, analytics can help identify areas of focus. In this case, since the owner was concerned that settlement revenue had been duplicated, revenue was our starting point. A series of simple pivots that were tied to revenue by year in the general ledger helped us determine areas to request additional documentation.
Review of the general ledger, and based on the growth the firm had experienced, indicated that revenue would likely not see the decrease the owner was anticipating.
Our review of settlements and journal entries indicated the finance staff had been performing detailed reviews of settlements to ensure revenue is captured in the proper period. Our greatest area of concern was that there appeared to be little to no management review to ensure the balance sheet had been accurately reflected since 2022.
Our recommendations included adding a controller to the finance team to perform substantial monthly reviews and analysis of the financial statements. We also recommended the reversal of any accrual journal entries in the period they were recorded, as these entries were not consistent with cash basis of accounting. Finally, we recommended creating a dashboard of key indicators to give the owner quick visibility of the Firm’s performance.
Analytics alone are not always sufficient when conducting financial investigations. Interviewing personnel and stakeholders provides much needed context, even when malfeasance is not suspected. An inquisitive mindset, understanding transaction flows, and strong knowledge of accounting and auditing are critical aspects of forensic accounting. In addition, supporting documentation is necessary to verify assertions. However, in this era of large data, knowing where to start can make a tremendous difference in the effectiveness of an investigation. Analytics provide a quick way to determine if results are in line with expectations and can highlight areas of focus that serve as a launching pad for the investigation.
We would like to thank our colleague, Pamela Hefner, CPA, CFE, for providing insight and expertise that greatly assisted this research.
Pamela Hefner is a Vice President in J.S. Held’s Economic Damages and Valuations practice. She specializes in litigation consulting, utilizing financial analysis to provide business, financial, and accounting advice to attorneys and their clients throughout the commercial litigation and investigation process. As a certified public accountant (CPA) and certified fraud examiner (CFE), she has provided expert support across multiple industries, including retail, manufacturing, food and beverage, and local government. Pamela provides expert witness and consulting services in accounting, investigations, and litigation, with specific expertise in damages calculations, class certifications, and fraud examinations.
Pamela can be reached at [email protected] or +1 229 337 4067.
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