The Auditors Responsibility in the Detection of FraudPublic Perception Issues

The Auditors Responsibility in the Detection of FraudPublic Perception Issues

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The Public Oversight Board of the American Institute of Certified Public Accountants (AICPA) SEC Practice Section commented in 1993 that there has been a significant public concern regarding the accounting profession's performance in detecting management fraud. This concern appears to be the result of the highly publicized cases of accounting improprieties that have taken place in recent years. Included in the list of companies that have been rocked by extensive fraud are Phar-Mor, ZZZ Best, Crazy Eddie's and the Grabill Corp., just to name a few. These cases and others have been discussed ad nauseam in the past. Senate committees have been convened to explore audit issues, public confidence and audit failure. Although there is a perception that fraud schemes are complex and difficult to unravel, in reality, most frauds are carried out with relative simplicity. One accounting scholar recently opined that collusive fraud is impossible to detect. In fact, based on cases reported to the AICPA's Quality Control Inquiry Committee, one of the most prevalent reasons that an audit appears to fail is an inappropriate response by an auditor to clear indications that appear during the audit process.[1]

In 1988, to continue to enhance the self-regulation of the accounting profession, the Auditing Standards Board (ASB) issued Statement on Auditing Standards No. 53 (SAS No. 53), The Auditor's Responsibility to Detect Errors and Irregularities. The major purpose of this statement was to narrow the gap between a financial statements user's perception of the independent auditor's responsibility to detect material fraud and actual professional requirements and practice. However, because public concern and a perception gap regarding the auditor's responsibility for detecting fraud heightened after this standard was adopted, as a result of some of the cases mentioned above along with Congressional inquiry, the ASB determined it was time for a new pronouncement. In February 1997, the ASB released SAS No. 82, Consideration of Fraud in a Financial Statement Audit, which supersedes SAS No. 53. This article will provide an overview of the new fraud auditing standard, which is important to understand in the context of financial reporting and fraud.

This new standard, which is effective for audits of financial statements for periods ending on or before December 15, 1997, provides expanded guidance to the audit practitioner in assessing fraud characteristics, evaluating audit test results, documenting procedures performed and communicating fraud findings to management. It also clarifies, but does not expand, the auditor's responsibility to detect fraud. To further this goal, the ASB amended SAS No. 1 (AU Section 101), Responsibilities and Functions of the Independent Auditor, to revise the auditor's responsibility for detecting fraud as follows:

"The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by fraud or error. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that errors of fraud that are not material to the financial statements are detected."

This revised statement of responsibility of the independent auditor clearly articulates that the auditor is only obtaining reasonable, not absolute assurance, that material misstatements are detected. An auditor cannot obtain absolute assurance because the fraudulent activity typically involves collusion or forged documentation. Therefore, even a properly conducted audit may not detect a material misstatement from fraud.

Two types of fraud are identified that the auditor must be cognizant of when performing a financial statement audit. The first is misstatements arising from fraudulent financial reporting. This fraudulent activity can be characterized as follows:

  • Manipulation, falsification or alteration of accounting records or supporting documents.
  • Misrepresentation in, or intentional omissions from, the financial statements, transactions or other significant information. For example, although management knew that, due to environmental issues, the entity's cost basis of land and building reported in the financial statements should have been revised downward, this fact was concealed from the independent auditors.
  • Intentional misapplication of generally accepted accounting principles (GAAP).

For example, misstatements arising from the misappropriation of assets that involves the theft of an entity's assets causes the financial statements to not be presented in conformity with GAAP. Examples are embezzlement, theft of assets and making payments to fictitious vendors. However, normal inventory shrinkage due to theft in a retail environment probably would not cause a misstatement to the financial statements, as long as the losses are properly included in cost of goods sold. In this instance, the financial statements would still be considered to be in conformity with GAAP.

SAS No. 82 requires the auditor to specifically assess the risk of material misstatement in financial statements due to fraud as part of the procedures performed in an audit engagement. To accomplish this, the standard provides the auditor with a rather exhaustive list of fraud risk factors to consider. Examples of these risk factors are management compensation tied to profits, management disregard of regulatory authorities, poor controls over assets and missing documents. The significance of such risk factors vary and cannot be ranked in order of importance. An auditor must exercise professional judgement when assessing risk. Additionally, the entity's size, complexity and ownership characteristics also come into play in this evaluation process.

The assessment of risk is an ongoing process that should be considered by the auditor throughout an audit. Conditions may be identified during the fieldwork stage of an audit, which may change or support a judgment that the auditor has made during the planning stage of the audit. These conditions include discrepancies in the accounting records, conflicting or missing documents, unusual reaction of the client to an auditor request, such as denied access to records, facilities and employees. The auditor's response to these or other identified risk factors may range from little change in planned audit procedures to withdrawal from an engagement. Also, the auditor may decide to modify audit procedures. Some examples of such responses are:

  • Visiting inventory locations to observe inventory on an unannounced basis.
  • Contacting major customers and suppliers orally in addition to written confirmation.
  • Confirming with customers relevant contract terms and the absence of side agreements, such as the right to return merchandise.

An auditor's response to fraud depends on materiality. Small matters require that appropriate levels of management are notified. Larger issues require careful consultation, planning and response. Normally, an auditor is not required to notify third parties regarding fraud detection.

It is important that users of financial statements understand the auditor's responsibility in the consideration of fraud in a financial statement audit. Resignation of an auditor may be a trouble indicator to third parties such as insolvency counsel. An auditor cannot provide absolute assurance regarding the detection of fraud, whether by collusion or falsified documentation. Insolvency professionals should understand the auditor's limited role in detecting fraud, and be aware of fraud indicators and auditor resignations.


Footnotes

[1] Howard Groveman, "How Auditors Can Detect Financial Statements Misstatement," Journal of Accountancy (October 1995).[RETURN TO TEXT]
Journal Date: 
Saturday, November 1, 1997