Elementary, my dear retail investor

To survive in this age of austerity and fraud, there is need for a smarter and more accomplished set of accountants, equipped to offer insights and solutions for all modes of business.

This includes not only accounting for proper conduct of business and strengthening inbuilt process controls, but also methodologies for the detection and prevention of fraud and misconduct.

Ahead of the economic downturn, the accounting profession had undergone radical changes due to accounting debacles such as Enron and WorldCom. Now, a new breed of ‘forensic accountants’ has emerged. Forensic accounting is an integration of accounting, auditing, and investigative skills. There is demand for it as the public is forced to deal with financial downfalls, and a rise in white-collar crimes and misstatement of financial information.

Financial misstatement is one of the biggest constituents of fraud today. It is the ‘deliberate misrepresentation of the financial condition of an enterprise, accomplished through intentional misstatement or omission of amounts or disclosures in the financial statements to deceive users’.

According to the Association of Certified Fraud Examiners, misstatement of financial information can be further classified under corruption, asset misappropriation and fraudulent financial statements.

Corruption: Includes fraudulent situations in the nature of conflict of interest, bribery, illegal gratitude and economic extortion.

Asset misappropriation: Includes skimming and larceny of cash, fraudulent billing, payroll and reimbursements, and misuse and larceny of assets.

Fraudulent financial statements: Includes improper representation of liabilities and expenses, improper disclosures in financial statements, improper valuation of assets and inventory, improper realisation of revenue, and timing differences.

In the Indian context, the Satyam fraud can be categorised as a financial statement fraud, as it involved misrepresentation of assets, including receivables and deposits, misrepresentation of expenses and liabilities, and other alleged financial misrepresentations.

According to the KPMG in India’s Fraud Survey 2012, respondents pointed to financial statement frauds as a key area of concern. Moreover, in the recent past, organisations have understood the importance of deterrent mechanisms, and are working towards implementing monitoring systems to address financial statement frauds. The key role of forensic accountancy is to address the impending losses forced upon the users of financial information as a result of frauds.

Some of the key red flags that a forensic accountant should watch for include:

Improper composition of the Board of Directors or Audit Committee;

improper oversight or other neglectful behaviour by the Board of Directors or audit committee;

weak or non-existent internal controls or process controls, including an ineffective internal audit function and improper conduct of external audits;

unusual or extensively complex transactions;

financial statements requiring significant subjective judgment by the management;

rapid growth or unusual profitability, especially when compared with industry peers;

recurring negative cash flows or inability to generate positive cash flows;

significantly high transactions with related entities not in the ordinary course of business;

improper disclosure of related-party transactions;

unusual changes in the relationship between fixed assets and depreciation;

unusual increase in gross margin or profitability compared with industry peers;

improper or inappropriate ethical standards;

recurring attempts by the management to justify marginal or inappropriate accounting on the basis of materiality;

complex organisation structure involving unusual legal entities or managerial lines of authority;

domination of management by a single person or group;

significant operations in places considered tax havens, with no clear business justification;

The deterrence mechanisms should be proportionate to the size and extent of business conducted by an organisation.

The nine bench rules of prevention speak about setting the right tone at the top, generating awareness about fraud in the system, ongoing self-assessment of fraud risks, regular inventory and improvement of organisational risk matrix, ongoing identification and remediation of gaps in the system, continuous monitoring of transactions, deployment of whistleblower help-lines, incident response mechanisms, and a dedicated information mechanism for this exercise.

The author is Head of Forensics, KPMG in India