A top-to-bottom forensic accounting investigative analysis before can save millions after.

Nearly a decade after the financial crisis and almost eight years after passage of the Dodd-Frank Act, companies continue to grapple with how to prevent corporate fraud and respond when it happens.

Many remain in reactive mode, waiting until they have an inkling that something might be amiss before taking a hard look at their accounting and management procedures. Those companies often lack sufficient controls to find and avert fraudulent activity—which, in turn, may subject them to government scrutiny, substantial fines, and public embarrassment.

Meanwhile, Dodd-Frank has given federal regulators strong, new anti-fraud enforcement tools and has empowered corporate whistleblowers to report suspected wrongdoing. Under Dodd-Frank, whistleblowers received additional protection from retaliation in the workplace and financial incentives for providing actionable information to the Securities and Exchange Commission (SEC).

In a report to Congress last year, the SEC said it had paid out “$111 million to 34 whistleblowers whose information and cooperation assisted the agency in bringing multiple successful Commission enforcement actions and related actions.” More than half of that amount was collected in the 2016 fiscal year alone—a signal that the program is accelerating as it matures. Companies have been forced in the wake of whistleblower activity to pay more than $584 million in fines and $346 million to disgorge ill-gotten gains and interest.

Clean-Up and Cooperation

For companies, an internal investigation by a forensic accounting specialist can help root out financial misconduct, create strong accounting controls, and improve prospects for the company in the event that it does face federal regulators. Acting to clean up one’s own mess is not only the right thing to do—it provides a company with additional cover when facing the government.

How and when a company deals with fraudulent activity is a key component in the way the government views a case. When companies discover wrongdoing, the biggest decision they face is whether to self-disclose their issues to the government. Regulators have been working to make self-disclosure an easier pill for companies to swallow. During the last several years, the federal government has made it clear that it will reward companies that identify fraud and come forward to report it.

The policy was refined in 2015 by the Yates Memo, named for then-Deputy Attorney General Sally Yates. The memo laid out Department of Justice policy around cooperation and stated that corporations must provide all related facts and identify all individuals involved in misconduct if they expected to receive credit for their cooperation. If a company can show that it has made a strong effort to remediate issues, regulators may give it a far greater benefit of the doubt when assessing penalties.

That’s where having had a forensic accountant investigate issues can be a major help. The government will see that the company has had a top-to-bottom analysis of its financials by an independent professional trained to spot reporting anomalies. The activities of key personnel would have been scrutinized. Managers and rank-and-file employees would have been interviewed to determine how a fraud occurred and who was involved. And the accountant/investigator would have worked with company executives to create new controls to prevent issues from occurring again.

Cooking the Books: A Few Common Recipes

When forensic accountants like the ones at K2 Intelligence investigate misconduct, they find that those committing accounting fraud often rely on a few common tricks to inflate revenues and profits. Areas most often manipulated include:

Revenue and Expense Recognition. Revenue recognition is supposed to occur when a company receives income from its goods or services. But a company cooking its books might recognize revenue before it’s actually earned. Similarly, it might manipulate the date it incurs expenses. Both moves can artificially inflate profit or help cover up losses.

Capital Expenses. Companies may also improperly convert operating expenses into capital expenditures. With a capital expense, a company need not reflect all of the cost at once on its balance sheet. Some of the cost can be taken as depreciation over a longer period. This helps reduce expenses and boosts profitability.

Cost of Goods Sold. The size of a company’s inventory can also be manipulated to help improperly boost profits. In general, the more inventory sold, the higher the costs to the company. Conversely, the more inventory on hand, the lower the costs incurred. Thus, the company may report more inventory on hand at the end of the fiscal year than it actually has—lowering expenses and inflating profits.

A forensic accounting investigation may uncover any number of reasons that employees may have participated in a fraud. Manipulating the profit-and-loss statement can drive up stock prices or help the company secure debt. Stronger revenue may allow the company to better position itself for a sale or for an initial public offering. For executives, a brighter profits picture could enhance bonuses, putting money directly into their pockets.

Whatever the motive, accounting fraud puts the company at extreme risk. A well-managed forensic effort can help stop the behavior, stave off a regulatory meltdown, and give the company the controls it needs to build a fraud-free future.