A Phased Engagement Approach to Forensic Accounting

By M. Jacob Renick

JUNE 2007 - There are several approaches to a forensic investigation. A phased engagement approach manages the investigation efficiently because it controls the engagement with decision points throughout the process. A phased engagement is a step-by-step methodology that manages time and fees, and yields conclusions based upon parameters defined by the client (often an attorney) and the forensic accountant.

In recent years, attorneys, as well as management and other interested parties, have come to rely on forensic accountants as the primary financial investigator, the consulting financial expert, or the testifying expert in financial investigations and disputes. Equally critical to their investigative skills is forensic accountants’ ability to communicate financial information in a clear and concise manner. Forensic reports are written as words with numbers supporting them, as compared to traditional accountants’ reports, where numbers are presented with words to support them.

Why Is It Effective?

A phased engagement is effective because the scope and timeframe of each phase is controlled. That permits the client to decide whether to expand or limit the scope of each phase or the scope of the entire engagement. Accordingly, each phase stands on its own and has its own parameters and deliverables.

As a result, costs for each phase and, therefore, the cost of the entire engagement, can be controlled. A phased engagement also allows faster response and completion times because all time and energy are devoted to the completion of each phase before the next phase is commenced.

Phase 1: Exploration and Evaluation

Before any work can begin, the client and the forensic accountant must define the problem, the issues involved, and the scope of the engagement. Then a projection of the timeframe, cost, and expected deliverables for each phase can be determined.

In identifying the areas to examine, consideration must be given to both the obvious and the not so obvious. For example, in a potential defalcation engagement, the obvious areas may include cash, receivables, and inventory. The not-so-obvious areas may include accounts payable, payroll, and property assets, as well as intellectual property and propriety information.

One purpose of this phase is to determine if a cause of action is supportable. A forensic accountant must identify what information is needed and then perform an initial review sufficient enough to conclude whether there is a potential cause of action. During phase 1, the forensic accountant limits the review to readily accessible information. This information is usually contained in an entity’s (or individual’s) books and records, third-party documents, and any information previously obtained during discovery.

Phase 1 concludes with a report of preliminary findings, written or oral. The report should indicate what additional information and documents are needed, a recommendation on how to proceed, and the identification of any potential risks. These might include risks to the business from public disclosure or government scrutiny, and to clients for their actions or inactions, as well as litigation risk. Forensic accountants must bear in mind that all written communications may be subject to discovery.

At this point, a determination must be made whether to continue to phase 2 (i.e., expansion of scope) or to conclude the engagement. This determination is made after the client, the client’s attorney, and the forensic accountant have discussed the matter. This is where a major advantage of a phased engagement comes into play. If it is decided to end the engagement, there will be no further costs. If it is decided to proceed to phase 2, the problem and the issues involved have been clearly defined, as to allow for a focused continuation of the investigation.

Phase 2: Expansion of Scope

Tracking and tracing. Phase 2 commences with specific document analysis. This analysis is more in-depth than in phase 1; it will probably include a review of many more transactions, books, records, and documents requested from the opposing side. Phase 2 may also include the verification of certain findings from third parties.

The books and records that are analyzed generally include the general ledger, general journal entries, bank statements, tax returns, financial statements, cash receipts and disbursements, and electronically stored information. Although some of the same information may be reviewed during phase 1, the level of review and analysis during phase 2 is much deeper.

Several approaches are used in the analysis of books and records. The approach or combination of approaches used will be based upon what the forensic accountant is trying to find.

These approaches may include one or more of the following:

  • Specific account analysis;
  • Specific time-period analysis, or a comparison of similar data for similar time periods;
  • Account-by-account analysis;
  • Interrelated account analysis (e.g., sales and sales commissions); and
  • Payee-by-payee analysis.

By combining several of these approaches, forensic accountants can obtain the information they are looking for. For example, the analysis may include all inventory purchases from a specific vendor for a specific period of time. Those purchases would then be compared to all purchases from all vendors for that same period of time or for the whole year, both in quantity and as percentages.

Similarly, depending upon the nature of the engagement and investigation, it may be important for a forensic accountant to analyze related-party transactions, journal entries, and any transactions that relate to stockholders’ equity (or partners’ capital) accounts.

Preparing the analysis. In preparing an analysis, it is important for a forensic accountant to trace transactions from beginning to end and from end to beginning, and to review supporting documentation. One example would be a purchase. The beginning-to-end tracing may start with the request by the factory foreman for certain materials. The tracing would include requisition and inventory logs, the purchase journal, the accounts payable subsidiary ledger, the cash disbursements journal, and the general ledger. The documents related to that request might include the materials requisition, the purchase order, the warehouse receipts journal, the voucher payable, and the cancelled check.

In an end-to-beginning analysis, the same items would be reviewed, except in reverse order starting with the general ledger and working back to the materials requisition. The beginning-to-end analysis is necessary to determine the propriety of the transaction and to ensure that the items have been authorized and properly recorded. The end-to-beginning analysis assures the forensic accountant that all items recorded in the particular general ledger account are proper, that the individual items were authorized, that they belong to the entity, and that the goods or services were actually received.

With electronically generated books and records, a review of systems controls, backups, and logs is critical, as it is much easier for one to alter information today than when transactions were recorded in separate physical books. The need to obtain sufficient documentation to support certain analyses has not changed much, but the verification and documentation have become significantly more difficult.

Reconstruction of books and records. At times, the forensic accountant may have to reconstruct books and records, or specific transactions, from whatever information is available. The specific information needed may not be readily available or may not be in a form that the forensic accountant needs or can use.

In reconstructing the books and records and performing the analyses discussed above, forensic accountants will look for information or evidence to support their assumptions. This information may be included in the books and internally generated records (e.g., inventory logs, purchase orders, sales and commission reports) or in the form of externally generated documents (e.g., bank statements and cancelled checks, leases, contracts, bills of lading).

Third-party verification and confirmation. At times, the forensic accountant may need to obtain third-party verification to confirm matters that arise during the investigation. These third parties may include vendors, customers, and banks.

In some instances, the forensic accountant may need to conduct interviews, with various parties within and outside of the entity. Before conducting interviews, the forensic accountant should confer with counsel, because there are significant legal requirements and ramifications. It is important to use a forensic accountant trained and knowledgeable in investigative interviewing techniques and the related legal issues.

Conclusion of Phase 2. Phase 2 concludes with the delivery of a report to the client. As compared to the report issued in phase 1, the phase 2 report is almost always in writing and more formal. The report in phase 2 should include detailed findings, any additional potential risks that the forensic accountant believes are present, any additional information that might still be needed, and a recommendation as to whether the forensic accountant believes there is sufficient evidence or information for the process to continue.

Similar to phase 1, a determination as to how to proceed must be made: whether to expand the investigation even further, whether to seek depositions and further discovery, or whether to conclude the matter for lack of sufficient cause or evidentiary matter, or because of potential risks.

Cautionary Note

Although a forensic investigation can be approached in many ways, the phased engagement permits a forensic accountant and client to divide the investigation into distinct phases, allowing for the control of the investigation and its costs.

In preparing their reports, analyses, and notes, forensic accountants should be familiar with the issues of attorney work product. In addition, forensic accountants must bear in mind that almost everything involved in the process, including their drafts and notes, may be subject to discovery by the opposing party. Scrupulous caution is advised whenever forensic accountants undertake an engagement.

M. Jacob Renick, CPA, CIRA, CFE, is director of bankruptcy and restructuring services at Eisman, Zucker, Klein & Ruttenberg, LLP, White Plains, N.Y. He is a member of the NYSSCPA’s Litigation Services Committee and Bankruptcy and Financial Reorganizations Committee, of which he is also immediate past chair. The author would like to thank Ciro V. Cuono, CPA/ABV; Daniel Forbes, CPA, CFE; and Stephen L. Pados, CPA/ABV, CFE, all with Eisman, Zucker, Klein & Ruttenberg, LLP, for contributing to this article.