Chapter 4 forensic accounting and fraud detection: the increasing role of data analytics

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Chapter 4 forensic accounting and fraud detection: the increasing role of data analytics

Michael E. Brodsky

Anthony DeSantis

Jonathan Nash

The key stakeholders in a midmarket merchandising company were baffled. The company's financial statements showed positive cash flow, but its revolving line of credit was insufficient to fuel the business. Standard metrics, notably EBITDA and the balance sheet, indicated that the business was healthy. Yet directors, private-equity shareholders and lenders realized that its performance was quickly degrading to the point that the company's lenders were threatening foreclosure action.

The lenders called for a collateral "audit." The analysis revealed a massive, brazen fraud by the company's tenured CFO, not for personal gain but simply to hide the deteriorating conditions. The CFO was fired, and the company was ultimately sold below liquidation value, with the extent of the fraud never fully determined.

Could the company have avoided this fate? A proper fraud-prevention program that employs both data analytics and the skills and experience of forensic professionals very likely could have detected the fraud earlier and helped avert the meltdown.

How can organizations evolve from reacting to damaging fraud incidents such as this to proactively identifying fraud threats and indicators? This chapter provides an overview of the data analytics tools and methodologies available to fight fraud originating internally or externally, both to test for instances during a restructuring and as an ongoing organizational priority. In the hands of forensic accountants and other investigators of varying experience levels, data analytics can become a potent tool both for fraud prevention and retrospective assessment of fraud incidents.

I. Why Data Analytics?

Individuals who come forward with information on existing or potential fraud can find themselves praised by investigators, thanked by victims, and occasionally romanticized in literature and film. Indeed, whistleblower tips are vital to uncovering many schemes, and encouraging and pursuing them is an obvious component of an effective anti-fraud strategy.

However, less than half (about 42 percent) of occupational frauds — those committed by employees — have been found as a result of tips.¹⁵ Many more schemes can be uncovered through other means, such as management reviews and internal audits, while others may never be found or may only be "stumbled upon" inadvertently. A more proactive approach involving data analytics can be vital to uncovering fraud. Fueled by increasing computing power and new tools, analytics complement and strengthen in a cost-effective manner the capabilities of forensic accountants and other professionals engaged in fraud discovery and investigation.

Analytics can uncover patterns and clues in voluminous data that humans simply cannot divine on their own, leading to faster, more targeted analysis. Analytics can help investigators such as forensic accountants and data analysts to focus their attention on data subsets that are likely to reveal fraud such as anomalies, outliers and missing items.

II. Analytics and Forensic Accounting: Upping the Detection Game...