FORENSIC ACCOUNTING

• Forensic accounting utilizes accounting, auditing

and investigative skills to conduct an examination
into the finances of an individual or business.
• Forensic accounting provides an accounting
analysis suitable to be used in legal proceedings.
• Forensic accountants are trained to look beyond
the numbers and deal with the business reality of
a situation.
• Forensic accounting is frequently used in fraud
and embezzlement cases to explain the nature of
a financial crime in court.
• Forensic accountants analyze, interpret and
summarize complex financial and business
matters.
• They may be employed by insurance
companies, banks, police forces, government
agencies or public accounting firms.
• Forensic accountants compile financial
evidence, develop computer applications to
manage the information collected and
communicate their findings in the form of
reports or presentations.
• Forensic accounting is a combination
accounting and investigative techniques used
to discover financial crimes.
• One of the key functions of forensic
accounting is to explain the nature of a
financial crime to the courts.
• Forensic accounting is used by the insurance
industry to establish damages from claims.
Classification of fraud
• https://www.indiainfoline.com/article/news/s
ome-of-the-biggest-accounting-scandals-5504
117311_1.html
• https://www.ndtv.com/topic/accounting-fraud
• https://www.hindustantimes.com/business/sa
tyam-scam-all-you-need-to-know-about-india-
s-biggest-accounting-fraud/story-YTfHTZy9K6N
vsW8PxIEEYL.html
• https://www.ft.com/content/c1231f40-f695-1
1e7-88f7-5465a6ce1a00 (PwC
Banned)
 Behavioral aspects of fraud
• To proactively manage the fraud, organizations
should attempt to understand the behavioral
root cause of fraud.
• Who commits fraud and why it is done.
• Behavioral scientists consider fraud to be
intentional acts that are committed by human
beings by deception, trickery, and cunning.
• Frauds can be committed by two types of
misrepresentation; suggestion of falsehood or
suppression of truth.
• Any white collar crimes have three factors-
supply of motivated offenders, availability of
suitable targets, absence of capable guardians.
• Employees obtain a key position in committing
such frauds
• They do it themselves or assist external
parties in doing so.
• Pump and dump scams
• Boiler room scams
Origin and growth of Forensic Accounting

• The origin of Forensic Accounting dates back to

ancient Egypt
• The first recorded history of FA in India dates
back to 300 BC and is credited to Mauryan
period.
• Kautilya in his book Arthashastra, Archimedes
and Birbal were some of them who found tricks
to investigate various crimes and incidences.
 3 major audit objectives
• Detection of fraud
• Detection of technical errors
• Detection of errors in principle
 Areas of FA
• Fraud
• Valuation
• Bankruptcy
• Forensic accountant is expected to have:
• Knowledge of accounting, auditing, legal
environment and good communication
• Capable of summarizing, analyzing, interpreting,
and presenting complex financial issues.
 Forensic Accounting in India

• Given the nature and types of fraud in India, the Reserve

Bank of India (RBI) has compulsorily made forensic
accounting audit mandatory for all banks within the
country. The establishment of Serious Fraud Investigation
Office (SFIO) in India has become the turning point for
forensic accountants in the country. The indications of the
growing demand for the field are:
- The growing list of online criminal offences
- Breakdown of regulators to trace and detect cyber-
security frauds
- The long chain of co-operative banks going bust
Fraud theories
Triangle of fraud action
 Fraud scale
• The scale ranked situational pressure, perceived
opportunities, personal integrity
• Situational pressure is described as the immediate
problem that individuals experience within their
environment
• Opportunities are created by deficient or missing
internal controls
• Personal integrity is a complex issue about the
personal code of ethical behavior adopted by each
individual
Fraud diamond
• Capability is the sum total of the individuals personal
traits and abilities.
• There are four observable traits in committing fraud
• An authoritative position of a person
• Capacity to understand and exploit the accounting
system and weakness in the internal control
• Confidence that the fraud will not get detected, and if a
person is caught, can get out of it easily
• The capability to deal with the stress created within the
person, when the act of fraud is committed.
 MICE
• Money, Ideology, Coercion and Ego.
• Money & Ego are the main motivators for the
perpetrators of fraud
• Ideology is not a very strong motivator but in many
instances, perpetrators resorts to frauds like evasion of
taxes and money laundering under the pretext that they
are achieving certain perceived greater good.
• Coercion is a situation where unwilling individuals are
pressured into participating in fraudulent activities.
• Money:
• If a person with privileged access to
information needs money badly enough, they
may be tempted to sell government secrets to
keep themselves afloat. That’s why financial
reasons are so consistently the top cause of
security clearance denial or revocation; people
do foolish things when they’re strapped for
cash
• Ideology

• For those that fall in the hacktivist group of

threat actors, ideology is a big motivating factor.
For example, the Syrian Electronic Army uses
their ideology and support for troubled Syrian
leader Bashar al-Assad as motivation behind
their many successful attacks on media outlets,
government organizations and private citizens.
• Compromise

• The term compromise here is more about the threat

in the human terrain, or the insider threat, and not
the digital one. Compromise can be seen in the form
of blackmail or coercion of an individual to assist in
corporate espionage or sabotage. These actions
could be assisting with remote or physical access or
giving up proprietary data, intellectual property or
sensitive system information.  
• EGO:
• In the world of insider threats, money may be
the shot, but ego is usually the chaser.
 Tools in FA
• Ratio Analysis
– Continuous high level of cash, cash equivalents
and current assets: Satyam Computers showed
high cash balance over the years. Later it turned
out it had inflated cash and bank balances by as
much as Rs 5,040 crore.
– Sudden increase in inventory/sales ratio: This
indicates the company may be inflating assets such
as inventories.
https://www.ey.com/in/en/services/assurance/fra
ud-investigation---dispute-services/deterrence-and
-detection-of-financial-fraud
• Data Mining Techniques
– Discovery
– Predictive modeling
– Deviation analysis
• Benford’s Law
– Benford’s Law, named for physicist Frank Benford, who worked on
the theory in 1938. is the mathematical theory of leading digits.
Specifically, in data sets, the leading digit(s) is (are) distributed in a
specific, nonuniform way.
– While one might think that the number 1 would appear as the first
digit 11 percent of the time (i.e., one of nine possible numbers), it
actually appears about 30 percent of the time. Nine, on the other
hand, is the first digit less than 5 percent of the time.
– The theory covers the first digit, second digit, first two digits, last
digit and other combinations of digits because the theory is based
on a logarithm of probability of occurrence of digits
• Benford’s Law holds true for a data set that grows
exponentially (e.g., doubles, then doubles again in the
same time span), but also appears to hold true for many
cases in which an exponential growth pattern is not
obvious (e.g., constant growth each month in the number
of accounting transactions for a particular cycle).
• It is best applied to data sets that go across multiple
orders of magnitude (e.g., populations of towns or cities,
income distributions). While it has been shown to apply in
a variety of data sets, not all data sets follow this theory.
 Behavioral corporate finance

Corporate decision making involves high risk. Unless

it is taken with great care and caution, it would
destroy shareholder value and harm all the
corporate constituencies
Approaches to BCF
 Market timing and catering approach
• It is related with securities mispricing
• It assumes that prices in the market can be too
high or low
• These mispricing decisions may give short term
benefits but the prices may get back to their
equilibrium in long run due to their
fundamentals
• Managers usually balance three conflicting goals.
 Managerial bias approach
• It is assumed that managers do have number
of behavioral biases like self attribution,
anchoring, loss aversion, optimism etc
• They believe that their firms are undervalued
and shall encourage over investments from
internal sources
• They found to have preference towards
internal funds
 Irrational investor approach
• Rational managers coexists with irrational
investors
 Irrational managers approach
• CEO overconfidence
• Financial policy
 Issues related to valuation
• Surveys of valuation techniques used in
practice suggest that financial executives
and analysts use the traditional DCF
approach as well as some non- DCF
heuristics.
• P/E ratio, PEG ratio, and price- to- sales
ratio appear to be the most commonly used
non- DCF heuristics.
• Excessive Optimism : optimistic about P/E
• The 1/n Heuristic: use 1/n heuristic , a rule of
thumb that assumes all the methods are
equally valid
• Agency Conflicts: conflict of interest
 Capital budgeting
• First, estimate the post- tax incremental cash
flows associated the project.
• Second, compute the weighted average cost of
capital (WACC). In calculating the WACC, calculate
the cost of equity using the capital asset pricing
model and use market value weights.
• Third, determine the net present value (NPV) of
the project and accept it only if its NPV is positive
• The NPV of a project represents its contribution to the value of
the firm. A close cousin of NPV is the internal rate of return
(IRR) criterion. It is the discount rate at which the NPV is zero.
• The survey evidence suggests that even though in theory NPV is
superior to IRR, in practice IRR has an edge over NPV. Further,
the payback criterion, historically the most important criterion,
continues to be relevant.
• What explains the sustained appeal of the payback criterion
and why is IRR more popular than NPV? A comparison of NPV,
IRR, and the payback criteria suggests that the payback
criterion is the most intuitive whereas NPV is the least intuitive.
• Affect Heuristics: mangers rely on intuition,
instinct, gut feeling
• Overconfidence: perceived control and
inadequate planning and risk mgmt leads to
overconfidence
• excessive Optimism: familiarity, perceived
control, representativeness
• Confirmation Bias:
 Dividend policy
• Merton Miller and Franco Modigliani (MM,
hereafter) provided the standard neoclassical
treatment for dividend policy.
• The central premise of the MM framework is
that the value of a firm depends solely on its
earnings power and is not influenced by the
manner in which its earnings are split between
dividends and retained earnings.
• If a company retains earnings instead of giving is out as
dividends, the shareholders enjoy capital appreciation
equal to the amount of earnings retained.
• If it distributes earnings by way of dividends instead of
retaining it, the shareholders enjoy dividends equal in
value to the amount by which his capital would have been
appreciated had the company chosen to retain its
earnings.
• Hence, the division of earnings between dividends and
retained earnings is irrelevant from the point of view of
the shareholders.
• Despite the tax disadvantage of dividends and the issuance costs associated with external
equity, firms pay dividends and investors generally regard such payments positively.
Why? There are several plausible reasons:
• Investors’ behavioural preference for dividends,
• Information signaling: Actions taken by a company to telegraph its financial outlook. For
example, the declaration of an unscheduled dividend may be a company's attempt to
convey a positive outlook on its earnings prospects and stock price.
• Clientele effect: The clientele effect first assumes that specific investors are preliminarily
attracted to different company policies, and when a company's policy alters, they will
adjust their stock holdings accordingly. As a result of this adjustment, stock prices may
fluctuate.
• Agency cost: Agency costs are internal costs incurred due to the competing interests of
shareholders (principals) and the management team (agents). Expenses that are
associated with resolving this disagreement and managing the relationship are referred to
as agency costs
 Mergers & Acquisitions
• The traditional approach to M&A assumes that the market prices
of both the acquiring firm and the target form reflect their
intrinsic values, assuming that both remain as stand-alone firms.
• However, a merger of the two firms is expected to generate
potential synergistic gains.
• If the acquiring company pays the target company the latter’s
current value plus a premium, the gains for the shareholders of
the acquiring company and target company would be as follows:
• Gain to the shareholders of the acquiring company = Synergistic
gains – Premium paid Gain to the shareholders of the target
company = Premium paid.
• If markets are efficient and acquirers pay a
premium which is less than the real synergistic
gains, acquisitions should create value for the
shareholders of both the acquiring company
and the target company, regardless of the form
(cash or stock) of compensation.
• Further, the level of acquisition activity should
not be a function of the level of the stock
market.
• Empirical evidence, however, suggests the following:
• Acquirers usually pay too much. This benefits the
shareholders of the target company, but hurts the
shareholders of the acquiring company.
• CEOs fall in love with deals and don’t walk away when they
should.
• Mergers and acquisitions thrive during periods of stock
market buoyancy.
• Acquirers who pay stock compensation are more likely to do
value-reducing deals than acquirers who pay with cash or
debt.
• Warren Buffett explains why acquisitions tend
to fail:
• “The sad fact is that most major acquisitions
display an shocking imbalance: They are a
bonanza for the shareholders of the target co
they increase the income and status of the
acquirer’s management, and they are a honey
pot for the investment bankers and other
professionals on both sides.”
• Several behavioural factors seem to explain the discrepancy.
The important ones are:
• Winner’s Curse : The winner's curse is a tendency for the
winning bid in an auction to exceed the intrinsic value or true
worth of an item. 
• Hubris: excessive pride or self confidence
• Managerial hubris is the unrealistic belief held by managers in
bidding firms that they can manage the assets of a target firm
more efficiently than the target firm's current management.
Managerial hubris is one reason a manager may choose to
invest in a merger that on average generates no profits
 Homo Economicus

• Homo economicus is a financial term that

some economists use to describe a rational human being. 
• Homo economicus is a model for human behavior,
characterized by an infinite capability to make rational
decisions.
• The model is generally used in economics and was first
proposed by John Stuart Mills in an 1836 essay defining
the characteristics of political economy.
• Modern research has proved that the theory of an
economic man is a flawed model.
• The most common example provided of homo economicus is that of a
businessperson. The businessperson seeks to eke out profits from each
transaction and decision.
• For example, they may automate operations and lay off workers in order to
maximize productivity.
• Similarly, they might get rid of non-performing parts of their business to focus
on the ones that generate profits.
• A homo economicus being brings the same rationality to their dealings in
other spheres of life. But the theory falls short in explaining the rationale
behind some seemingly irrational decisions.
• For example, rationality should dictate that the rational business person
should use profits from their business to live a fairly economical existence.
But that is not always the case. The prevalence of luxury items and
philanthropy are direct refutations of the theory.
• Homo sapiens, unlike Homo economicus, may have
all sorts of motivations for making specific choices.
The existence of some professions in the arts and
non-profit sector undermines the notion of
maximizing utility.
• All people living today belong to the species Homo
sapiens. We evolved only relatively recently but with
complex culture and technology have been able to
spread throughout the world and occupy a range of
different environments.
• I predict that Homo Economicus will evolve into Homo
Sapiens, or, more simply put, economics will become
more related to human behavior.
• My specific predictions are that Homo Economicus will
start to lose IQ, will become a slower learner, will start
interacting with other species, and that economists
will start to study human cognition, human emotion,
and will distinguish more clearly between normative
and descriptive theories.
• By: Richard Thaler
 Zurich Axioms
• https://www.capitalideasonline.com/wordpre
ss/lessons-from-the-zurich-axioms/
 Future of BF
• https://economictimes.indiatimes.com/marke
ts/stocks/news/behavioural-finance-what-is-in
-it-for-investors-wealth-managers/articleshow
/69958222.cms?from=mdr
• https://blogs.cfainstitute.org/investor/2018/0
1/04/best-of-2017-behavioral-finance-and-indi
a/