ADVANCED AUDITING & PROFESSIONAL ETHICS CA C.V.SARMA, M.Com.

, FCA

12
INVESTIGATIONS
The term investigation implies a systematic and in-depth examination or inquiry to
establish a fact or to evaluate a specific situation. In other words, investigation
means inquiry into facts".
It covers areas of financing decisions, investment decisions, fraud or profitability
determination or cost determination etc.
AUDIT VERSUS INVESTIGATION
Investigation differs substantially from an audit assignment. The scope of audit is
broad based and general in nature whereas investigation is narrow and specific.
The difference is tabulated below:

BASIS OF INVESTIGATION AUDIT

DIFFERENCE

OBJECTIVE An investigation aims at The main objective of an audit

establishing a fact or a is to verify whether the
happening or at assessing a financial statements display a
particular situation. true and fair view of the
state of affairs and the working
results of an entity.

SCOPE The scope of investigation may be The scope of audit is wide and
governed by a Statute or it in case of statutory audit the
may be non-statutory. scope of work is determined
by the provisions of
relevant law.

PERIODICITY It may cover several years, as The audit is carried out either
the outcome of the same is not at quarterly, half-yearly or
certain. yearly intervals.

NATURE Requires a detailed study and Involves test checking or

examination of facts and figure. sample technique to draw
evidences for forming a
judgment and expression of
opinion.

INHERENT No inherent limitations owing Audit suffers from inherent

LIMITATIONS to the nature of engagement. limitations.

EVIDENCE It seeks conclusive evidence. Audit is mainly concerned with

prima-facie evidence.

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REPORTING The outcome is reported to the The outcome is reported to the

person (s) on whose behalf owners of the business entity.
investigation is carried out.

The approach to an investigation is different from that followed in an audit. An

investigation involves a more detailed examination of the selected areas than
what is required in an audit. An investigator does not accept a stated fact as correct
until it is substantiated.
INVESTIGATION UNDER COMPANIES ACT
Section 210 of Companies Act, 2013
The Central Government may order an investigation into the affairs of the
company, either:
 On receipt of a report from Registrar or Inspector (According to Section 206 if
the registrar/inspector satisfied that the business of a company is being carried
on for a fraudulent or unlawful purpose or not in compliance with the
provisions of this act may carry out such inquiry as he deems fit and may submit
a report to the Central Government recommending for further investigation into the
affairs of the company) or
 On intimation of a Special Resolution passed by the company that the affairs of
the company ought to be investigated or
 In public interest or
 On an order passed by a court requiring investigation
 On an order passed by Tribunal requiring investigation
For the purpose of carrying out investigation, the Central Government may appoint
one or more persons as inspectors. Such inspectors shall carry out
investigation and shall submit a report to the Central Government in such manner
it may direct.
Section 212 of Companies Act, 2013
The Central Government, may, by an order assign the investigation, into the affairs
of the company, to the Serious Fraud Investigation Office (SFIO), when it
considers necessary to investigate into the affairs of the company:
 On receipt of a report of the Registrar or inspector; or
 on intimation of a special resolution passed by the company or
 in the public interest or
 on a request from Government Departments (Central/State)
If the case is assigned to SFIO for investigation, no other investigating agency of
Central Government or any State Government shall proceed with investigation in
such case.
Where the reports states that the fraud has taken place in a company and due to such
fraud any director, key managerial personnel, or other officer of the company or any other
person or entity, has taken undue advantage or benefit, whether in the form of any
asset, property or cash or in any other manner, the Central Government may file an
application before the Tribunal for appropriate orders for holding such director,
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key managerial personnel, other officer or any other person liable personally without any
limitation of liability.
Section 213 of Companies Act, 2013
The tribunal may order an investigation into the affairs of a company:
i) on receipt of an application made by specified numbers of members along
with evidence or
ii) on an application made by any other person or
if it is satisfied that there are circumstances like:
a. the business of the company is being conducted with an intent to
defraud creditors or
b. the company was formed for any fraudulent or unlawful purpose or
c. the members of the company have not been given all the information
with respect to its affairs etc.
The investigation may be ordered after giving a reasonable opportunity of being
heard to the parties concerned.
If any of the above points were proved in the investigation, then every officer of the
company who is in default and the person or persons concerned in the formation of the
company or the management of the affairs shall be punishable for fraud.
The term affairs of a company was considered in R.V.Board of Trade Ex. Parte St.Martin
Preserving Co. ltd. It was held that it can cover investigation into all aspects of its business;
its assets including goodwill, profits and losses, contracts and transactions, investments and
rather property interests and control of subsidiary companies and transactions of a receiver
and manager of a company.
SPECIAL ISSUES IN INVESTIGATION
Whether an investigator is required to undertake a cent per cent verification
approach or whether he can adopt selective verification
It depends on the exact circumstances of the case under investigation. While
establishing the amount of cash defalcated by the cashier, he has to carefully examine
all the cash vouchers and related transactions. On the other hand, if he is to arrive at the
profitability of a concern, he may verify constituent transactions on a selective basis
taking extreme care to see that no material transaction that affects profit has remained
concealed from his eyes.
Whether the investigator can put reliance on the already audited statement of
account
It depends on the exact circumstances of the case under investigation. If the investigation
has been ordered because of some doubt in the audited statement of account,
there would be no question of reliance on the audited statement of account in such a
case.
If it has been ordered to establish value of a business or a share or the amount of
goodwill payable by an incoming partner, the investigator can rely on audited
materials made available to him unless, in the course of his test verification, he finds
the audit to have been carried on very casually or unless his terms of appointment
clearly require to test everything afresh.
If the statements of account produced before the investigator were not audited by a
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qualified accountant, then of course there arises a natural duty to get the figures in the
accounts properly checked and verified.
Whether an investigator necessarily requires assistance of expert
 For proper conduct of investigation, some times, the investigator may decide to
make use of an expert.
 For this purpose, the investigator shall get written general consent from his
client to refer special matters to the expert.
Basis of opinion of an investigator
The investigator should refrain from issuing speculative opinion. He should confine
his opinion to the established facts and nothing more. If the facts, as conveyed through the
books, records, papers and other evidence, are not capable of being properly established, he
should not express an opinion or, if at all he expresses any opinion, he should qualify the
opinion appropriately. This problem may particularly arise in cases where
incomplete books and records are produced for investigation.
Whether an investigator can make futuristic statements
The investigator should refuse to be futuristic. He may assume that the established
trend in the business will continue in the near future, in the absence of any contrary
evidence, in arriving at the present value of a business. He, however, should not
project the trend into any future years to establish a value.
Whether to retain working papers or not
Another important precaution is that the investigating accountant should retain, on his
files full notes of the work carried out, copies of schedules and all working papers, record of
conversations and the like.
SPECIAL ASPECTS IN CONNECTION WITH BUSINESS INVESTIGATIONS
Statement of Profit and Loss
 Compare each item in Statement of Profit & Loss account with
corresponding figures.
 To facilitate comparison, he has to prepare a summary for P&L account for 5 to 7
years in a columnar form.
TURNOVER
 Break down the sales between various products. Breaking down the sales
will help the investigator to find out the products the sales of which have been
increasing and the sales of which have been falling.
 Prepare list of customers and go through the Order book to identify whether
the business has a very large turnover with a few customers or a small
turnover with several customers.
WAGE STRUCTURE
Rate
The method of computing wages and the rates of wages should be examined. On
occasions a business may have to pay higher wages than those prevailing in other business
in the same neighbourhood in pursuance of an industrial award.

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Relationship
Another factor which is important to consider in this connection is the relationship of the
business with its workers. A business which has suffered several industrial
disputes, strikes, etc. and has had its working interrupted by them frequently cannot be
expected to prosper unless a proper settlement is reached with workers’ unions.
DEPRECIATION
Adequacy & consistency
The charge on account of depreciation and maintenance of machinery and other assets
included in the accounts of different years should be compared to ensure about the
following:
 Adequately provided for
 Basis for calculation is consistent
Revaluation
Further, if assets have been revalued, it should be confirmed that depreciation on the
increased valuation has been adjusted.
Compliance with AS
Further, compliance of relevant AS should also be verified.
MANAGERIAL REMUNERATION
It should be verified that the remuneration payable to various members of managerial
personnel is not excessive in relation to the profits of the business after taking into
account the time devoted by each of them. However, it could also be that no or only a
nominal remuneration has been charged in the accounts. In either case, an
adjustment should be made to arrive at true profitability of the concern. Further,
in case of company, requirement of relevant section of Companies Act, 2013 is to
be seen.
EXCEPTIONAL AND NON-RECURRING ITEMS
It is customary to adjust exceptional items in the summary of Statement of Profit and
Loss in order that they may not obscure the trend of the profits.
In this connection, it is worthwhile to examine the income tax assessment orders of
the business to find out the items which have been treated as revenue but have been
regarded by the taxing authority as inadmissible. Where the effect of these has been
abnormal on the tax paid by the company from year to year, suitable adjustments should be
made in the figures of taxes paid, as well as in the assets amounts.
Likewise, adjustments should be made in respect of exceptional profits and losses.
REPAIRS AND MAINTENANCE
It is one of the recurring expenses of a business. Occasionally it is noticed that this
expenditure is unduly heavy in some of the years, while quite low in some others.
Generally, companies, as a matter of routine undertake major repairs, overhauls and
maintenance programme at an interval of 3 or 4 years while running repairs and
maintenance continue in the usual manner which gives rise to fluctuating charges in the
accounts unless periodic major expenses are treated as deferred expenditure.
Besides, due to wrong allocation of expenses between capital and revenue,
repair charges may appear to be heavy or low. If fluctuating and abnormal charges

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for repairs is noticed, it would be the duty of the investigating accountant to scrutinise this
head thoroughly to establish correct and normal charge for repairs.
UNUSUAL YEAR
A company’s record of profitability may show a trend of increasing or decreasing
profit or loss or it may be highly erratic and fluctuating. Where a definite trend is
established, the job of the investigating accountant is somewhat simplified. He can adopt
recent years’ record of profitability as the basis for estimating future
maintainable profit having regard to the inflationary state in the economy.
But if the same is fluctuating, it may even be necessary to take into consideration results
of past 9 to 10 years with a view to iron out the fluctuation. If, however, it is noticed that
results of one or more years under scrutiny were materially vitiated by exceptional
factors like a long term industrial dispute, natural calamities, fire, war, ravage etc., the
investigating accountant should eliminate such year / years from consideration
altogether since they do not reflect the results obtained through normal business.
BALANCE SHEET
FIXED ASSETS
Fixed assets, usually, are shown in accounts at cost less depreciation but the accounts do
not show the ages of different assets. It is desirable, therefore, to obtain age analysis of
various items of fixed assets. Assets which are old or are obsolete would naturally have
to be replaced. It should be seen that their values are not in excess of the value of service
that they could be expected to render to the business during the balance period of their
active life and the amount they would fetch on sale as scrap.
In addition, from a study of the maintenance expenses incurred from year to year, it
should be judged whether the assets have been properly maintained. If not, it might
be necessary to incur heavy expenditure on repairs to put them in a proper working order.
In such a case, an allowance for this factor should be made in the value of assets.
INVESTMENTS
Investments should be broadly classified into long term investments and current
investments. A current investment is by its nature readily realisable and is intended to be
held for not more than one year. All other investments are long term investments.
Current investments are valued on the basis of lower of cost and fair value determined
either on an individual investment basis or by category of investment but not on an overall
basis.
Long-term investments are usually carried at cost. However, when there is a
permanent decline in the value of long-term investments, the carrying amount should
be reduced to recognise the decline. The carrying amount of long term investments is
determined on an individual investment basis. Interest, dividends and rentals receivable in
connection with investment are generally regarded as income. However in some cases, such
receipts represent recovery of cost and should therefore be reduced from, the cost of
investment (e.g. dividend out of pre-acquisition profits).
INVENTORIES
It should be seen that inventories have been valued consistently and that the basis of
valuation was such that the value placed on inventories did not include any element of
profit. Also, there should be due allowance for damaged, obsolete and slow moving

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inventories.
TRADE RECEIVABLES
In assessing their value, the following should be taken into account:
 The length of the credit period allowed throughout the period under
investigation, to determine whether it has been necessary to increase continually the
credit period in order to effect the sales. If it has been so, it would indicate that the
demand for the goods manufactured by the concern in the market has been
diminishing gradually.
 Debts should be classified according to their age. This would disclose the
character of the parties with whom the company trades and the amount of
working capital that will be necessarily blocked on this account in the course of
business.
OTHER LIQUID ASSETS
It should be ascertained that the assets so described are readily realisable. Money with a
bank in liquidation should be taken only to the extent guaranteed by Deposit Insurance
Scheme.
IDLE ASSETS
On a scrutiny, it may appear that certain assets are remaining idle and are not being
properly applied in the business. These may come from all sections of assets. For example,
certain plant and machinery may have been put to use after a considerable period of time
after acquisition. Some of the fixed assets may be awaiting installation even at the valuation
time. The company may hold large cash and bank balances, not warranted by the need of
the business. Then again, there may be instances of obsolete and slow moving inventories of
large value in the accounts of the company. It would be the duty of the investigating
accountant to eliminate these idle assets, if any, after proper identification from the
net worth of the business. However, proper value of these assets may be separately
added to the value of the business.
LIABILITIES
The important matter to investigate in this regard is whether those are stated fully or
understated or overstated. In other words, whether the profits of the business have
been inflated by suppression of liabilities or there are any free reserves included in the
liabilities. In either case, an adjustment would be necessary. Secondly, it should be
ascertained that liabilities are not unduly large or are not outstanding for a long
time, in such cases, it would be necessary to pay off some of them which would cause a
drain on the liquid resources of the concern. The fact should be stated in the report.
Taxation
Orders in respect of assessments completed should be studied and it should be verified that
adequate provision has been made in respect of liabilities for taxes which have not
been assessed. Also, it should be seen that in the past there has been no reopening of
assessments. If so, the company may be liable for an undisclosed sum of taxes plus
penalties.
Capital
In this regard, it is necessary to ascertain:
Whether the capital is well balanced. This would not be the case if the amount of
debentures and preference share capital are disproportionately large as compared to the

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equity capital, for this would be a handicap to the company in raising further equity capital,
on favourable terms for financing the business or to pay off capital commitment.
Interpretation of figures
Fixed Assets
The amount of capital expenditure which would be necessary in the future for the
continuation of the business, in its existing stage, should be assessed having regard to the
under-mentioned factors:
 the amount required for the replacement of assets when these would become
worn out or obsolete;
 the expenditure which will be necessary to replace obsolete machinery by more
sophisticated machinery for manufacturing different types of goods for which
there is demand.
Turnover
In assessing the turnover which the business would be able to maintain in the future,
the following factors should be taken into account:
Trend
Whether in the past sales have been increasing consistently or they have been
fluctuating. A proper study of this phenomenon should be made.

Marketability: Is it possible to extend the sales into new markets or that these have
been fully exploited? Product wise estimation should be made.
Political and economic considerations
Are the government policies likely to promote the extension of the market for goods to other
countries? Whether the sales in the home market are likely to increase or decrease as a
result of various emerging economic trends?
Competition
 What is the likely effect on the business if other manufacturers enter the same
field?
 Is the demand for competing products increasing?
 Is the company’s share in the total trade constant or has it been
fluctuating?
WORKING CAPITAL
In making assessment of the working capital requirements in the future, the following
matters should be taken into account:
 Has the ratio of inventory to turnover been increasing and if so, is it a
continuing or only a temporary trend?
 Are the trade payables being paid promptly or is there a backlog which will
have to be dealt with?
Sometimes, Chartered Accountants may be called upon to investigate certain matters such
as:
INVESTIGATION ON BEHALF OF A BANK PROPOSING TO ADVANCE LOAN
TO A COMPANY

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The objective behind ordering investigation by a bank is to ascertain things such as:
a. The purpose of Loan
b. Sources of Repayment of Loan
c. Securities available
The Investigating accountant is required to collect the following information in this respect:
1. Whether the company is authorized by its memorandum and articles to borrow
money.
2. The purpose for which the loan is required, for example, whether to finance the new
project or ongoing project.
3. The time and the manner of repayment. Particular attention should be given to
the assumptions made by the company while forecasting the annual profits.
4. The adequacy of security intended to be offered.
5. The financial standing and the reputation that the company possesses in the
market, among customers, its suppliers etc.
6. Whether the company has taken a loan in past from other institutions or banks,
if yes, the performance of company as to its repayment with that bank or
institution and the reason for switching to another bank.
7. The history of growth and development of company for the last 5 years.
8. The possible affect on the economic position of the company due to the economic,
political and social changes that might take place during the period of loan.
9. Investigate the profitability of the company by preparing a condensed income
statement and computing important ratios like stock turnover ratio, fixed assets
turnover ratio, equity to fixed assets, current ratio, liquid ratio, return on capital
employed etc.
INVESTIGATION ON BEHALF OF AN INDIVIDUAL OR A FIRM PROPROSING
TO BUY A BUSINESS
The matters which require investigator’s attention are as follows:
a. General particulars of the business such as date of formation, promoters,
customers and markets, plants and their location, production capacity, technological
soundness etc.
b. The organization structure as to the qualifications and experience of its
directors.
c. The availability of raw material and labour.
d. Financial position of the entity through statements of changes in financial position,
ratio analysis and so on.
e. The tax liability of the enterprise.
f. The existence of internal controls, accounting system, the policies of the
enterprise as regards its assets like cash, debtors, inventories, investments etc.
g. The details of fixed assets as to the type of fixed assets, depreciation, market value,
any encumbrances, leases etc.

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h. Amount of loans specifying interest component separately, the summary of long term
debts, contingent liabilities etc.
i. The composition of company’s capital, reserves and surplus and dividend policies
INVESTIGATION ON BEHALF OF AN INCOMING PARTNER
Some times the incoming partner appoints the investigator to examine the affairs of
the partnership firm to judge whether the terms and conditions offered to him are
reasonable or not.
1. The history of inception and growth of the firm should be ascertained.
2. Investigate the reasons as to why the business needs a new induction.
3. Obtain a draft copy of the proposed partnership agreement to ensure that
there is nothing in the agreement which is detrimental to the interests of the
incoming partner.
4. Examine the profitability of the firm as well as its rate of return and compare this
with alternative business avenues.
5. Examine the valuation of goodwill.
6. Ascertain that adequate provisions for doubtful debts, tax liabilities etc. have
been made.
7. The values of various assets and liabilities appearing in the books should also be
examined to ascertain the proposed values to be brought in the books of a new firm.
8. Position of orders on hand and the range and quality of clientele should be
thoroughly examined.
9. Have knowledge about specializations, if any, attained by the firm in any of its
activities.
10. Study the composition and quality of key personnel employed by the firm and the
likelihood of their leaving the organization in near future.
11. Whether any of the existing partners is likely to retire in near future and what
will be the effects of retirement on the firm’s business.
12. The standing and reliability of the existing partners and their personal
reputation should be properly judged.
13. Pay particular attention to the partner’s remuneration which may be excessive or
inadequate in relation to the nature and profitability of the business, qualifications and
expertise of the partners and such other factors as may be relevant.
DUE DILIGENCE
Due diligence implies a general duty to exercise care in any transaction.
Due diligence aims to take “the care that a reasonable person should take” before
entering into an agreement or a transaction with another party.
Due diligence is a process of investigation, performed by investors, into the details of
potential investment before acquiring a controlling interest in a company.
(Also Called as Target Business).
CLASSIFICATION OF DUE DILIGENCE
Commercial or Operational Due Diligence
It is generally performed by the concerned acquiring enterprise involving an evaluation

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from commercial, strategic and operational perspectives. For example, studying

whether, the proposed merger would create operational synergies.
Financial Due Diligence
It involves analysis of the books of account and other information pertaining to financial
matters of the entity. It should be performed after completion of commercial due
diligence.
Tax Due Diligence (direct and indirect)
It is a separate due diligence exercise but since it is an integral component of the financial
status of a company, it is generally included in the financial due diligence. The accountant
has to look at the tax effect of the merger or acquisition.
Information System Due Diligence
Whether, information system of target entity is providing right information, to the
right management at the right time in the right quantity. It pertains to all
computer systems and related matters of the entity.
Legal Due Diligence
This may be required where legal aspects of functioning of the entity are reviewed. For
example, the legal aspects of property owned by the entity or compliance with
various statutory requirements under various laws.
Environmental Due Diligence
It is carried out in order to study the entity’s environment, its flexibility and
adaptiveness to the acquirer entity.
Personnel Due Diligence
It is carried out to ascertain that the entity’s personnel policies are in line or can be
changed to suit the requirements of the restructuring.
AREAS COVERED IN FINANCIAL DUE DILIGENCE
If a full-fledged financial due diligence is conducted, it would include the following matters:
BRIEF HISTORY OF THE TARGET AND BACKGROUND OF ITS PROMOTERS
 The details of how the company was set up and who were the original
promoters have to be gone into, before verification of financial data in
detail.
 An eye into the history of the target may reveal its turning points, survival
strategies adopted by the target from time to time, the market share enjoyed by
the target and changes therein and product life cycle.
ACCOUNTING POLICIES
 The accountant should study the accounting policies being followed by the target
and should ascertain their appropriateness.
 The accountant should also see the effects of the recent changes in the
accounting policies. The target might have changed its accounting policies in the
recent past keeping in view its intention of offering itself for sale.
 The areas in which differing accounting policies are being followed by the target
entity and the acquiring enterprise and the effect of such differences.
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REVIEW OF FINANCIAL STATEMENTS

 The accountant should examine whether the financial statements of the target
have been prepared in accordance with the statute governing the target,
framework for preparation and presentation of the financial statements and the
relevant accounting standards.
 Review the operating results of the target in detail, as the price of the target would
be largely based upon is operating results.
 The accountant should consider the presence of an extraordinary item of income
or expense that might have affected the operating results of the target.
 It is advisable to compare the actual figures with the budgeted figures for
the period under review and those of the previous accounting period.
 Consider the basis upon which assets have been valued and liabilities have been
recognized.
 Check whether the net worth of the business has been arrived at by taking into
account the impact of over/under valuation of assets and liabilities.
The accountant should pay particular attention to the valuation of intangible assets. The
objective of the due diligence exercise will be to look specifically for any hidden
liabilities or over-valued assets.
Examples of Hidden Liabilities are:
+
 The company may not have shown any show cause notices which have not
matured into demands, as contingent liabilities. These may be material and
important.
 The company may have sold some subsidiaries/businesses and may have
agreed to take over and indemnify all liabilities and contingent liabilities of the
same prior to the date of transfer. These may not be reflected in the books of account
of the company.
 Long pending sales tax assessments
 Agreement to buy back shares sold at a stated price.
 Huge labour claims under negotiation when the labour wage agreement has
already expired.
Examples of overvalued assets could be:
 Uncollectible receivables
 Obsolete/slow or non-moving inventories valued above NRV;
 Huge inventory of packing material with name of the company
 Underused or obsolete plant and machinery and their spares
 Asset values which have been impaired due to sudden fall in the market value
 Litigated assets and property
 Investments carried at cost though realizable value is much lower
 Intangibles of no value

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TAXATION
 It is important to check if the company is regular in paying various taxes to the
government.
 The accountant has to look at the tax effects of the merger or acquisition.
CASH FLOW
 A review of historical cash flows and their pattern would reflect the cash
generating abilities of the target company and should highlight the major trends.
 It is important to know if the company is able to meet its cash requirements
through internal accruals or does it have to seek external help from time to time.
It is necessary to check:
1. Is the company able to honour its commitments to its trade payables,
to the banks, to government and other stakeholders
2. How well is the company able to turn its trade receivables and inventories
3. How well does it deploy its funds
4. Are there any funds lying idle or is the company able to reap maximum
benefits out of the available funds.
FINANCIAL PROJECTIONS
 The accountant should obtain from the target company the projections for the
next 5 years with detailed assumptions and workings.
 He should ask the target company to give projections on optimistic, pessimistic
and most likely basis.
 The accountant should evaluate the appropriateness of assumptions used in
the preparation and presentation of financial projections.
 If, the accountant is of the opinion that assumptions used by the target is
unrealistic, the accountant should consider its impact on the overall
valuation of the company. In case he feels the projections provided by the target
are not achievable or aggressive he has to mention this in his report.
MANAGEMENT AND EMPLOYEES
 Check whether all employee benefits like PF, ESI, gratuity, leave and
superannuation have been properly paid/ provided for.
 In the case of PF, ESI etc. the accountant has to see if all eligible employees
have been covered.
 It is very important to consider the pay package of the key employees as this can
be a crucial factor in future costs.
 It is also important to identify the key employees who may not continue after
the acquisition either because they are not willing to continue or because they
are to be transferred to another group company of the target.
STATUTORY COMPLIANCE
 It is important to make a list of laws that are applicable to the entity as well as to
make a checklist of compliance required from the company under those laws.
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 If the company has not been regular in its legal compliance it could lead to
punitive charges under the law.

FORENSIC AUDIT
The corporate accounting scandals are accelerating all over the world. In India, the
best example of such accounting scandal is the case of Satyam Computer Services.
This led the regulators and experts to shift their focus from traditional auditing
techniques to investigation based techniques called as Forensic
Auditing/Accounting.
A Forensic Audit is an examination of a company’s financial records to derive
evidence which can be used in a court of law or legal proceeding.
For example, A Ltd. on the recommendation of its Chief Financial Officer (CFO),
entered into a contract with B LTD for the supply of carts. At the time, B Ltd. was not
authorized to conduct business, as its license was suspended due to certain
irregularities in taxes paid. The CFO had knowledge of this fact, but
still recommended that A Ltd. enter into a contract with B Ltd. because he was
secretly receiving compensation from B Ltd. for doing so.
A forensic audit can reveal such cases of fraud.
In other words, forensic audit will try to resolve the allegations of fraud and
embezzlement through performing thorough investigation and helps in prosecuting
a party for fraud, embezzlement or other financial claims.
“Forensic” means “suitable for use in the court of law”. Forensic Auditing includes
the use of accounting, auditing and investigative skills to assist in legal matters.
Why is a forensic audit conducted?
Forensic audit/investigations are made for several reasons, including the following:
Corruption
In a Forensic Audit, while investigating fraud, an auditor would look out for:
Conflicts of interest – When fraudster uses his/her influence for personal gains
detrimental to the company. For example, if a manager allows and approves
inaccurate expenses of an employee with whom he has personal relations. Even
though the manager is not directly financially benefitted from this approval, he is
deemed likely to receive personal benefits after making such inappropriate
approvals.
Bribery – As the name suggests, offering money to get things done or influence a
situation in one’s favor is bribery. For example, A Ltd. bribing an employee of B Ltd.
to provide certain data to aid A Ltd. in preparing a tender offer to B Ltd.

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Extortion – If a company demands money in order to award a contract to another

company, then that would amount to extortion.
Asset Misappropriation
This is the most common and prevalent form of fraud. Misappropriation of cash,
raising fake invoices, payments made to non-existing suppliers or employees, misuse
of assets, or theft of Inventory are a few examples of such asset misappropriation.
Financial statement fraud
Companies get into this type of fraud to try to show the company’s financial
performance as better than what it actually is. The goal of presenting fraudulent
numbers may be to improve liquidity, ensure top management continue receiving
bonuses, or to deal with pressure for market performance.
Some examples of the form that financial statement fraud takes are the intentional
forgery of accounting records, omitting transactions – either revenue or expenses,
non-disclosure of relevant details from the financial statements, or not applying the
requisite financial reporting standards.
Procedure for a forensic audit investigation
A forensic auditor is required to have special training in forensic audit techniques and
in the legalities of accounting issues.
A forensic audit has additional steps that need to be performed in addition to regular
audit procedures.
Plan the investigation – When the client hires a Forensic auditor, the auditor is
required to understand what the focus of the audit is. For example, the client might
be suspicious about possible fraud in terms of quality of raw material supplied. The
forensic auditor will plan their investigation to achieve objectives such as:
 Identify what fraud, if any, is being carried out
 Determine the time period during which the fraud has occurred
 Discover how the fraud was concealed
 Identify the perpetrators of the fraud
 Quantify the loss suffered due to the fraud
 Gather relevant evidence that is admissible in the court
 Suggest measures that can prevent such frauds in the company in future
Collecting Evidence – By the conclusion of the audit, the forensic auditor is required
to understand the possible type of fraud that has been carried out and how it has
been committed. The evidence collected should be adequate enough to prove the
identity of the fraudster(s) in court, reveal the details of the fraud scheme, and
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document the amount of financial loss suffered and the parties affected by the fraud.
A logical flow of evidence will help the court in understanding the fraud and the
evidence presented. Forensic auditors are required to take precautions to ensure
that documents and other evidence collected are not damaged or altered by anyone.
Common techniques used for collecting evidence in a forensic audit include the
following:
Substantive techniques – For example, doing a reconciliation, review of documents,
etc.
Analytical procedures – Used to compare trends over a certain time period or to get
comparative data from different segments
Computer-assisted audit techniques – Computer software programs that can be
used to identify fraud.
Understanding internal controls and testing them so as to understand the loopholes
which allowed the fraud to be perpetrated.
Interviewing the suspect(s)
While collecting evidence, the forensic auditor should concentrate on the following:
Personal Records
The personal background of a suspected offender can reveal patterns that may be
indicative of fraud. For instance, the suspect may have a litigation history or past
bankruptcy filings. Other checklist items include criminal history or arrest records.
Background checks can also include a person’s Internet search history, employment
history and education verification. These items alone do not confirm fraud, but when
paired with financial evidence, irregularities may be evident.
Financial Investigation
Upon launching a forensic audit, a forensic accountant meticulously gathers
information and reviews it to determine if and how fraud occurred, when it occurred
and the financial amount involved. Under this heading, the auditor shall check credit
reports, real estate transactions, stocks, domestic and foreign bank accounts,
retirement plans etc. Financial evidence may reveal hidden assets or a lifestyle
inconsistent with income.
Others
All the relevant documents and bank accounts of a company suspected to be
involved in fraudulent activities are to be collected from the company directly. These
documents are examined to trace out the utilization of various funds of the company
collected from the public, banks and financial institutions and to examine whether
that has been done as per the declared objectives of the company. After these

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examinations, patterns and connections of financial transactions are discovered

which may be prejudicial to the interest of the company and its stakeholders but
benefiting any particular promoter or employee of the company or its related
concerns.
Fraudulent activities of a company can also be traced by collecting information from
diverse sources such as capital market, statements of bank accounts of the company,
its related business concerns, promoters, directors and employees of the company
obtained from banks, various records of companies available with different
Government agencies i.e. Income tax, Customs & Central Excise, Director General of
Revenue Intelligence (DGRI) etc.
Disgruntled employees and trading partners can be very good source for gathering
evidence. Pattern of deteriorating financial condition of the company and flourishing
economic condition of promoters, employees, directors and related concerns of the
company can be analysed to detect possible fraud.
REPORTING
A report is required so that it can be presented to a client about the fraud. The report
should include:
 The findings of the investigation
 A summary of evidence
 An explanation of how the fraud was perpetrated and
 Suggestions on how internal controls can be improved to prevent such frauds
in future.
The report needs to be presented to a client so that they can proceed to file a legal
case if they so desire.
Court Proceedings – The forensic auditor needs to be present during court
proceedings to explain the evidence collected and how the suspect was identified.
They should simplify the complex accounting issues and explain in layman’s language
so that people who have no understanding of the accounting terms can still
understand the fraud that was carried out.

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