On June 18, 2014, our ACFE Chapter and partners, the Virginia State Police and Health Management Systems (HMS), will be jointly conducting a free afternoon training session on the topic of ‘Advanced Trends in Data Analytics’ at the VSP Training Academy here in Richmond. Several of us were struck in going over the speaker’s presentation by how useful something as basic as fundamental financial analysis can be to fraud examiners and other assurance professionals in setting up and implementing the sorts of advanced analytical testing that companies like HMS are pioneering to such good effect.
I can remember graduate finance classes at the University of Richmond so many years ago where we were told what an important tool financial analysis could be at every level of management, but especially for anyone tasked with performing operational and compliance reviews. After reviewing the foundational steps needed to effectively set up and use today’s advanced analytical and data mining techniques, I think fraud examiners in general would be well advised to develop or update even their basic financial analysis skills so as to do a more efficient job as the ‘fraud expert’ on the data mining and analytics team directing what to test and how much to test it to efficiently identify and investigate the various types of financial frauds.
Fraud examiners should plan to actively reach out to financial analysts (FA’s), initially when performing fraud risk assessments, and then when setting up analytics and data mining supported testing for the suspected presence of fraud or to investigate actual fraud. The FA is an expert in the construction and analysis of ratios and comparisons derived from all the entity’s financial data but especially from its financial statements. If the entity is a public company using some taxonomy of XBRL markup language to prepare and file automated quarterly and annual statements with the SEC, the company’s FA will be an invaluable resource to the fraud examiner in structuring the analytic, financial data tests essential to building her case.
Comparison analysis of financial data can be performed simply or, depending upon the data moving and crunching tools available, with great sophistication. What are the established financial expectations for the entity under review from one performance period to the next? This is a question that can be answered in almost any degree of detail and the answer, as any auditor knows, can be quite important when seen in the context of the investigation of any on-going fraud or financial irregularity. The fraud examiner working with the FA can piggy back on the FA’s existing work to examine actual account balances, relevant to an actual fraud or postulated fraud scenario, from current and prior periods, as well as to budgeted or forecasted plans that anticipate actual results for a past or current period.
And don’t look down on humble ratio analysis in the hands of an experienced FA as a tool to guide the setup of advanced analytic procedures. Even though ratio analysis is by far the most commonly used type of basic financial analysis, it can still provide information on the effectiveness and efficiency of operations and highlight relationships between target accounts in light of industry and economic trends … as such it’s can be very effective for the fraud examiner who wants to demonstrate a client’s due diligence in the application of systems of internal controls associated with best practice. Because ratio analysis is fundamentally about actual and expected relationships between items of financial data as manifested over time, significant changed in the ratios from period to period are usually caused by the type of apparent or recurring “errors” or “poor performance” that often mask on-going frauds.
By working with an FA who has developed a powerful set of ratios specific to the client, the fraud examiner is forced to understand quickly not only the operations of the examination target organization but also those of its industry; we all know how useful it is to be able to demonstrate to a jury that financial shenanigans we’ve uncovered in connection with investigating a suspected fraud are just not typical of enterprises in the target’s industry … ratio analysis can be of great help in forcefully demonstrating that point to a judge and jury.
The Achilles heel of analytics, data mining, comparison and ratio analysis as tools for fraud examination is that these three techniques primarily look at what was previously done or experienced at the company and, by straight-forward extension, at what was anticipated. This is where the FA can come in to assist the fraud examiner using financial information to build her case to avoid the many pitfalls and minefields inherent in these types of data. The FA might say, for example, that anticipated performance does not necessarily indicate what constitutes good performance or even what should necessarily be expected from effective and efficient business operations; for those reasons she will warn that our fraud examiner might want to expand her comparison and ratio analysis based analytic tests to include a general look at other players in the same industry … in other words, applying ‘best of class’ comparisons across comparable companies before drawing conclusions based only on the performance, or lack thereof, of a single company. This is only a single example of how useful FA’s can be in sharpening the investigation of financial data, especially if they are experienced with the client.
In every case, whether employing simple ratios or comparison analysis or building complex analytical tests, fraud examiners must use their own professional judgment but that doesn’t mean, as in the case of the FA, we can’t all use some help from time to time from our professional friends!
