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AUDITORS’ LIABILITY IN DETECTING FRAUD, FRAUD SCHEMES AND RED FLAGS

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  • AUDITORS LIABILITYIN DETECTING FRAUD, FRAUD SCHEMES AND RED FLAGS

  • AUDITORS LIABILITYThe responsibility of auditors to safeguard public interest has increased as the number of investors increase and also the stakeholders also demand more accountability.When auditors agree to perform audits they purport to be experts in assessing the fairness of the financial statements.Even if the audit is performed at the highest level of quality, the firm can still be sued and incur substantial legal cost.Even if the firm wins the case the reputation is tarnished.

  • AUDITORS LIABILITYIt is not only auditors who are being sued, students sue lectures, patients sue doctors etc.The following are the factors which lead to increased litigation.Liability environment and the laws. The deep pocket theory i.e. sue those who can pay.Pressure to reduce audit time and feesSome investors view audit as an insurance policyLaw firm payments i.e. contingent fee payment (payment made only if the case is won)Increased complexity of audits

  • AUDITORS LIABILITYCauses of legal actionBreach of contract- fails to perform contractual duty e.g. if hired to find fraud and you dont.Negligence- failure to exercise reasonable care thus causing harm to investorsInvolvement in fraud- intentional concealment or misrepresentation of material fact.

  • AUDITORS LIABILITYMinimizing liability exposures.Policies to help assure auditor independencePartner rotation- brings fresh approachRestrictions on non-audit servicesAudit independence programsSound quality controlsIntegrity and objectivityPersonnel managementContinuance and engagements of clientsmonitoring

  • AUDITORS LIABILITYReview programsExternal inspectorsPeer reviewsContinuing educationDefensive auditingMeans taking special action to avoid litigation e.g.Issuing engagement letter- cornerstone of every defense. It states the scope.Screening clientsNot taking engagements they cant handle.Maintaining accurate audit documentationAppropriate insurance

  • Detecting FraudThere has been numerous examples of fraud cases and alleged auditor negligence such as the cases of:Enron- Arthur AndersenXerox- KPMGWorldCom- Arthur AndersenThese scandals are synonymous with fraudulent financial reporting.

  • Detecting FraudIn many of the cases against the auditors, the auditors failed to obtain appropriate evidence or failed to recognize and follow up on the red flags.Historically, external auditors have counted on the internal controls as the main defense against fraud, but this cannot work if managers themselves can override the controls

  • Detecting FraudFraud can be divided into three main categories:Asset misappropriationFraudulent financial reportingcorruption

  • Detection MethodsTo reduce the risk of having frauds occurring the auditors should use such practices as:Horizontal and vertical analysisConducting frequent ratio analysis, including assessment of trends over periods of several years.Rigorously applying the guidance of SAS No.99 to all audit exercises.

  • Statement of Auditing Standards SAS- is an auditing statement issued by Auditing Standard Board of the American Institute of Certified Public Accountants (AICPA)To serve as a cornerstone of anti-fraud program AICPA issued SAS No.82: consideration of fraud in financial statements audit.It was then superseded by SAS No.99: consideration of fraud in financial statement fraud.

  • SAS No. 99SAS 99 defines fraud as an intentional act that results in a material misstatement in financial statements. There are two types of fraud considered: misstatements arising from fraudulent financial reporting (e.g. falsification of accounting records) and misstatements arising from misappropriation of assets (e.g. theft of assets or fraudulent expenditures).

  • SAS No. 99The standard describes the fraud triangle. Generally, the three fraud triangle conditions are present when fraud occurs First, there is an incentive or pressure that provides a reason to commit fraud Second, there is an opportunity for fraud to be perpetrated (e.g. absence of controls, ineffective controls, or the ability of management to override controls.) Third, the individuals committing the fraud possess an attitude that enables them to rationalize the fraud.

  • SAS No. 99- RequirementsRequires brainstorming sessions to discuss how and where the entitys financial statements might be exposed to material misstatement due to fraud.This requirement is a new concept in audit standards and it has two primary objectives. The first objective is that the engagement team will have an opportunity for the seasoned team members to share their experiences with the client and how a fraud might be perpetrated and concealed. The second objective is to set the proper tone at the top for conducting the engagement. The brainstorming session is to be conducted in a manner that models the proper degree of professional skepticism and sets the culture for the entire audit.

  • SAS No. 99- RequirementsRequires the auditor to gather information necessary to identify risks of material misstatement due to fraud by the followingMaking inquiries of management and others within the entityConsidering the results of analytical procedures performed in planning the audit.Considering fraud risk factors.Considering certain other information

  • SAS No. 99- RequirementsRequires the auditor to use the information gathered to identify risks that may result in a material misstatement.This section provides guidance and support on how to identify and assess risks. It challenges auditors to change the way they think about assessing fraud risks. Auditors should identify risks and synthesize how those risks could lead to a material misstatement. This section specifically requires that improper revenue recognition and management override of controls be considered.

  • SAS No. 99- RequirementsRequires the auditor to evaluate the entitys programs and controls that address the identified risks of material misstatement.SAS 99 provides specific examples of programs and controls for both large and small businesses. The auditor should consider which controls mitigate the identified fraud risks.

  • SAS No. 99- RequirementsRequires the auditor to assess the risks of material misstatement due to fraud throughout the audit and to evaluate at the completion of the audit whether the accumulated results of auditing procedures and other observations affect the assessment.The standard provides examples of conditions that may be identified during the audit that might indicate fraudOne example is management denying the auditors access to key IT operations staff including security, operations, and systems development personnel. The auditors must determine whether the results of their tests affect their assessment.

  • SAS No. 99- RequirementsProvides guidance regarding the auditors communications about fraud to management, the audit committee, and others.The standard requires that any evidence that fraud may exist must be communicated to management and others.

  • SAS No. 99- CriticismThe primary criticism of the standard is that many procedures are suggested rather than required For example, it is suggested that auditors consider surprise procedures like showing up unannounced for an inventory count In actual practice auditors often tell clients which inventory locations they are going to observe. Telling clients which locations are going to be audited makes it easier to commit inventory fraud.

  • SAS No. 99- CriticismA similar criticism is that SAS 99 doesnt close expectation gaps. The guidelines and suggestions provided in the standard increase expectations on the profession. As a result, auditors must consider the requirements of SAS 99 as the minimum level of work required to detect fraud. They must be prepared to defend any decision not to pursue one of the recommended procedures listed in SAS 99.

  • Schemes, Red flags and Questions to ask?The opportunity for misstatement exist on every financial statement, a handful of culprits account for the majority of the cases.The managers need to be familiar with these culprits and know which red flags might indicate the presence.Overstating or improper recognizing revenues is a common form of financial statement fraud

  • RevenueThe schemes are:Recording gross rather than net salesRecording revenues of other companies while actually a middlemanRecording sales that never took place.Recording future sales in the current periodRecording sales of products which are on consignment.

  • RevenueRed flagsIncreased revenues without a corresponding increase in cash flow, especially overtime.Unusual or highly complex transactions, particularly those that are close to the year end.Unusual growth in the number of days in receivables.Strong revenue growth when peer companies are experiencing weak sales.

  • RevenueQuestions to askWhy did revenues increase sharply during the end of the period compared with prior-year and current-year results and the budget forecast?How does revenue growth compared with that of peers during the same period? If substantially higher, does the explanation make sense?Did receivables increase due to a particular customer? If so, should a reserve be established?

  • Understating expensesSchemesReporting cost of sales as a non-operating expense so it does not negatively affect gross marginCapitalizing operating expenses, recording them as assets on the balance sheet instead of as expenses on the income statementNot recording some expenses at all, or not recording expenses in the proper period

  • Understating expensesRed flagsUnusual increases in income or income in excess of industry peersSignificant unexplained increases in fixed assetsRecurring negative cash flows from operations while reporting earnings and earnings growthAllowances for sales returns, warranty claims, etc., that are shrinking in percentage terms or are otherwise out of line with those of industry peers

  • Understating expensesQuestions to askWhy did gross margin (by location, product and geographic area) increase during year end or period-end compared with the prior year and current-year budget forecast?Does the explanation make sense?

  • Improper asset valuations

    Asset write-downs following the disclosure of faulty reserve reports should make all company managers pay special attention to how they report their most important hard assets.SchemesManipulating reservesChanging useful lives of assetsFailing to take a write-down when neededManipulating estimates of fair market value

  • Improper asset valuations

    Red flagsRecurring negative cash flows from operations while reporting earnings and earnings growthSignificant declines in customer demand and increasing business failures in either the industry or the overall economyAssets, liabilities, revenues or expenses based on significant estimates that involve subjective judgments.

  • Improper asset valuations

    Questions to askHow is the overall economy affecting customer demand and business? Declines in both could be a signal that there might be an asset impairment issue involving inventory or allowance reserves.For areas where there are significant estimates, what is the method used to determine the estimate?Is this method consistent with that of prior periods?What supporting documentation is available to support the calculation?

  • Other Schemes

    The following are also schemes used to cook the booksSchemesSmoothing of earnings: Often referred to as using cookie jar reserves, this involves overestimating liabilities during good periods and storing away funds for future use against declining revenuesDisclosing information improperly, especially concerning related-party transactions and loans to management Executing highly complex transactions, particularly those dealing with structured finance, special-purpose entities and off-balance sheet structures, and unusual counterparties

  • Other Schemes

    Red flagsDomineering managementDecision to fix accounting in the nextperiodNo apparent business purposeReality of transaction differs from accounting or tax resultSignificant related-party transactions Multiple memos rationalizing an aggressive accounting treatment

  • Other SchemesQuestions to askIs there an overly aggressive push by management to meet previously disclosed revenues or earnings targets?Can management explain the business purpose for entities that are outside the consolidated financial statements?Were there significant adjustments made at the end of the period?Has there been an unusual focus on achieving a certain accounting treatment?Does the business purpose make sense?Does the preferred accounting treatment allow the company to meet certain targets?Has there been a change in the method of calculating the reserve estimates for any item from that used in the prior quarter or prior years? If so, why?

  • When fraud is suspected

    Red flags will result in answers that make perfect sense. But when they dont, its time to consider two actions: notifying the audit committee and calling in the forensic accountants.Forensic accountants are the crime scene investigators of the financial world. They have extensive experience examining the DNA of financial statements; sifting through email records, documents and data entries; and conducting extensive interviews to uncover and explain the most complex financial statement fraud.

  • END