Tips and tactics for developing professional skepticism

RMA Journal, The, July-August, 2003 by Colleen A. Vallen, John A. Slavek

Humankind cannot bear very much reality," said T.S. Eliot. Except bankers, of course, who know that complete knowledge of a customer's business reality will avoid a reality that is even harder to bear: fraud. While the authors, who are forensic accountants, cannot help us cope with reality, they do provide tips on how to uncover it.

The frequency and magnitude of fraud have almost desensitized our society to reports of corporate scandal. With the yearly cost of fraud exceeding the GDP of many countries, a company tends to breathe a sigh of relief if it finds itself the victim of only a small fraud. Yet Wall Street and regulators alike tell institutions to batten down the hatches. Thus, we are operating in a contradictory period, in which society's waning sensitivity to fraud is offset by a higher expectation put on professionals to identify it.

The joint impact of a slow economy and increased fraud awareness has caused bankers to look for new tactics in reviewing financial information. To identify fraud, whether internal or external, requires equal parts of due diligence and professional skepticism. This approach requires both an enhanced understanding of the financial information provided and insight into the business or individual, the industry, and the economy. With this knowledge, the risk professional can develop a business reality scenario for the entity or individual being reviewed. From a forensic accountant's perspective, business reality means an accurate and comprehensive financial picture that allows a bank to make better financial decisions for itself and its customers.

How can you be sure that fraud is not occurring at your clients' businesses or your own? Tagging alongside slow economic growth is a greater risk of unemployment, and fraud can be an irresistible temptation to an employee with personal financial problems. Thus, creditors have a greater need than ever to know that their employees and borrowers are taking responsibility for detecting fraud.

The forensic accountant can offer practical tactics and tips for illuminating the business reality picture for your employees and customers. Some of these tactics can be incorporated into banks' policies and procedures to assist bankers in making a variety of financial decisions, including identifying unintentional errors or outright fraud.

Due Diligence

Anyone relying on financial information today needs to take a hands-on approach; therefore, the due diligence process had better involve more than a good feeling about a customer and a passive review of financial statements. Forensic accountants, as well as the best auditors, begin the due diligence process with a healthy dose of professional skepticism combined with an extensive document review, discussions with management, and industry research.

Remember, the goal is to discover the business reality, and this process includes determining how the subject has performed historically and what its economic future is likely to be. Strong historical results do not necessarily indicate strong future performance.

Information needed for a thorough analysis. What do you need to start your client review? Obviously, you want to start with the financial statements--balance sheet, statement of operations, and cash flows. However, don't be satisfied with annual or even quarterly statements. Most businesses prepare monthly statements that can be very revealing. The statements should be comparative, providing corresponding information for prior periods, the same period for the previous year, or versus budget. You should request such other critical financial information as tax returns, bank and investment records, budgets and projections, contracts, supplier agreements, and loan commitments. Supporting documents for financial statements and tax returns also should be reviewed. It's important to gain insight into the adjustments between the numbers recorded on the general ledger and those that ultimately appear on the financial statements and tax returns.

Caution: Do not analyze this information in a vacuum. Performance, lack thereof, or unfulfilled expectations are often caused by outside factors beyond management's control. Combining the financial analysis with market and industry research and a thorough understanding of the business, its activities, and key personnel is critical to understanding an entity's business reality. Information on personnel should include three histories--employment, credit, and criminal.

Assume, for example, you discover that one person's compensation is tied closely to the performance of the business. This should raise a red flag. Clearly, additional investigation of this person's involvement with financial reporting would be necessary. If the employee had the motive, he or she could be in a position to manipulate financial data to inflate results and thus commit fraud. A person in such a position could put the reliability of the company's financial statements at risk. The purpose of due diligence is to identify these very issues.