External Auditors and Fraud Examiners - Essay Example

 EXTERNAL AUDITORS AND FRAUD EXAMINERS: A CRITICAL EVALUATION OF THE DIFFERENCES IN SKILLS SETS AND TASK OBJECTIVES Auditing /External Auditors Auditing is an activity that involves investigation of accounting and other financial information prepared by a third party to arrive at a conclusion whether the information so furnished has been fairly stated. An auditor is a chartered accountant professional who certifies that the financial statements of an entity give true and fair view of its affairs. An external auditor is so called as to distinguish him from an internal auditor who is an in-house professional. While the internal auditor is a paid employee of the entity, the external auditor is an independent professional engaged by the entity for a fee and as required by Companies Act. To be more specific, an external auditor gives his opinion as to whether financial statements are materially correct. He is deemed independent as he has no special relationship and pecuniary interest in the client that might possibly encourage him to ignore adverse facts and evidence of the client the auditor evaluates. Thus, to be independent, the auditor cannot both work under the client as well as act as the client’s external auditor. The external auditor also carries out compliance, operational and forensic audits. Forensic auditing is a special purpose audit to unearth financial frauds and other crimes. Forensic as its meaning (i.e. of the law) suggests, forensic auditors detect information for being used as litigation support. If the forensic auditor is a CA or CPA, his evidence at trial would lend more credibility although it is not mandatory for a forensic auditor to have a CPA licence in the U.S. The external auditor in the process of his auditing activity concludes whether the assertions made in the financial statements are true and fair. The assertions are in the nature of how the business is conducted that is how its business generates income and spends it, how it manages its inventory, how it records information about its property, plant, equipment, its long-term liabilities, equity, cash and investments[Lou10]. Although forensic auditing and fraud examining is interchangeably used, both are different disciplines. While forensic accounting involves the application of professional accounting skills in a civil or criminal litigation. Thus, most of the fraud examinations are part of forensic accounting, but every forensic accosting is a fraud examination. For example, an expert may be said to be engaged in forensic accounting while the furnishing value of a property to the court which need not involve any fraud unlike in the case of fraud examination. While fraud examination can be performed by any accountants or non- accountants, forensic accounting can only be performed by the accountants. While the latter involves litigation support, fraud examination would address only matters involving frauds[ACF14]. Since fraud examination would certainly involve forensic accounting, it can attract “computer forensics, electronic discovery, bankruptcies, insolvencies and reorganisations, workplace fraud investigations and computation of economic losses”[ACF14] Fraud Examination/ Fraud Examiners Fraud has been a problem ever since the business era began. Fraud that includes "bribes, skimming money from the company and stealing product, etc. is of three types namely asset misappropriation, financial statement fraud and corruption[ACF12]. Business fraud is more acute since the recession. At least one in three companies were affected in 2009 due to business fraud [Gil09] and the rate has gone up to 70 % as reported by companies affected by the confirmed fraud which takes one to three years to confirm and report[Kno13]. It has been estimated that worldwide organizations incur 5 percent of their revenue because of occupational fraud and the average loss per year per organisation is $ 160,000[Bel12]. Fraud audits have of late gained popularity as part of corporate governance in view of large scale theft of assets by both employees as well as management such as Enron, World.Com etc. In the recent past. The aim and objective of a fraud audit or fraud examination are to investigate discrepancies and collect evidence of fraud that may result in criminal convictions. The management of a company may engage fraud examiners to investigate its own executives upon a suspected theft of assets or financial fraud. Those entities affected by fraud engage fraud units of public accounting firms or with organizations specializing in forensic accounting. The fraud auditors/examiners are usually qualified in Certified Fraud Examiner (CFE) certification granted by the Association of Certified Fraud Examiners (ACFE). Fraud examiners are now engaged by the audit committee which is a subcommittee formed by the board of directors of publicly traded companies with the advent of Sarbanes Oxley Act (SOX) which requires at least one of the three members of the sub-committee to be a financial expert. Thus, the audit committee functions as an independent “check and balance” for the internal audit function and as a liaison with external auditors[Hal12]. Although external auditors are also expected to detect frauds, fraud examiners' role is more specialized than the former. The objectives of the tasks of external auditors and fraud examiners are different and therefore their respective skill sets have to vary necessarily with each other although the roles and objectives may overlap. This paper examines in detail the objectives of the tasks and skills of the two different professionals both theoretically as well as practically with case studies for the sake of better understanding of the respective professionals. Task objectives In the UK, the Companies Act 2006, required all public listed companies to have their financial statements audited by an external auditor who could be individuals or firms with a majority of individuals holding at least one of the six recognised qualifying bodies and registered with one of the five Recognised Supervisory bodies. Financial Reporting Council is now acting as the unified and authoritative, independent regulator under whose supervision, Institutes of Chartered Accountants in England and Wales have established Quality Assurance Directorate (QAD) to watch the work of its members who are the registered auditors. Decentralization of the management of professional bodies has rather strengthened the supervision from the top level. The ISA 240 requires an external auditor conducting an audit of public limited companies to ensure that financial statements of the companies are free from material misstatement due to fraud or error. The external auditor should identify and assess the risks arising from misstatements as a result of fraud. The objective of the external auditor are (1) identification and assessment the fraud related risks of the material misstatement in the financial statements. (2) to gather sufficient evidence of the risks assessed resulting from fraudulent material misstatement by proper responses and (3) to appropriately respond to the fraud or suspected fraud discovered in the course of the audit. Auditors are expected to observe professional scepticism during the course of the audit with the object of detecting any fraud. Professional scepticism will motivate the auditors to recognise possible existence of fraud through material misstatement. The auditor should be in a position to identify the areas in the financial statements susceptible to possible material misstatement because of fraud. Once the auditor finds a fraud or suspects a fraud, it is his legal duty to report it to the regulators in spite of client confidentiality he is expected to maintain[Zho12] Skills The external auditor’s main objective being certification of the financial statements as representing true and fair view of the entity concerned, he should be vigilant and sceptic enough in scrutinising the financial statements and books expecting irregularities. Auditor’s responsibilities particularly with respect to fraud are that as an independent auditor, he should perform the audit after systematic planning to get himself convinced or reassured, to be precise, of the financial statements being rid of material misstatement by error or fraud. Fraud has become so rampant in the corporate world that an organization loses about 5 % of its revenue because of fraud. Restatement of financial statements has nearly doubled within a short period from 2004 to 2005 i.e., from 616 in 2004 to 1,195 in 2005. Frauds have been perpetrated mostly due to insufficient internal controls. This is an opportunity to indulge in fraud which the fraudster does as an incentive to meet goals, or without being aware of their actions being wrongful. Or it may be a simple case of lack of integrity. Some people, who commit frauds, do so for delight they out of them. Three of the Duke Energy workers demonstrated how they were incentivised to commit frauds. They had inflated the trading volumes so they could receive more bonuses. It was not a small amount. The bonuses amounted to $ 7 million from March 2001 to May 2002[Smi04]. The auditor's responsibility to detect fraud is shown in five different headings by the Public Company Accounting Oversight Board (PCAOB). They are: Auditor's approach as a whole, brainstorming sessions and fraud related inquiries, Auditor's response to fraud risk factors, misstatements in financial statement and fraud by the management ignoring controls. The overall approach: Auditing procedures requiring more authentic evidence that can be verified. For example, digital audit techniques that will provide corroborative evidence on the accounts of considerable volumes. The adjustment of timing of substantive tests which will help assess the risk of material misstatement because of fraud sometime close to the reporting date. The nature of the procedures employed should be in line with the assessment of material misstatement due to fraud. This can be achieved by increasing the sample size[Apo08]. Brainstorming sessions and Fraud-Related Inquiries It deals with how an audit can be conducted effectively. The auditing team should discuss and exchange ideas about the possible susceptibility of the financial statements to material misstatement caused by fraud and the management’s role in guarding it. The audit team is alerted about the possible commitment of fraud and its concealment with the available information which may be general and the client-specific information well known to some of the team members. They should possess a questioning tendency, being aware of the incentives and opportunity available for management to commit fraud[Apo08]. Auditor’s Response to Fraud Risk Factors The auditor should be responsive enough to the identified risks through the timing, and the amount of auditing procedures to be carried out[Apo08]. Misstatements in financial statements The auditor should record nature and effect of misstatements and assess whether the misstatements point to fraud[Apo08]. Fraud by the management ignoring the internal controls Management can commit fraud, by virtue of its position manipulate accounting records and submit misleading financial information. This occurs due to the management’s override of controls[Apo08]. Fraud Examination Fraud examination can be for several organizational objectives such as recognizing conduct that is not proper, people involved in the said conduct, checking fraud, making people become of organisation’s zero tolerance for fraud, assessment of possible losses that already exist, helping organisations recover losses, preventing further losses, mitigating other likely consequences and plugging loopholes in the internal control. Further, fraud examination may arise as an obligation arising from law, agreements or common law duty. For example, company directors and officers in their fiduciary capacity may initiate fraud examination when suspicion arises. Fraud examination refers to the process of evidence gathering, submitting reports, deposing as a witness and providing assistance in discovery and further prevention of fraud. The fraud examiner is expected to submit impartial reports which should be clear and accurate as they are likely to be referred by the “ lawyers, insiders in the organization, defendants, witnesses, juries, judges, media and others” (3.102). The fraud examiners upon being called to give testimony, are expected to be honestly giving details in a clear and accurate way. Although they are not duty-bound to prevent fraud which is the responsibility of management or a particular authority, they should deliberate and recommend suitable policies and procedures to stop fraud any further. The Certified Fraud Examiners are specially trained to provide assistance to Organisations in this regard[ACF14]. Fraud examiners’ skills involve understanding of criminal behaviour, behaviour analysis and fraud prevention. He has to work with behaviourist principles in order give consultation on fraud prevention[ACF14]. Critical evaluation When an external auditor detects a fraud and confronts his client with it, the latter would admit to the fraud and promise to make amendments in the entity’s financial statements. The external auditor also informs the audit committee which decides no further action is necessary. Even though the client has attempted to commit fraud which is more relevant for the fraud examiners, the external auditor has no recourse but to issue an unqualified opinion. This situation however questions the compromising ethical behaviour of the external auditors their professional obligations. This has resulted in severe criticisms of the external auditors’ failure to prevent serious financial scandals such as Enron, Tyco and WorldCom. External auditors who are the certified accountants have the right to maintain client confidentiality guided by the Rule 301 of the AICPA Code of Professional Conduct (Confidential Client Information) which says that the member of the professional practice must not divulge any client information of confidential nature. This principle of confidentiality is availed of by the external auditors when a fraud is unearthed by virtue of SAS No 99 which states that auditors are not required to disclose the fraud information to anyone other than the client and its audit committee. The accountant-client privilege would prevent an external auditor from going any further in making the fraud public. Privileged communication stems from the common law principles of confidentiality between spouses, clergy, legal counsel-client, physician-patient and accountant-client. Courts have applied “Wigmore test” having four criteria to determine whether claims of privilege exist in a given relationship. This test applies to the jurisdictions of the US, England and Canada. The four criteria are (1) the communications must have originated on an understanding that it would not be disclosed. (2) the element of confidentiality is necessary to maintain the relations between the parties. (3) the relation must be such that in the community’s opinion, it must be fostered. (4) the injury that would hamper the relationship should outweigh the benefit gained through litigation. These criteria do not in any way recognize a privilege between the accountants and their clients. The U.S. Supreme Court held in the cases of Couch v United States (1973) and United States v Arthur Young & Co (1984) that the accountant had a “public watchdog” function that compelled the accountant to always maintain independence from the client and to display fidelity towards public trust. However, it is argued by the external auditors that breaching client confidentiality in cases of fraud would prompt the client not to cooperate any further. As a result of exposure, client will work out alternative methods to hide fraud which the external auditors cannot find any more and that the damage to the client firms later found to be not responsible, will be irreparable.[Sny11] In China, with the economic reforms initiated since 1978 resulting in foreign direct investments, there were demands from the foreign investors for external audits as they wanted to be sure of the accuracy of financial statements of the entities in which they had invested. The Government of China responded by enacting Income Tax Law for Sino-foreign Joint Ventures in September 1980 and Provisional Regulations Concerning the Establishment off Accounting Consultancies. This resulted in the establishment of more than 200 Chinese accounting firms and 2000 certified public accountants by the end of 1988. Chinese Institute of Certified Public Accountants (CICPA) was the first professional accounting body to be established in 1988 with the objective of enhancing the professional credibility and integrity of the accounting profession. People's Law of the People’s Republic of China on Certified Public Accountants (CPAs Law) came into force from January 1, 1994 and as a result, there were 10,000 Chinese CPAs and 2,000 Chinese accounting firms by 1997. This went up to 6,900 accounting and auditing firms and 62,460 practicing CPAs by 1999. This further increased with the country's entry in the World Trade Organization (WTO) in 2000. In China, external auditors of listed companies have a duty to detect and report fraud in the financial statements although majority of the auditors interviewed have no clarity of their responsibilities in this connection. Lack of understanding of the regulation CSA 1141 as a new auditing standard places the auditors at a disadvantage in detecting and reporting corporate fraud due to the more than three years delay in incorporating the standard in their work schedule[Zho12]. Main kinds of fraud are “fraudulent misrepresentation of material facts , negligent misrepresentation, concealment of material facts, bribery, illegal gratuity, economic extortion, conflicts of interest, forgery, theft of money or property, breach of contract, breach of fiduciary duty, gross negligence, conspiracy, obstruction of justice, perjury, and false claims and statements to government agencies”[ACF14]. These are self-explanatory and need not be elaborated. The ACFE‘s first surveyed their members’ fraud investigations in 1996. The ACFE periodically conducts a survey among its 50,000 plus members every once two years. From 2002 to 2012, total number of cases reported was 6,495. The cases are classified into fraud tree. Assets misappropriation alone accounted for 88.1 percent of the frauds reported It is a widely prevalent method of fraud. Second ranking fraud is corruption which is 29.5 %, and the third ranking fraud is fraudulent statements accounting for 7.5 %. . 61.8 percent males and 38. 2 percent females account for the total frauds reported. In terms of frequency, employees account of 45.7 percent, Manager, 39 percent and owners 18.2 percent. 90 percent of the cases showed how fraud was detected to start with. Internal audits discovered 17.2 per cent of fraud cases, 63.8 percent of fraud cases were found during internal audit activities, and 29.2 percent of fraud cases were found through internal control[Hun14]. A Kenyan study concluded that life style indicators and behavior changes could be traced to successfully identify fraud in all the industries and occupations[Gic14]. Whether it is external auditing or fraud examination or even forensic accounting, they all involve life-threatening risks. Anti-fraud professionals must learn from the murder of the auditor Sallie Rohrbach set about investigating a suspected fraud at the Dilworth Insurance Agency simply because she had taken it as routine investigation as it had been the case with her earlier assignments. Common protocols for external auditing, fraud examination and forensic accounting professionals do not caution them against the risk factors associated interviewing of suspected or known white-collar criminals. According to the Occupational and Safety and Health Agency, murder is the fourth leading cause of job-related deaths in the USA. Work-place violence by the white collar criminals is not sufficiently regarded as a serious risk factor since they are generally not believed to be criminals. It is unfortunate that classification of white-collar crime as non-violent has led to consider that the perpetrator is also non-violent. However, research has shown that white collar criminals whether they males or females are found to have committed violence including murder. To recall a fraud investigator for the prosecution namely Nazim Kaziakmedov in the former USSR was shot twice in the chest and once in the head while investigating the fraud of an investment group known as Finvest. The insurance case stated above involved embezzlement of more than $150,000 insurance premiums by one Howell resulting in the drivers remaining insured. The fraud investigator should, therefore, be mindful of negative personality traits perceived during the interview of the suspected or known offender[Per11]. Conclusion Although it may appear that the roles of external auditors and fraud examiners as overlapping, in reality they are employed under different situations. External auditors are a compulsory requirement, and whether there is fraud or not, their role as the auditors of the entity continues as long as the entity continues to exist. The fraud examiners, on the other hand, are engaged on an ad hoc basis, and it is not a statutory requirement to have them on a permanent basis. They are mostly engaged by the management or by any regulatory authority which is possible in a situation where the management and external auditors appear to be hand in glove with each other. It is also possible where it may be beyond the competence of the external auditors. Works Cited Lou10: , (Loughran), ACF14: , (ACFE 3.103), ACF12: , (Shelton 2), Gil09: , (Gillentine), Kno13: , (Kroll), Bel12: , (Belot and Schroder 3), Hal12: , (Hall), Zho12: , (Zhou 6), Smi04: , (Smith A15 ), Apo08: , (Apostolou and Crumbley 1), Apo08: , (Apostolou and Crumbley), ACF14: , (ACFE 3.102 ), ACF14: , (ACFE 4.102), Sny11: , (Snyder), Zho12: , (Zhou 9), ACF14: , (ACFE 2.201), Hun14: , (Hunt and F 176), Gic14: , (Gichobi and Zani 17), Per11: , (Perri and Brody 17), Read More