Audits, External

DETECTING FRAUD

Detection of potentially fraudulent financial record keeping and reporting is one of the central charges of the external auditor. According to Fraudulent Financial Reporting, 1987—1997, a study published by the Committee of Sponsoring Organizations of the Treadway Commission, most companies charged with financial fraud by the Securities and Exchange Commission (SEC) posted far less than $100 million in assets and revenues in the year preceding the fraud. Not surprisingly, fraud cropped up most often in companies in the grips of financial stress, and it was perpetrated most often by top-level executives or managers. According to the study, more than 50 percent of fraudulent acts uncovered by the SEC involved overstatements of revenue by recording revenues prematurely or fictitiously.

As the study's authors, Mark Beasley, Joseph Carcello, and Dana Hermanson, noted in Strategic Finance, fraudulent techniques in this area included false sales, recording revenues before all terms were satisfied, recording conditional sales, improper cutoffs of transactions at period end, improper use of percentage of completion, unauthorized shipments, and recording of consignment sales as completed sales. In addition, many firms overstated asset values such as inventory, accounts receivable, property, equipment, investments, and patent accounts. Other types of fraud detailed in the study included misappropriation of assets (12 percent of charged companies) and understatement of liabilities and expenses (18 percent).

Accidental misstatements are almost always detected in audits. But these errors should not be confused with fraudulent activity. Errors can occur at any time, in any place with unpredictable financial statement effects. Fraud, on the other hand, is intentional and is often more difficult to detect than are errors. Part of the job of an external auditor is to recognize when conditions indicate potentially higher risks of employee or management fraud and then increase the scrutiny of all records accordingly.

WORKING WITH EXTERNAL AUDITORS

Experts urge business owners to establish proactive working relationships with external auditors. In order to accomplish this, companies should make sure that they:

• Select an auditing firm with expertise in their industry and a proven track record.
• Establish and maintain efficient record keeping systems to ease the task of the auditor.
• Make sure that owners, executives, and managers know the basics of financial reporting requirements.
• Establish effective lines of communication and work processes between external auditors and internal auditors (if any).
• Recognize the value that external auditors can have as objective reviewers of existing and proposed operational processes.
• Focus on high-risk areas of operations, such as inventory levels.
• Focus on periods of change and expansion, such as transitions to public ownership or expansion into new markets.
• Build an effective audit committee that can provide cogent financial and operational analysis based on audit results.

ACCOUNTING FIRMS AND CONSULTING SERVICES

The 1980s and 90s saw an increase in the types of service offered by accounting firms. The situation became so prevalent that, according to an article on the subject in Internal Auditor, 307 of the Standard & Poor's 500 companies paid their audit firms, on average, almost three times as much in fees for non-auditing services as for auditing itself. Many analysts believe that it was the resulting conflict of interest that was at least partially responsible for the rash of bankruptcies of large corporations which occurred in the early 2000s. How important accounting firm collaboration was in the accounting fraud of the early 2000s has yet to be fully determined. However, passage of the Sarbanes-Oxley Act in 2002 put into place increased restrictions on the consulting services that an accounting firm can offer the clients for which it performs audits.