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Audits vs. Forensic Investigations (Part 2)
Audits and forensic investigations are different services. They are planned and performed to accomplish unique objectives. This blog is the second part of a three-part blog that compares the roles of the auditor and the forensic accountant. It is focused on materiality and team building.
Materiality and Team Building
By L. Erik Ringoen, CPA, CFF, CIRA
This is the second in a series of three blogs discussing the difference between an audit and a forensic investigation. In this blog, I discuss the roles of the auditor and the forensic accountant related to risk assessment, the concept of materiality, and building the right team. In my previous blog, I compared the auditor’s and forensic accountant’s objectives, responsibilities, professional standards, and engagements. In Part 3, I discuss the gathering of evidence and reporting for audits and forensic investigations.
It is the job of everyone in a company to be committed to the characteristics of a successful company culture. Auditors and forensic accountants should evaluate evidence that supports whether management has created and maintained a culture of honesty and ethical behavior.
The execution of an audit and a forensic investigation are similar in that they both include planning, gathering evidence, a review process, and a report to the client. As part of planning and developing an overall strategy, both should gain an understanding of the business and assemble the most appropriate team for the task. As knowledge and evidence is accumulated, the auditor and the forensic accountant both will revisit their plan and revise procedures to achieve their respective objectives.
Risk Assessment and Materiality
To be in accordance with professional standards, an auditor should identify the client’s risks of material misstatement by gaining an understanding of the client and its internal control over financial reporting, assess the risks, and design audit procedures to address those risks. The auditor should understand the client’s business, the business environment, the industry in which it operates, how it makes money, the products or services it sells, who their customers are, and what the competitive advantages are (i.e., low cost, superior product, unique business model) and performance measures, among other business risks. The auditor should also obtain an understanding of the client’s internal control over financial reporting, and determine if control processes have been adequately designed and implemented, and operate effectively. The auditor’s objective is to identify and appropriately assess the risks of material misstatement, and design and implement audit procedures that will uniquely mitigate the risks identified.
An auditor does not, and cannot, test every transaction. Instead, the auditor sets a “materiality” threshold. This threshold is subject to the professional judgment of the auditor. The U.S. Supreme Court has noted, an auditor’s determination of materiality requires “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him.”1 In interpreting federal securities laws, the Supreme Court has held that a fact is material if there is “a substantial likelihood that the … fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ on information made available.”2
Similar to the auditor, the forensic accountant should gain an overall understanding of the company, its environment, and the internal control procedures over financial reporting. In planning and developing an overall strategy, the forensic accountant is not constrained by the concept of materiality. The forensic accountant’s objective is to understand what information is available to develop investigative procedures focused on an alleged fraud.
Building the Right Team
The audit engagement partner and other key members of the of the audit engagement team should be involved with planning the audit, including selecting members with appropriate capabilities and competence, allocating team members’ responsibilities, assisting in the coordination of work done by a specialist, and quality control procedures. The auditor should determine whether any specialists with expertise outside the field of accounting or auditing are necessary. Specialists may include valuation experts, appraisers, actuaries, or tax and IT professionals.
A forensic investigation team may consist of different experts, depending on the nature of the alleged fraud. Forensic accountants are specialized in the field of accounting, and use a combination of accounting, auditing, and investigative skills. Depending on the nature of the allegations, available information, and the client’s business, the forensic accountant determines the skills, knowledge, and experience in a particular field required to conduct the forensic investigation efficiently, effectively, and competently. The type of experts on the team will depend on the facts and circumstance of the case, and may include experts in cyber investigations, computer forensics, data analytics, business intelligence analysts, former prosecutors, former law enforcement, former C-suite executives, regulatory specialists, and other subject matter experts as deemed necessary. The forensic investigation team should understand the circumstances surrounding the engagement, in that the client may want the forensic investigation conducted discreetly.
Audits and forensic investigations are unique services. The forensic accountant is not constrained by the auditor’s concept of materiality, and a forensic investigation team is composed of experts in differing aspects of a forensic investigation.
In the third and final part of this blog series, I discuss the gathering of evidence and reporting for audits and forensic investigations.
1 TSC Industries v Northway Inc., 426 U.S. 450 (1976).
2 TSC Industries v Northway Inc., 426 U.S. 438, 449 (1976). See also Basic Inc. v Levinson, 485 U.S. 224 (1988).
L. Erik Ringoen, CPA, CFF, CIRA, is a director with Forensic Resolutions Inc., which has offices in Westmont, N.J., and Philadelphia. He can be reached at eringoen@forensicresolutions.com.
