More than a means to look into financial crimes, forensic accounting is a thorough method for due diligence, compliance and. Smaller companies tend to overlook its importance. Here’s the reason why this is risky.

Ryan is a Senior Editor at Toptal. He has more than ten years of experience in reporting and editing, covering technology and business.

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Carlos Salas Najera An investor regulated by the Financial Conduct Authority, Carlos has strong experience overseeing equity strategy. He has served as an investment analyst, portfolio manager, and head of equity for several investment companies. Margaryta Pugachova Margaryta is an Association of Chartered Certified Accountants-certified finance expert with 16 years of experience. As a leader in finance, she has led companies from their inception to turnovers of $70 million. She also completed 20 million dollars worth of M&A deals and secured the financing of $10 million in debt. Her first job was as an auditor with Deloitte. Benjamin Ostrow Ben is a private equity investor wwithaquity public distressed credit and personal equity experience. Ben has experience working for $15 billion in public and mid-market businesses in various industries, including wireless networking, aerospace, SaaS, and retail. He has an MBA in business administration from Columbia Business School.  

The phrase “forensic accounting” may conjure images of professionals who are detectives looking through documents or conducting interviews, as well as conducting background checks to uncover cases of financial fraud. While that’s an aspect of the task, forensic accountants must look into legitimate financial transactions and carry out due diligence reviews to analyze possible mergers, investments, and acquisitions.

However, while many companies require due diligence regularly, it’s not typical for them to hire exceptional accounting to aid in the process, according to financial expert Margaryta Pugachova, who has been a part of the Toptal network since 2020. This is especially true for smaller and mid-sized businesses. “They don’t place a high enough value on the practice, which is quite expensive, so they try to get by just having their in-house team handle it,” she elaborates. “But these internal teams typically lack the experience, knowledge and broader perspective to carry out this task properly. This results in errors and poor investment decisions, which can be more costly than the capital expenditure for due diligence investigations.”

How Does Forensic Accounting Work?

Forensic accounting is distinct when compared to the general accountant. While the latter examines whether financial statements conform to the rules referred to as General Accepted Accounting Principles (GAAP), The former focuses on whether the narrative being presented by these financial statements is reasonable and likely to be accurate.

Specialists in this kind of accounting do not just look at the financial statements. They adopt an integrated approach that incorporates the analysis of statistics and big data and machine learning, interviews, and physical observation to determine the truth. This is as important in the due diligence process as in criminal cases.

If the investigation is to conduct with due diligence or for the purpose is compliance. A forensic accountant generally starts by examining the business’s balance account, income statement, and statement of cash flows. They read the data on these reports in time, compare and discuss those of rivals, and look at the company’s self-reported valuation. They make sure that it’s logical by comparing accounts against the counterparties’ records and reviewing the ownership of shares. The forensic accountant might employ other methods, such as conducting interviews with customers and validating them as well as talking with suppliers, industry colleagues, and the investor relations department; visiting warehouses and offices; and, sometimes, even looking over video surveillance footage from cameras to confirm whether production equipment exists as well as the activities of employees, Pugachova says. They may use AI software to discover whether electronic documents were modified or falsified. They can also search databases to determine whether executives have been investigated for fraud. This work is to confirm or debunk the company’s assertions.

Growing fraud and cybercrime, stricter financial regulations, and the growth of other assets, such as cryptocurrency, are the main reasons for developing forensic accounting’s market size.

The primary applications of forensic accounting to proper due diligence and conformity are detecting bad investments, revealing hidden value, and determining the ideal time to buy or sell stocks. Let’s examine real cases of how it works to accomplish these goals.

Revealing Poor Investments

Some years ago, financial professional Carlos Salas had one of his clients consider investing in the private mobile e-commerce firm Powa Technologies. T015 was the last time Powa stated that its company was valued at $2.7 billion and that over 1200 businesses had signed up to utilize its products. The client took Salas and his group to investigate the claims of these and other sources and gain a complete picture of the company’s finances.

“Our review of Powa encompassed fieldwork such as contacting suppliers, customers, and peers; visiting company headquarters; interviewing employees; and confirming international bank accounts,” claims Salas who has been a part of the Toptal network since t, the year 2020. “We uncovered irregularities that included poor cost discipline, nonexistent clients, offshore shell firms generating fictitious revenue, and mischievous past behavior from the CEO.”

Salas, and his staff, wrote more than 300 companies who had executed contracts to become Powa customers. A majority of the respondents stated that they hadn’t signed any contracts. The company later discovered that most other companies mentioned also had no contract with Powa.

Identifying the Right Moment

Salas frequently uses his expertise in accounting research when short-selling stocks on behalf of clients. The process is focused on timing. If you don’t decide to store and buy it at e proper time, you might be a victim of the market. One way to gain an edge is to conduct thorough due diligence on the company you plan to short to determine the stock’s performance.

In 2018, Salas looked into Wirecard Wirecard, a German payments firm. He initially noticed that the company’s shares were exorbitantly priced and then realized that the company’s financial statements were not wholly authentic. Wirecard’s stock was highly volatile, offering investors an attractive possibility to short the stock. But, German authorities soon started an inquiry and stopped any short-selling for a period of two months.

Salas’s investigation into his case didn’t reveal to him when to sell the stock; however, it helped him pinpoint the company to keep an eye on and be ready to act when the right time came along.

Using Investigative Accounting Judiciously

Since forensic accountants possess specialized expertise, even enterprises with internal accounting teams could benefit from having them on board to handle high-risk transactions, Pugachova says. “These professionals also bring the context of operations from other companies, so they have a strong sense of the norms and can provide a broader, more holistic view of a business’s financials–increasing the chances of identifying issues that may have been missed in-house.”