UK: An Introduction to Forensic Accountants
Alvarez & Marsal
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Forensic accounting broadly encompasses three overlapping areas: Financial analysis and fraud investigations, dispute resolution (particularly expert services, litigation support and expert determinations), and forensic technology services. Forensic accountants regularly work with diverse stakeholders, including law firms, regulatory bodies, in-house legal teams, law enforcement agencies, corporations, and individuals.
Forensic accounting is global by nature and closely impacted by geopolitical events. The workload of forensic accountants over the next year will be significantly affected by the continuing impact of the COVID-19 pandemic, the Russian invasion of Ukraine, and a global economic slowdown which threatens to tip countries into recession. In the UK, the government support schemes that were put in place during COVID-19 have now ended, coinciding with new challenges for companies including higher interest rates, rising inflation and supply chain disruptions.
From a disputes perspective, the London Commercial Courts had a record year in 2020–2021. All of the major arbitration bodies, including the London Court of International Arbitration and the International Court of Arbitration, also had a record year in 2020. Between 2020–2021 there was an increase in non-EU foreign litigants in the UK courts, most notably from the USA and Russia. In the same time frame, the proportion of EU litigants declined – principally due to Brexit but potentially also the result of international commercial courts being established across the EU. Despite a reduction in referrals to the London Commercial Courts and most of the arbitral bodies during 2021, this trend is expected to reverse as we return towards pre-pandemic levels, and as a result of the wider repercussions of the Russian invasion of Ukraine on transactions and agreements. We also expect to see a significant number of new cases arising as issues which were deferred due to the pandemic re-emerge.
From an investigations perspective, there is likely to be a significant increase in forensic accounting work arising from the current economic climate, a renewed focus on economic crime, increasing sanctions activity, increasingly complex and contentious insolvencies, as well as stakeholder focus on ESG.
Forensic accountants are well-placed to support stakeholders through complex scenarios. Below, we set out the key trends we expect to see over the coming year. The global economic slowdown, the ongoing conflict in Ukraine, and COVID-19 will have profound impacts on our working lives in 2022 and will leave their mark on key industry trends.
Fraud and Accounting Misstatements
The investigation and assessment of fraud and accounting misstatements will continue to form a significant part of a forensic accountant’s work.
2021 saw record numbers of global mergers and acquisitions (M&A) deals, often performed at speed and with limited due diligence. The value of global publicly-disclosed deals in 2021 has been reported as approximately USD5 trillion, far larger than the previous record of approximately USD4 trillion in 2007. Given the unique global economic pressures experienced in 2022, we are likely to see buyers scrutinising the value of their historical purchases. A particular challenge for post-acquisition disputes will be the separation of the impact of misrepresentations and/or false warranties on a target’s value from the impact of COVID-19.
We expect to see increasing regulatory attention to directors’ conduct. As the UK debate on audit reform continues, we will see greater scepticism and scrutiny applied by company auditors, placing greater incentives on company directors to report and investigate irregularities.
Worsening economic conditions are inherently linked with fraud. COVID-19 brought unique opportunities for fraudsters, as companies shifted operations and employees worked from home with reduced levels of internal controls and management supervision. The scale of this will become apparent as companies continue to restart operations and return to offices. In particular, we may see increasing whistle-blower reporting and issues in companies’ management of conflicts of interest. Investigating these issues will be difficult, as much of the relevant data may reside on personal systems and devices that may not be easily accessible.
As the UK faces worsening economic conditions and increasing technology use, we will see increasingly complex frauds. For example, investment fraud schemes that involve cryptocurrency and digital payment platforms are likely to increase, especially as regulation around cryptocurrency comes into force and more consumers use crypto-products. Increasingly complex fraud ultimately leads to more complex and contentious insolvencies. Litigation funding, seen as an attractive choice for litigants in complex and unpredictable cases, will remain an essential part of contentious insolvency.
On-going impact of COVID-19 on quantum of loss calculations
There are two areas of loss quantification that illustrate how COVID-19 is likely to have a lasting impact on the work of forensic accountants: Valuation methodology and attribution of alleged losses to COVID-19 in investor-state disputes.
Accounting for COVID-19 in valuation methodology
Disputes about the purchase price of an acquisition target often centre on how the target company is valued at the acquisition. Commonly applied valuation techniques derive a target’s value either by way of an assessment of the target’s future cashflows, adjusted for the risks associated with those cash flows, or by applying a valuation “multiple” to the target’s financial metrics. This multiple is calculated with reference to similar companies operating in common industries as the target. Both methodologies are heavily dependent on historical financial information of either the target or the comparable companies.
Future cashflow forecasts are reliant on assumptions as to a company’s expected performance and are often based, in part, on historical performance. Where the target’s historical cash flows were impacted by the COVID-19 pandemic, the forensic accountant must assess the extent to which such effect was the result of COVID-19 and assess the likely extent of – and timeframe for – recovery. Similarly, the reliability of valuation techniques that apply industry-specific multiples will require more scrutiny, as multiples are based on historical trading data and will therefore have been impacted by comparators’ performance during COVID-19.
Attributing alleged losses to COVID-19 in investor-state disputes
The aftermath of COVID-19 is likely to influence the nature of investor-state disputes. Throughout the pandemic, governments implemented far-reaching measures that impacted supply chains, consumer activity, and infrastructure. These measures may leave governments vulnerable to allegations that they have breached their International Investment Agreements, if investors can build a case that they have suffered a loss as a result of government measures that were discriminatory, arbitrary, or disproportionate. In such cases, the forensic accountant will need to assess which factors contributed to the investor’s alleged losses and isolate specific factors that can be attributed to the respective government’s actions. Extricating the impact of a government’s actions from the wider impact of COVID-19 will prove challenging.
Increasing impact of Environmental, Social, Governance (ESG) factors
We expect an uptick in the influence of ESG on all areas of business, as companies balance increased stakeholder focus on ESG with the high costs of ESG compliance. We are already seeing litigation involving “greenwashing” claims against fund managers and banks. As more and more businesses articulate emissions-related pledges, we expect to see increasing numbers of investigative compliance reviews by businesses proactively assessing their own ESG policies.
Many stakeholders now see ESG as a key factor to the long-term success of a company. As such, during M&A activity, buyers are increasingly using ESG measures when analysing target companies for acquisition. This leaves the target and seller exposed to litigation if the target had articulated ESG commitments that it subsequently does not achieve. We expect an increase in requirements for ESG due diligence, both during M&A for the valuation of a business and during post-acquisition disputes as buyers seek damages for misrepresented ESG claims.
Increased regulator and public interest focus on integrity and governance is driving higher levels of supply chain scrutiny. COVID-19 recovery, climate risk, and political instability will disrupt supply chains, as nearsourcing and reliance on key suppliers gains prominence. We expect continued demand for operational assessments of: Product footprints; compliance with ethical and legislative standards in modern day slavery, child labour, workplace safety; and the conduct of third parties/associates. Companies’ cyber integrity and data management will become even more significant. It is vital that companies better understand their supply chain and governance risks and fully assess the use of third parties in their business cycle.
Renewed focus on economic crime
In 2022/23, we expect to see a renewed focus on the UK’s fight against economic crime. We anticipate attention being on trade and financial sanctions, anti-money laundering, enhanced tax transparency, and continued pressures on companies to execute effective protection against bribery and corruption. The USA’s 2022 bribery strategy indicated that foreign corporate economic crime will be an area of focus for US enforcement agencies. As such, more UK regulators are beginning to flex their muscles. Trends to watch include whether regulators focus on pursuing economic crime via corporate Deferred Prosecution Agreements or via individual criminal cases and whether corporates will be required to demonstrate adequate procedures against facilitation of economic crime. Although, it appears today that such measures are some way off.
In March 2022, the UK’s Economic Crime (Transparency and Enforcement) Act received Royal Assent. The Act aims to strengthen the UK’s current regime in relation to Unexplained Wealth Orders, create a register of overseas entities that own UK property, and to streamline sanctions implementation. The Act has made the pathway for seeking an Unexplained Wealth Order easier for government agencies, who may seek to appoint receivers in certain circumstances. Further personal insolvencies or Court-appointed Receiverships of a contentious nature are expected as more Unexplained Wealth Orders are issued. Receivers, Liquidators and Trustees are required to unravel complex offshore structures and trusts to recover estate assets for the benefit of creditors. As we expect more complex structures and trusts to be set up to evade recovery, the Court-appointed Receivership will remain a powerful tool within the contentious insolvency market.
In December 2021, the regulator for gambling, the Gambling Commission, published its Compliance and Enforcement Report detailing the regulator’s extensive investigation of the industry. The Gambling Commission issued a record value of fines in 2021 – over GBP32 million issued to 15 firms. The Gambling Commission raised concerns that the industry was below expectation in the performance of customer due diligence and Anti-Money Laundering (AML) assessments. We expect to see the continuing increase in demand by companies in the gambling sector for a full-scale compliance review, as these businesses are recognising the need to raise their standards to achieve compliance with AML requirements and treating customers fairly.
Increased complexity in funds tracing
Sanctions enforced globally following President Vladimir Putin’s invasion of Ukraine are likely to have ongoing repercussions for due diligence requirements. In March 2022, the UK government issued guidance to Insolvency Practitioners to state that, although a creditor who is sanctioned is permitted to take part in an insolvency process and make a claim for payment, the sanctions regime would in most cases preclude payments to sanctioned entities. This also applies if payments are due to a company that is owned or controlled by a sanctioned entity. Given the changing nature of the international sanctions regime, forensic accountants will need to be able to respond quickly and efficiently to shifting requirements and marshal large volumes of data to comply with legislation.
We expect further tranches of sanctions to be announced as the geopolitical impact of Russia’s invasion of Ukraine continues to unfold. It is likely that sanctioned individuals will seek to protect their assets via complex ownership structures, while entities and individuals at risk of being sanctioned will be moving their assets away from jurisdictions likely to impose restrictions. This could create complexities with asset tracing and recovery efforts, especially with assets located in jurisdictions that are not constrained by English law. A significant development to watch is what will happen to the sanctioned individuals’ assets, and which portion of such assets will ultimately be identified, recovered, and sold. One may also expect the sanctions regime to lead to a number of both corporate and personal bankruptcies.
It has been recognised that challenging a sanctions designation is incredibly complex. As the scope of sanctions increase, it is likely that the number of individuals caught in the crosshairs will also increase. This typically creates a demand for firms who can perform a funds tracing exercise to determine the source of funds subject to freezing orders.
Demand for asset tracing and recovery expertise will expand in response to the requirement to identify global and offshore assets as part of non-performing loan resolutions, insolvency recoveries and enforcement of arbitral awards and litigation damages.
Increasing scrutiny over banks’ COVID-19 lending practices
Throughout the pandemic the UK Government supported businesses with a total of GBP80 billion in government-backed loans, including schemes such as the Coronavirus Business Interruption Loan Scheme, the Bounce Back Loan Scheme and the Recovery Loan Scheme. Banks were tasked with administering and lending these funds, which included performing some degree of due diligence over borrowers.
The National Audit Office has estimated that as much as GBP4.9 billion of COVID-19 loans could have been given out fraudulently. Chancellor Rishi Sunak has committed over GBP100 million to an anti-fraud taskforce responsible for recovering falsely-claimed funds. The British Business Bank is deploying sophisticated data analytics to identify fraudulent loans. These measures may bring increased scrutiny over banks’ lending practices.
Banks, having been more focused on forbearance regarding loans, are looking closely at loan management and recovery as interest rates rise. Banks should be performing an independent risk analysis to assess their potential financial exposure to loan defaults, and to identify loans that were issued to potential fraudsters. Each bank should be performing a detailed review of the due diligence procedures undertaken historically when the loan applications were assessed and approved. This will highlight any shortcomings in the bank’s procedures and identify key risk areas requiring remediation.
The COVID-19 loan fraudsters are almost certainly involved in other activities that warrant investigation and review. This could result in an increase in demand for forensic accountants to identify whether fraud has taken place and to identify potentially recoverable assets.