What is Forensic Audit:
Forensic audit is the process used to examine an individual's or a company's financial information for use as evidence in court. It helps to detect diversion of funds, wilful defaults and window dressing of financial statements. Financial forensic is the application of financial principles and theories to facts or hypotheses at issue in a legal dispute and consist of two primary functions:
1. Litigation Advisory Services which recognizes the role of the financial forensic professional as an expert or consultant.
2. Investigative services, which make use of the financial forensic professional's skills and may or may not lead to courtroom testimony.(Forensic Accounting and Fraud Examination by Mary-Jo Kranacher, Richard Riley, Joseph T Wells)
A forensic audit, also known as forensic accounting, refers to the application of accounting methods for detection and gathering evidence of frauds, embezzlement, or any other such white- collar crime like misappropriation of funds/assets, fraudulent financial reporting, corruptions, bribery. It is the application of accounting skills to legal questions and takes up an important role in both public and private organizations, especially in India. Financial forensic engagements are conducted only after allegations of misconduct. The purpose of the examination under forensic audit is to resolve specific allegations based on financial evidence and its deep impact over public interest at large. It is a more proactive, skeptical approach in examination of books of accounts and records with no assumption of management integrity and shows less concern for the arithmetical accuracy but keen in exposing any possibility of fraud.
Necessity under law and regulatory stance on forensic audit:
The forensic audit is a skill that can be developed by training, practice, updating and reading. Forensic professional has to look beyond surface i.e. on reality of business. The reader can understand it better if the most practical and famous usage of forensic audit is mentioned herein under various laws:
Growing cybercrimes and financial frauds, failure of regulators to track the security scams like 'Satyam' scandal etc. pinpoint the need of forensic audit. The Reserve Bank of India has made forensic audit mandatory for large advances and restructuring of accounts. The Enforcement Directorate (ED) and the Serious Fraud Investigation Office (SFIO) have underscored the need for forensic audit following the rise in money laundering and willful default cases that are plaguing the banking system. Further, the amendment of Benami Transactions (Prohibition) Act increases the importance of forensic audit in the country's fight against financial offenders.
Section 3 of the Prevention of Money- Laundering Act, 2002- defines the offence of money laundering as the involvement of a person in any process or activity connected with the proceeds of crime and projecting it as untainted property, where the scope of integrating forensic audits can be clearly seen. Placement of fund (including cash), structuring and layering, integration and finally carrying such fund to tax haven foreign countries have been checked through forensic audit process.
The Reserve Bank of India (RBI) vide notification number RBI/DBS/2016-17/28, DBS.CO.CFMC.BC.No.1/23.04.001/2016-17 dated July 01, 2016 containing Master Directions on Frauds - Classification and Reporting by commercial banks and select Financial Institutions ('FIs'), operationalized a Central Fraud Registry (CFR) based on the Fraud Monitoring Returns, , for which banks have been given access through user-ids and password. CFR is a web-based and searchable database.
CFR was launched to monitor digital payments related frauds on a real-time basis with periodic aggregated data of risks associated with individual payments operators in a bid to improve customer confidence in these channels. The RBI also directed a self-conducted forensic audit for top 12 defaulters, on top of the audits done by the Banks, 'to know whether lenders followed established practices and processes while sanctioning those loans.' Under the same notification, the RBI has also mentioned Early Warning Signals, that is, the list of alarming transactions which, inter alia, include : default in undisputed payment to the statutory bodies as declared in the Annual Report, bouncing of high value cheque, frequent change in the scope of the project to be undertaken by the borrower, foreign bills remaining outstanding with the bank for a long time and tendency for bills to remain overdue, high value RTGS payment to unrelated parties, heavy cash withdrawal in loan accounts, non-production of original bills for verification upon request, significant movements in inventory, disproportionately differing vis-a-vis change in the turnover, significant movements in receivables, disproportionately differing vis-à-vis change in the turnover and/or increase in ageing of the receivables, disproportionate change in other current assets, significant increase in working capital borrowing as percentage of turnover, increase in Fixed Assets, without corresponding increase in long term sources (when project is implemented), increase in borrowings, despite huge cash and cash equivalents in the borrower's balance sheet, frequent change in accounting period and/or accounting policies, costing of the project which is in wide variance with standard cost of installation of the project, claims not acknowledged as debt high, substantial increase in unbilled revenue year after year, large number of transactions with inter-connected companies and large outstanding from such companies, substantial related party transactions, material discrepancies in the annual report, significant inconsistencies within the annual report (between various sections), poor disclosure of materially adverse information and no qualification by the statutory auditors, raid by Income tax /sales tax/ central excise duty officials, significant reduction in the stake of promoter /director or increase in the encumbered shares of promoter/director, resignation of the key personnel and frequent changes in the management.
Sections 210 of the Companies Act, 2013- empowers the Central Government to investigate into the affairs of companies. Based on the Registrar of Companies' inquiry report, the investigation can be initiated under Section 212(1) of the Companies Act, 2013 which becomes base of forensic audit by the concerned regulators to unveil potential fraud.
The Insolvency and Bankruptcy Code 2016 ('IBC' or 'the Code') is enacted seeking to deal with insolvency and liquidation proceedings in a time bound and efficient manner in order to maximize value of assets and enhance investor confidence by providing an efficient framework to deal with business failures. Under the Code, the key driver of the insolvency resolution process would be insolvency professionals (IPs) who would have a multifaceted role and various responsibilities in the proceedings. Considering the fact that the IBC contains provisions on avoidance transactions, fraudulent or wrongful trading, and protecting business value during the insolvency period, IPs would be expected to unearth and report transactions of questionable nature. Therefore, they have to be equipped with forensic skills for forensic review of claims and adjudication (Section 18 and 35), to determine authenticity of proofs, liquidation analysis and support (Section 59), monitoring fund distribution in compliance with the Code (Section 18) i.e. verification of asset ownership either through enquiries or documented evidence, family tree/layering of disclosed/undisclosed entities and structures to understand potential corporate ownership, proof of ultimate beneficial ownership trail, or evidence that assets represent proceeds of a fraud or other crime. Sections 43 to 51 and Section 66 of the Code stipulate that IPs or liquidators have to file avoidance of specified transactions with the adjudicating authority, including transactions which are preferential, undervalued and/or extortionate in nature, and fraudulent or wrongful transactions carried out with an intent to defraud creditors within a period of two years preceding the insolvency commencement date in which forensic methodologies such as data analytics, document review, market intelligence, etc., have to be applied to investigate such transactions and conduct background checks on the entities involved to help identify any undisclosed relationship with the corporate debtor.
Section 11C of the SEBI Act, 1992 empowers the Securities and Exchange Board of India (SEBI) to direct any person to investigate the affairs of intermediaries or brokers associated with the securities market whose transactions in securities are being dealt with in a manner detrimental to the investors or the securities market. The Capital Market Regulator has been exercising this power regularly in order to curb/prevent fraudsters in the capital market. Ponzi /Pyramid Schemes, 'eight- ball' model schemes, insider trading in stock market, unethical circulation of funds, round trip trade and swaps are major fraudsters area requiring intervention of the Capital Market Regulator. In the year 2017, SEBI forwarded a list of 331 shell companies as identified by Ministry of Corporate Affairs (MCA) and directed the Stock Exchanges to identify the companies listed on their trading platform and initiate surveillance measures like restrictions on trading of shares of all these companies. Stock Exchanges also had initiated a process of verifying the credentials / fundamentals of such companies by appointing an independent auditor to conduct forensic audit of these companies.
Section 33 of the Insurance Act, 1938 - empowers the Insurance Regulatory and Development Authority of India (IRDA) to direct any person (Investigating Authority) to investigate the affairs of any insurer. In order to investigate into the intension of claimant in case of false claim possibility, the scope of provisions of section 33 has been increased and utilized by all the insurance companies widely. Maximum frauds committed in the general insurance sector are of the nature of falsification of the documents, like medical bills / certificates, driving license, FIR which are actually a government document. Fraudsters do not even fear of forging such documents. Claims fraud is one of the biggest fraud risks facing by the insurance companies. A fraudulent claim, inflated claims carried out with the involvement of any or all of surveyors, intermediaries, customers and employees are required to be investigated in detail on the ground to confirm facts, check for evidence, identify the modus operandi and fix responsibility which is possible only through forensic audit.
It is pertinent to note that internal and statutory audit can surely detect what has been happening in the organizations but they are hardly in a position to initiate proper action in proper time even after strict amendments in Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements), 2015 and Companies Act, 2013 pertaining to the appointment, resignation of auditors and audit process. The days are not far when, just like foreign countries, it will become a corporate practice to hire forensic auditor for carrying out audit for either for proactive fraud check-ups or certain specific purpose to achieve better and transparent corporate governance practice in the organization.
Provisions of section 45 and 47 of Indian Evidence Act, 1872 also support the report of Forensic Auditors.
Matters to be sought under Forensic Audit from Companies
Generally, forensic audit is ordered by a regulatory body upon strong apprehension (based on prima facie evidence) of diversion of funds and for detection and gathering evidence of frauds, embezzlement, or any other such white- collar crime. Hence, object of the Forensic Auditor shall be based on the order passed by a regulatory body under which her/his appointment is done.
The forensic auditors are required to examine financial statements, books of accounts and records with supporting documents like e-way bills, tax returns, inventory statement, long term contracts, creditors and debtors confirmations, detailed capital work-in-progress accounts, all registrations, licences, policies including whistle-blowers' policy of the organizations, cookie-jar reserves and earning management, payroll registers, credit rating file, internal auditors report with observations, minutes books, statutory registers, criminal and civil court files, property ownership records, transfer of property ownership records, counter folios of slip books and cheque books etc. which revealed the indicia of fraud and/or the motivations of the parties under review. These documents and information in these documents would aid forensic auditors to know the legal ramifications of evidence and development of chain of custody over documents, for example, if relative of the Managing Director has been charging amount from suppliers without delivering any services / without any competitiveness, in the form of commission or salary, detailed audit might be initiated. Time, frequency, places, amount, parties of unusual transactions and/or related party transactions are factors to be considered during forensic audit. Ineffective internal control system of the organizations also attracts fraudsters.
In order to test the veracity of allegations, the forensic auditors also resort to the tool of 'interview' which is the process of obtaining relevant information about the matter from those with knowledge of it. Low employee morale, lack of motivation, job satisfaction level, corporate culture from top to bottom level of management are indirect measurement detecting fraud elements during forensic audit.
Company Secretary and Forensic Audit
Forensic audits are currently widely used tools to detect fraud and currently in great demand, with the public need for honesty, fairness and transparency in reporting increasing exponentially. Company Secretary acting as Corporate Compliance Manager, should get acquainted with the practical nuances of forensic audit. The role of Company Secretary becomes wider and important during forensic audit. Company Secretary may assist a forensic audit through either consultant / advisory firm or investigator firm. In every audit, the exercise of professional skepticism is paramount. Professional skepticism is an attitude that includes a questioning mind and critical assessment of audit evidence. Due professional care is to be exercised in planning, collecting data, gathering authentic information, performance of the audit and preparation of the report for which auditors should neither assume that management is dishonest nor assume unquestioned honesty. Company Secretary have the opportunity for entry and growth in the emerging field of forensic audit.
This Article of Author is published in E-newsletter 'Focus' presented by WIRC of ICSI for the month of May, 2020.
The author can also be reached at firstname.lastname@example.org.
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