Why does Forensic Accounting Exist?

Nov 28, 2018

Matt Conger

One of our most memorable clients was a fraud investigator who had to go to Shanghai to investigate whether a factory owner was embezzling money. He didn't speak Mandarin, so we stepped in to help. The investigation played out like a mix of Law & Order and a meeting with your auditors. There were interrogation rooms, two sets of books ('clean' and 'dirty'), and even a minor car chase!

Our linguists dispatched for this job didn't anticipate such drama. But they did anticipate the nature of the questions their client was being asked to solve. These questions all relate to the arcane-sounding practice of forensic accounting.

A Financial MRI

Forensic accounting basically looks to uncover fraud.

It uses a combination of data gathering, public filings, and company interviews to diagnose whether a company is committing fraud or is otherwise misrepresenting itself. Like a doctor reading an MRI, one conducting forensic accounting looks for hidden or obscured processes, procedures, and transactions that lie beneath the surface to help make well-informed decisions.

What is Forensic Accounting?

Often used in legal proceedings but applicable to a variety of impactful uses, forensic accounting is a specialized practice that utilizes unique problem solving, accounting, and auditing skills to investigate complex financial issues. Often a critical component of fraud investigations, forensic accounting is also a valuable resource in uncovering a dearth of information and insights by reverse engineering financial statements. It is based on objectivity and unbiased data that are particularly useful in an M&A environment to uncover any financial red flags lurking in the shadows of a potential target company.

In fact, given the stakes at hand in a complex transaction, forensic accounting should play an essential role in most, if not all, M&A due diligence strategies. If firms devote significant resources to uncovering more conspicuous bumps in the acquisition road like non-recurring items and EBITDA-related mishaps, it only stands to reason that uncovering details of the more unsavory and fraudulent variety would be in a company’s best interests.

Integrating Forensic Accounting into Due Diligence

Firms can maintain in-house forensic accounting specialists but, given the dynamic nature of the field, such internal abilities could prove to be expensive and time-consuming. As technology-driven efficiencies continue to take hold of the accounting industry, forensic accounting becomes more involved and specific as time passes, requiring substantial ongoing education to stay abreast of dynamic advancements and ever-evolving standards.

Fortunately, firms aren’t lacking for efficient and effective alternatives to in-house forensic accountants as several companies now specialize in the field. Rather than investing the resources to maintain those internal abilities when they could be better spent towards growth and innovation, using a forensic accounting partner can ensure due diligence is always as thorough and insightful as it needs to be. Likewise, using an experienced, qualified third-party specialist also means your forensic accounting is always on the forefront of technologies that complicate the space, lending you the transparency and insights needed to form your decision-making.

A Brief Case Study

Muddy Waters Research is one of the preeminent forensic accounting firms in the world and, as its name implies, specializes in providing insight into the often muddy waters of modern finance. With a talent for peeling back the layers of complicated transactions and environments, Muddy Waters is well-regarded for its abilities to source various types of fraud and operational issues in business targets.

In recent years, Muddy Waters has found itself in the short-selling spotlight on a number of occasions, perhaps most famously for its indictment, along with other research firms, of Chinese tech firm Qihoo 360 and its, at best, shaky business practices and revenue streams. Using forensic accounting to delve into the company’s financials, Muddy Waters determined that a significant portion of Qihoo’s revenue stemmed from commission-diverting practices that had escaped the attention of the company’s auditors and Chinese analysts.

From a broad perspective, the lesson to be learned for companies is never to take financials at face value. Amongst the fervor and intense M&A activity around Chinese tech stocks a few years ago, the markets were only made aware of Qihoo’s practices by the glaring eye of Muddy Waters and its forensic accounting investigation. Due diligence simply cannot be too intense or granular in modern commerce and, as the Qihoo example demonstrates, firms are well-served integrating forensic accounting into their own due diligence strategies. The possible repercussions are too significant to leave any financial stone unturned.

And, if you're a translator or interpreter reading this and you get assigned to help with a forensic accounting project, prepare yourself for a car chase!