What is “Forensic Accounting Analysis”?
Forensic accounting analysis involves detailed scrutiny of company financial statements to establish whether a company’s reported performance and position provide an accurate picture of its ‘true’ performance and position. This analysis can use either private information (for a deal) or public information (for investment research).
Although it’s easy (and maybe more exciting!) to assume that forensic analysis is looking only for evidence of major fraud, in reality, analysts are usually looking for evidence of bias in the decisions and judgments made by management when preparing the financial statements. For example, evidence of aggressive revenue recognition or evidence of off-balance-sheet financing. These are commonly observed early warning signs that something ‘worth hiding’ is being concealed by management. Forensic accounting is also used to assess leverage and build more robust expectations of future cash flow. It is therefore a key technique in credit analysis, deal due diligence (M&A and LBOs), and investment research.
Forensic analysis typically combines ratio analysis and scrutiny of key disclosures in the financial statements. This helps highlight which elements of the financial statements are ‘at risk’ of being manipulated by management; this is much more revealing (and more efficient) than just reading the financial statements from cover to cover. The cash flow statement receives the most amount of scrutiny because it gives a good indication of earnings quality and links the income statement and balance sheet.
Key Learning Points
- Forensic accounting analysis helps us assess whether financial statements reflect a company’s ‘true’ performance and position
- The cash flow statement is particularly important for forensic analysis as it helps assess earnings quality and links the income statement and balance sheet
- Forensic analysis can provide evidence that the balance sheet or earnings are being manipulated by management. It may therefore be used in corporate governance analysis
What does Forensic Accounting Analysis involve?
Forensic analysis combines ratio analysis and scrutiny of key disclosures in the financial statements. Analysts typically begin their analysis by looking at the following areas:
- Cash flow statement and earnings quality ratio analysis
- Non-GAAP metrics and the quality of adjustments made by management
- Classification of cash flow statement transactions
Once this analysis is complete, financial analysts then typically utilize the footnotes to identify whether any concerns can be explained by business developments.
Commonly identified issues include:
- Cherry-picking of adjustments to non-GAAP metrics
- Aggressive use of management estimates (particularly in relation to revenue recognition and inventory)
- Over capitalization of costs in the balance sheet
- Use of off-balance-sheet financing
Why is Forensic Accounting Analysis important?
Forensic accounting analysis is used to give reassurance of the accuracy of the reported performance and position of a company. It is used to assess leverage and make more robust predictions of future cash flows, which then impacts credit analysis and company valuation.
Forensic accounting, therefore, plays a critical role in several areas of financial analysis, including:
- Credit analysis for deal structuring or lending decisions
- Deal diligence for M&A, LBOs and IPOs
- Equity valuation for equity research and bond valuation for credit research
In addition to this, if forensic analysis provides evidence that a company’s reported performance or position is being manipulated by management, this will raise corporate governance concerns. Therefore, forensic analysis can be used as an input into corporate governance analysis.
Check your understanding
Below is a multiple-choice question to test your understanding of this topic. Download the accompanying excel exercise sheet for a full explanation of the correct answer.
Learn more about accounting analysis with our forensic accounting course.