A forensic audit is an independent, objective audit of financial statements that is performed with some degree of risk. A financial statement audit, by contrast, is a type of assurance engagement that tests the accuracy of a company’s financial statements (usually its balance sheet and income statement) for footnote disclosures about risk management and other factors. An independent audit, also called an unassisted audit is one in which the auditors are not hired by management or the board of directors. The word “independent” indicates that the auditors are unaffiliated with management and do not stand to gain from recommending certain accounting practices over others. In other words, their only motivation is to uncover potential problems so they can be solved before investors suffer a loss. This article explains what a forensic audit is and why companies might need one.
Did you know? Forensic auditors try to find evidence that could be used in a court of law during a forensic audit.
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What is a Forensic Audit?
A forensic audit is a financial audit that is performed with some degree of risk. Forensic refers to the fact that auditors are examining the financial statements for potential problems and risks that could lead to litigation.
Understanding the Meaning of Forensic Audit
Audits are of many different types and serve various purposes. One type of audit that is often misused is the forensic audit. Forensic audits are often portrayed as audits that uncover fraud, but that is not always the case. Rather, forensic audits are performed to provide information needed for litigation, such as a lawsuit between two companies over patent infringement. Forensic audits may also be done to provide information to help a company complete a deal, such as when a company wants to go public or is acquired by another company.
A forensic audit will include procedures beyond those normally conducted in a financial statement audit. Forensic auditors may also have access to a company’s employees, documents, and computer systems, which is not the case in a financial statement audit. The financial statement audit is conducted in accordance with auditing standards issued by Comptroller and Auditor General of India (CAG) or the Auditing and Assurance Standards Board (AASB). The forensic audit will be used to provide information that might be useful in deciding whether to buy or sell a business.
Categorisation of Forensic Audits
Forensic audits can be broken down into the following categories:
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Fraud Audits
Fraud auditors are looking for signs of financial fraud, including bribery, insider trading, or financial misrepresentations by management. They also examine whether financial controls are adequate to prevent such fraud.
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Litigation Support Audits
Litigation support auditors are hired by parties involved in major lawsuits to investigate the facts and prepare reports that might be used as evidence.
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Due Diligence Audits
Due diligence auditors are hired by investors to investigate the facts and prepare reports that might be used to decide whether to invest in a company.
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SEBI Investigations
Some companies are investigated by the Securities and Exchange Board of India (SEBI) for violations of securities laws. These are called “formal investigations.” Auditors who work for companies being investigated by the SEBI are forensic auditors because they look for signs that the company might have broken the law.
Why Would a Company Need a Forensic Audit?
A forensic audit is performed in situations where there is high risk. It may be conducted when there has been financial fraud, a company is involved in a lawsuit, or there is a significant acquisition or merger. A forensic audit provides details that may be used in determining the outcome of a lawsuit.
For example, if two companies are involved in a patent dispute, the results of a forensic audit may show how much money each company has spent on Research and Development (R&D) and may help the judge decide which party deserves to be awarded damages.
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It is commonly used when a company is acquired by another company or is going public with an Initial Public Offering (IPO). In these cases, the acquiring or IPO company may hire an independent auditing firm to review the financial statements of the other company. An acquiring company may require its target to hire a forensic auditor in order to obtain a clean chit from the auditing firm.
How are Forensic Audits Conducted?
Fraud auditors examine financial statements and other documents for signs of financial fraud. They also assess the adequacy of the company’s internal controls, which are designed to prevent such fraud. In litigation support audits, auditors collect evidence to support the positions of parties involved in lawsuits.
For example, in patent lawsuits, they may collect evidence of whether the disputed technology was ever invented and if so, when it was invented. In due diligence audits, auditors investigate the facts to prepare reports that may be used to decide whether to invest in a company. Auditors who work for companies being investigated by the SEBI are forensic auditors because they look for signs that the company might have broken the law.
The Types of Audits
There are two main types of forensic audits:
1. Financial Statement Audit
This is a type of assurance engagement that tests the accuracy of a company’s financial statements (usually its balance sheet and income statement) for footnote disclosures about risk management and other factors. The financial statement audit is conducted in accordance with auditing standards issued by the Comptroller and Auditor General of India (CAG) or the Auditing and Assurance Standards Board (AASB).
2. Financial Due Diligence Audit
This is an audit engagement that includes procedures beyond those normally conducted in a financial statement audit. A financial due diligence audit is conducted to obtain evidence that might be useful in deciding whether to buy or sell a business or to invest in a company.
The Limitations of Forensics Audits
Forensic audits are meant to be conducted independently of the people within a company being audited. However, in practice, auditors often become too dependent on the people within a company to provide access to all the necessary information. In other words, auditors may rely too much on management to provide them with access to employees, documents, and computer systems. This is sometimes referred to as “audit dependence,” and it can lead to problems if management is intentionally or unintentionally misleading the auditors. Audit dependence can have serious consequences when an auditor fails to discover fraud or an error because the auditor has become too dependent on management.
Forensics auditing is not a foolproof solution and it cannot replace a thorough data protection strategy. Unlike traditional security audits, forensics auditing endeavors to analyse the entire ecosystem of data protection tools, processes and personnel. Although both types of audits look for potential vulnerabilities, forensics audits are designed to find evidence of suspicious activity (e.g., unauthorised access, modification and deletion of sensitive data).
While traditional security audits aim to prevent unauthorised access to systems, forensics audits focus on detecting evidence of unauthorised access. This can be done by examining logs, monitoring systems and interviewing employees.
In addition to identifying weaknesses in the system perimeter, forensics audits can also help uncover patterns of activity that may indicate malicious intent (e.g., stolen credentials or unauthorised access).
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Conclusion
A forensic audit is a financial audit that is performed with some degree of risk. Forensic audits refers to the fact that auditors are examining the financial statements for potential problems and risks that could lead to litigation. Fraud auditors are looking for signs of financial fraud, including bribery, insider trading, or financial misrepresentations by management.
They also examine whether financial controls are adequate to prevent such fraud. Auditors who work for companies being investigated by the SEBI are forensic auditors because they look for signs that the company might have broken the law. Forensic audits also include procedures beyond those normally conducted in a financial statement audit.
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