This article is part of a larger series on Bookkeeping.
The difference between forensic accounting and auditing lies in how the engagement is performed. Forensic accountants look for the existence of fraud in a business and can go as far as spotting other criminal behaviors committed by the owners or employees. Meanwhile, auditors focus more on your business’s compliance with accounting principles, such as United States generally accepted accounting principles (US GAAP) and other regulatory frameworks like tax laws and environmental compliance laws. Auditors are bound to report fraud to management, should they uncover it during an audit.
Objective of the Engagement
Detect fraud, financial crimes, or unethical financial reporting
Determine if the financial statements (FS) are fairly presented in accordance with GAAP
Independence Requirement in Performing the Engagement
Accounting standards, auditing standards, laws and regulations, rules of procedures, rules of evidence
Accounting standards, auditing standards
Who Performs the Engagement
CPAs engaged in forensics and crime investigations
CPAs engaged in public accountancy
Evidence Gathering Techniques
Surveillance techniques, forensic audit techniques, Persuasive techniques, DNA analysis, digital forensics
Observation techniques, Sampling methods, Substantive procedures, Test of details, Test of controls
Forensic accounting is a subspeciality in accountancy practice that uses expertise in accounting, finance, auditing, law, investigative techniques, and quantitative methods to determine the existence of financial reporting misconduct. In forensic accounting, the forensic accountant’s main goal is to spot fraud and criminal behavior in a business.
When To Hire a Forensic Accountant
- Investigation of potential fraud: Forensic accountants study different kinds of fraudulent schemes. You can hire a forensic accountant if you feel fraud is prevalent in the business, especially if perpetrated by high-level employees.
- Litigation cases: Forensic accountants can serve as an expert witness in litigation cases. They can also help in gathering, analyzing, and producing evidence needed for prosecution.
- Business valuation: The complexities involved in some financial reporting requirements are a risky area. Some businesses may use creative accounting and earnings management ploys to defraud authorities or investors.
Forensic Accounting for Small Businesses
Businesses routinely engage auditors to ensure their financial statements are in compliance with US GAAP. But in rare cases, you can hire a forensic accountant to look deeper into your accounting system and business operations.
In a small business environment, it’s common for business owners to place too much trust in certain individuals. This trust can be a breeding ground for fraud, and it can be hard to detect fraud if perpetrated by trusted business personnel.
Auditing is a type of assurance engagement wherein a competent and independent person uses an established set of criteria to evaluate and report on a company’s subject matter information. Let’s break this definition down in layperson’s terms.
- Assurance engagement: The auditor provides assurance to the users of the financial statement (FS) that it’s fairly prepared using US GAAP. Audits can only give reasonable assurance, which means that evidence gathered in the audit supports the assertions in the FS.
- Competent and independent person: In the context of an audit, a competent and independent person refers to a certified public accountant (CPA). However, these CPAs must be engaged in public practice, members of an auditing firm, and independent of the company being audited. Your bookkeeper has different responsibilities and cannot perform auditing services for you.
- Established set of criteria: The US GAAP is the established set of criteria because it’s enforced across the United States by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). However, small businesses aren’t required to fully comply with all accounting standards.
- Subject matter information: This refers to the set of FS (income statement, balance sheet, statement of owner’s equity, and statement of cash flows) being audited.
- Evaluate subject matter information: The auditor uses the US GAAP to evaluate the company’s FS. Evaluation requires evidence gathering and analysis. Without evidence, auditors cannot report on the FS.
- Report on subject matter information: The goal of an audit is to provide an audit report that contains the auditor’s opinion.
When To Hire an Auditor
- Loan application: Banks often ask for audited FS from loan applicants to assess the applicants’ financial condition.
- Small businesses looking to sell: An audited FS gives more credibility to the selling company’s financial statements. If you’re looking to sell your business, you can supplement a high selling price with audited FS to prove to the buyer that your company earnings history is accurate.
- Companies holding large retirement funds: A large retirement fund is an employee benefit plan within a company with 100 enrolled employees. The IRS requires businesses to have audited FS when filing Form 5500 annually.
- General business checkups: An audit can uncover discrepancies and deficiencies within your business. While small businesses don’t need an annual audit, being audited at least once can help your business improve its accounting controls. If you’ve recently adopted new accounting procedures, external auditors can provide expert opinions on their operating effectiveness.
Auditing for Small Businesses
While larger businesses generally have their financial statements audited every year, small businesses that aren’t publicly traded only need audits if required by an external stakeholder. Here are some examples of when a small business might be required to have audited FS:
- Lenders might require audited financial statements before approving a business loan.
- Potential buyers might require that any business valuation be based on audited financial statements.
- Government agencies often require audited FS from any entity that’s receiving government funds.
In addition to being required to have an audit by external stakeholders, some small businesses voluntarily have financial audits done because part of the audit will access the strength of their internal control system. The auditors might make suggestions that will help prevent future financial misstatements and perhaps even theft.
The main difference between forensic accounting vs auditing is that forensic accounting looks into the existence of fraud, while auditing focuses on providing an opinion on the financial statements. There’s little need for forensic accounting or auditing services in a small business setup. However, loan applications and legal compliance may require an audited FS.
Of the two, most small businesses may not need forensic accounting. But since small businesses are at a higher risk of fraud, forensic accounting will play a role in uncovering fraud. Moreover, it can help in litigation and court evidence gathering.