Forensic accounting is the most in-depth type of due diligence and compliance, and it goes beyond simply being a tool to look into financial crimes. But smaller businesses frequently ignore its value. Here’s why that’s dangerous:

When you hear the term “forensic accounting,” you might picture detective-like experts searching through papers, interviewing suspects, and checking backgrounds to solve financial crime cases. While performing due diligence evaluations to assess potential investments, mergers, and acquisitions is also a component of the job description for forensic accountants, who are also required to look into lawful financial activities.

Forensic accountants carry out compliance evaluations following an investment, merger, or acquisition to ensure that all parties are adhering to agreements and rules. Similar—and perhaps identical—actions are involved in both procedures, but due diligence inspections are often more systematic than compliance reviews. And the results might be disastrous if neither discloses the financial reality.

How Does Criminal Accounting Operate?

General accounting and forensic accounting are very different from one another. The former considers if the story being told by those financials makes sense and is likely to be true, whereas the latter is interested in whether financial statements comply with guidelines known as the Generally Accepted Accounting Principles (GAAP).

The discipline of forensic accounting has been gradually expanding, partly due to an increase in financial fraud and cybercrimes like ransomware attacks. However, forensic accounting is also more in demand as a result of tighter financial regulations, as well as the fact that most regulations date back to the time before alternative assets like cryptocurrency and haven’t been updated to take into account the corresponding tax and reporting obligations and business practices.

The expanding market for forensic accounting can be attributed to factors including rising fraud and cybercrime, tighter financial laws, and the popularity of alternative assets like cryptocurrencies.

Forensic accounting is mostly used for due diligence and compliance to expose bad investments, find hidden value, and determine the ideal time to sell or buy stocks. Let’s look closely at some actual instances to see how the practice functions for each of these goals.

Identifying Bad Investments

Carlos Salas, a financial specialist, had had a customer who was thinking about funding private mobile e-commerce company Powa Technologies. In 2015, Powa claimed that 1,200 companies had signed up to utilize its software and that its business was worth $2.7 billion. In order to confirm these and other claims, as well as to have a complete picture of the company’s finances, the client hired Salas and his team.

More than 300 of the alleged Powa customers’ companies received emails from Salas and his colleagues. 20% of the respondents said they hadn’t signed any contracts in their response. It was later discovered that most of the other companies mentioned also lacked contracts with Powa.

Searching for Hidden Value

Investigative accounting is important for finding diamonds in the rough, but preventing calamity is likely the more compelling justification. A corporation may display income statements and balance sheets in ways that don’t accurately reflect the company’s true value, despite the fact that they are essential for placing reported revenue and asset price in context. However, investigative accountants are equipped to reveal that.

For instance, Toptal finance specialist Benjamin Ostrow worked as a senior associate for a family office in 2019 and researched new companies that the company was considering purchasing or investing in. He found that such companies’ financial statements occasionally concealed up crucial information.

However, Ostrow’s inquiry showed that the business was legal. “I was able to establish that a contract manufacturer they were utilizing in China had entirely duplicated what they were doing through more research,” says Ostrow. “There was an inflow of counterfeit goods, and customers couldn’t tell it apart from the genuine product. The issue wasn’t a lack of demand.”

Ostrow and his company decided to invest in the company after discovering the counterfeiting, earning millions of dollars in the process. The few months and several thousand dollars spent on forensic accounting investigation were well worth it.

Finding the Appropriate Moment

Salas frequently shorts stocks for clients using his experience in investigative accounting. The key to this strategy is timing; if you don’t sell and then purchase back your stock at the appropriate intervals, you risk losing money. Conducting thorough due diligence on the company you intend to short in order to forecast its stock performance is a good technique to gain an edge.

Salas researched the German payment company Wire card in 2018. He saw the firm’s shares were overvalued at first, and subsequently realized its financials weren’t totally accurate. The shares of Wire card became incredibly volatile, offering a seductive chance to short the stock. German regulatory authorities, however, swiftly launched an investigation and banned any short sales for two months.

A significant profit was made by Salas’s customer, who bought the shares back and gave it to the broker after the fall as a result of the more than 80% decline in Wire card’s stock price, which started just before former CEO Markus Braun was arrested. Soon after, Wire card experienced financial trouble.

Judiciously Using Investigative Accounting

Even big organizations with internal accounting teams might profit from using forensic accountants for high-stakes deals since they have specialized knowledge, according to Pugachova. These experts also bring the backdrop of operations from other organizations, so they have a strong feel of the standards and may provide a larger, more comprehensive perspective of a business’s financials—increasing the odds of detecting concerns that may have been missed in-house.

But ultimately, according to Pugachova, the advantages frequently exceed the hazards. “I haven’t encountered any mistakes made by organizations who committed the monies necessary to hire outside professionals to complete this work thoroughly. However, I am aware of businesses, including a private equity fund, who had to write off their entire operation due to disastrous investments they made as a result of skipping out on doing thorough due research. It costs more to get quality.