Why You Shouldn’t Rely on Financial Statement Audits When You Need a Forensic Audit

Back in 1974, the English rock band Ace had its one and only hit, in which lead singer Paul Carrack demands to know, “How long has this been going on?” At North American Forensic Accounting, we could put that song on a continuous loop for our clients, after we inform them they have been losing money for years, if not decades, due to waste, fraud, and abuse. How could they not have known? Often, it comes down to relying on financial statement audits when what they really needed was a forensic audit.

Recent case in point: NAFA was engaged by the mayor of a southcentral U.S. city to conduct a forensic audit. The new mayor was suspicious about past operational and financial matters even though prior financial statement audit results were generally positive. Indeed, they had passed their financial statement audits, but that “thumbs up” did not seem to align with some of the red flags observed. At this point, you can almost hear Paul Carrack’s voice intoning:

“Well, your friends with their fancy persuasion

Don’t admit that it’s part of a scheme

But I can’t help but have my suspicion

‘Cause I ain’t quite as dumb as I seem.”

So, the City Council voted to engage NAFA to conduct a forensic audit. The results, according to the local press, were scathing. The highlights of our 89-page report included:

• The lack of a Code of Conduct, Code of Ethics, and Conflict of Interest Policy.
• Failure to implement prior recommendations from audits, including incomplete cash reconciliations
• Having significant anomalies in budgeting and fund transfers, such as unauthorized fund transfers
• Misreporting personal income earned and inappropriate use of city personnel and assets by senior officials

Additionally, as is often the case where we find financial impropriety, we found patterns of inappropriate behavior that included the use of city email to send pornographic materials. The organizational culture had become one of willful ignorance with ethics and integrity in short supply.

Our conclusion noted that “These findings reflect a pervasive breakdown in accountability, governance, and oversight, with many issues exacerbated by the failure of past management to address red flags and act decisively. The City’s history of poor documentation, inadequate policies, and resistance to oversight has compounded risks to public trust and financial integrity.” These systemic problems had no doubt been years in the making.

Yet, all these deficiencies remained hidden for many reasons, one of which was that the financial statement audits did not uncover problems that a deeper dive would have exposed. To be clear, Financial Statement audits are not designed or intended to reveal many of these issues. The “deeper dive” needed is a forensic audit.

How forensic accounting differs from traditional accounting services

Traditional accountants specialize in systematic recording, reporting, and analysis of financial transactions. Traditional accountants use their skills to prepare financial statements, assist in financial planning, conduct financial statement audits, and prepare tax returns.

Forensic accountants are also trained in those areas, but we specialize in financial review and analysis that goes beyond mere numbers to understand patterns of behavior that relate a deeper narrative. We are also trained in investigative techniques. Those techniques involve the collection of evidence, interviewing skills and digital forensics and analysis. We are out to find financial aberrations, to investigate finances, prepare expert reports, and testify in court about our findings.

Forensic audit vs. financial statement audit

Auditing is designed to ensure the integrity of financial information recorded and put forth by organizations. While both forensic audits and standard financial statement audits aim to assess accuracy, they differ significantly in:

• Purpose — The primary difference between the two types of audits lies in their objectives. A financial statement audit is conducted to provide reasonable assurance that an organization’s financial statements are free from material misstatements due to fraud or error. Organizations generally perform this type of audit annually, as often required by regulators, investors, or lenders.

By contrast, a forensic audit investigates suspicions of fraud, misconduct, or financial irregularities. Its main goal is to uncover and document evidence that might be used in legal proceedings or internal disciplinary actions. Organizations initiate forensic audits in response to specific concerns rather than on a routine basis.

• Scope and approach — A financial statement audit takes a broad view of the organization’s financial reporting. Auditors assess internal controls, perform substantive testing, and analyze transactions across the entire financial reporting cycle to form an opinion on the overall accuracy of the financial statements.

Forensic audits are far more targeted. They focus on specific transactions, accounts, or business processes where stakeholders suspect wrongdoing. Forensic auditors delve deeply into the details, often tracing transactions to their source, reconstructing records, and interviewing employees to gather evidence.

• Standards and methodologies — Financial statement audits are governed by standardized auditing principles, such as Generally Accepted Auditing Standards (GAAS) or International Standards on Auditing (ISA). These standards ensure consistency, objectivity, and transparency.

Forensic audits rely on investigative techniques, such as digital forensics, data analytics, and specialized interviewing techniques.

• Outcome and reporting — At the conclusion of a financial statement audit, auditors issue an audit opinion — unqualified, qualified, adverse, or a disclaimer — which stakeholders use to assess the reliability and accuracy of the financial reports. Companies include this opinion in their annual financial report.

Forensic auditors, however, issue a detailed report documenting the findings, evidence, and conclusions of the investigation. It might include recommendations for legal action or internal control improvements. This report can serve as evidence in court or during arbitration.

• Use Cases — Financial statement audits are necessary for organizations to obtain an independent objective opinion on the credibility of the organization’s financial statements.

Forensic audits are essential in cases of suspected fraud, embezzlement, regulatory violations, or disputes between business partners. They can play a critical role in litigation, insurance claims, and corporate investigations.

While both types of audits aim to examine and enhance financial accountability, they are not interchangeable. If your purpose is to discern whether fraud has occurred in your organization and to strengthen your controls to correct the problem, a forensic audit is the appropriate tool. If you suspect there’s fraud in your organization, NAFA can help determine how long it has been going on, how much it has cost, and most importantly, help implement effective controls and other measures to mitigate the issues.