Detecting Fraud

47
2013 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).
DOI 10.1002/jcaf.21829
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Gin Chong
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n 2010, the Asso-
ciation of Certified
Fraud Examiners
(ACFE) estimated
that the IRS has lost
US$994 billion due to
fraud, and a whopping
US$2.9 trillion world-
wide was lost due to
fraudulent financial
statements, asset mis-
appropriation, and
corruption. The fraud-
related losses represent
approximately 7% of
the U.S. gross domes-
tic product (ACFE, 2008; ACFE,
2010). Based on the U.S. fiscal
year 2008 budget, losses result-
ing from fraud have exceeded
the combined net costs of the
Departments of Defense, Home-
land Security, Transportation, and
Education. Fraud is costly and
damages the reputation and cred-
ibility of the audit profession.
Stakeholders are pressuring audi-
tors to include detection of fraud
in the audit programs and audit
reports. In an effort to restore
public trust, accounting standard
setters, including the Public
Company Accounting Oversight
Board (PCAOB), require auditors
to adhere to the requirements of
Statement on Auditing Standards
(SAS) No. 99, Consideration of
Fraud in a Financial Statement
Audit (PCAOB, 2007).
The Standard requires audi-
tors to participate in brainstorm-
ing sessions and to consider
the possibility that a material
misstatement due to fraud could
be present (American Institute
of Certified Public Accoun-
tants [AICPA], 2002). Though
the PCAOB inspection reports
constantly paint disappointing
pictures, the findings are surpris-
ing. Financial statement auditors
are not fraud examiners, but
are to determine the
reliability of internal
control and the extent
of audit risk, and to
report whether the
financial statements
are presented fairly
in accordance with
generally accepted
accounting prin-
ciples (GAAP). Fraud
detections require
unique skill sets and
the development of
forensic techniques.
Specifically, individu-
als need to apply investigative
and analytical skills to gather
and evaluate audit evidence, to
interview all parties relating to
an alleged fraud situation, and to
serve as an expert witness. All
these involve resources in terms
of time, money, and, in many
cases, personal risk of being
persecuted even before a case
begins. But requiring auditors to
be aware of the possibility that
fraud may exist is not enough.
Waves of fraud emerge despite
professional bodies and standard
setters that formulate various
auditing standards as a response,
to restore public trust, and act
Detecting Fraud: What Are Auditors
Responsibilities?
High-profile fraud cases have continued to make
the news over the past few years. But exactly what
are auditors responsibilities when it comes to
detecting fraud? The author of this article reveals
that the auditing profession has come full circle
from being responsible to not being responsible for
detecting fraud. But the volume and critical nature
of fraud cases remain high, as do the number
of auditing standards addressing this issue. The
author explores this problem in depth, identifies
situations where fraud may take place, and sug-
gests various tools that auditors should use for
fraud detection. 2013 Wiley Periodicals, Inc.
48 The Journal of Corporate Accounting & Finance / January/February 2013
DOI 10.1002/jcaf 2013 Wiley Periodicals, Inc.
Audit firms responded by limit-
ing audit hours in an engagement
and reducing time and resources
on searching for fraud.
By the mid-1980s, the vol-
ume and dollar amounts involved
in fraud cases had increased
tremendously, making SAS No.
16 a redundant guideline. A
new wave of public concerns
and outcries forced Congress to
form the Treadway Commission.
The Commission was charged to
identify causal factors that lead
to fraudulent financial report-
ing and to recommend steps to
reduce its incidence. The Com-
mission concluded that at least
36% of the cases involved audi-
tors failure to recognize, or to
view with sufficient skepticism,
certain fraud-related warning
signs or red flags that would
have been noted had the audi-
tors been more diligent in their
audits. In response to the report,
the Accounting Standards Board
(ASB) issued nine statements of
auditing standards (SASs 53 61)
in 1988 to outline external audi-
tors role on fraud prevention and
detection and the potential illegal
activities of audit clients. Audi-
tors are required to apply pro-
fessional skepticism to assume
management is neither honest
nor dishonest (PCAOB, 1993).
Despite all these efforts,
there is no obvious decrease in
audit failures of fraud detection.
The Public Oversight Board
(POB) recognized that these new
SASs seemed to be having little
impact, as the auditors neither
consistently complied with these
standards nor applied the proper
degree of professional skepti-
cism to detect fraud (PCAOB,
2004). There was a widespread
public belief that while audi-
tors have a responsibility to
detect fraud, they were neither
willing nor capable of doing
so. Mounting criticisms of the
Examination of Financial State-
ments, in 1960. Although SAP
No. 30 acknowledged that audi-
tors should be aware of the pos-
sibility that fraud may exist dur-
ing an audit, it was so negatively
stated that auditors felt little or
no obligation to detect fraud.
The Equity Funding scandal
was the next major audit fail-
ure of fraud detection
2
(Seidler,
Andrews, and Epstein, 1977).
In response to the congressional
inquiry, the AICPA formed the
Cohen Commission to reexam-
ine auditors responsibility to
detect fraud. The Commission
recognized that while auditors
should actively consider the
potential for fraud, the inherent
limitations in an audit process
dampen auditors responsibility
for detecting all material frauds.
Specifically, the Commission
recognized that it is challeng-
ing for auditors to detect frauds
that are concealed and derived
from forgery or collusion by
members of management. In
response to Cohens report, the
AICPA issued SAS No. 16, The
Independent Auditors Responsi-
bility for the Detection of Errors
or Irregularities, to implicitly
acknowledge that auditors are
responsible for using a list of
red flags to detect fraud.
In the 1970s, the Department
of Justice and the Federal Trade
Commission (FTC) required pro-
fessional organizations including
the AICPA to eliminate elements
of their codes of professional
behavior that the government
deemed to violate federal anti-
trust statues. For example, the
codes had allowed audit firms to
engage in unrestricted advertis-
ing. The FTC also imposed a
ban on contingent fees and com-
missions for nonaudit clients.
Banning competitive bidding for
audit services has narrowed audit
firms profit margins on audits.
as reminders of their duties of
care. These reminders primarily
serve a symbolic function, but in
fact, the failure in fraud detec-
tion is due to differences in skill
sets and task objectives between
financial statement audits and
fraud detections.
HISTORICAL PERSPECTIVE
With the passage of time,
auditors responsibility for
fraud detection has changed
dramatically. Prior to the 1500s,
the British auditing objectives
that centered on the discovery of
defalcations became the basis of
the American auditing approach.
The emphasis on fraud detection
gradually dissipated during
the period of the 1930s until
the infamous McKesson and
Robbins scandal in late 1938.
1

McKesson and Robbinss auditor,
Price Waterhouse & Company,
was under intense scrutiny for
its inability to detect and prevent
the massive accounting fraud. In
the aftermath of the McKesson
and Robbins scandal, audi-
tors were required to perform
additional audit procedures on
accounts receivable and inven-
tories while the audit profession
formulated Statement of Audit-
ing Procedures (SAP) No. 1,
Extension of Auditing Procedure
(AICPA, 1939) to shift auditors
focus away from fraud detection.
Instead, the focus became deter-
mining fairness of the financial
statements in accordance with
the accounting standards. Subse-
quent to SAP No. 1, the auditing
profession came under mounting
pressure from the public and the
Securities and Exchange Com-
mission (SEC) to clarify audi-
tors responsibility with respect
to fraud detection. As a result,
the AICPA issued SAP No. 30,
Responsibilities and Functions
of the Independent Auditor in the
The Journal of Corporate Accounting & Finance / January/February 2013 49
2013 Wiley Periodicals, Inc. DOI 10.1002/jcaf
FRAUD TRIANGLE
Both SAS No. 99 and ISA
240 identify three conditions
that generally present mate-
rial misstatements due to fraud
risk: (a) incentives/pressures,
(b) opportunities, and (c) atti-
tudes/rationalizations. Incentives
or pressure may arise due to
external conditions like eco-
nomic, industry, or entity operat-
ing conditions that threaten the
financial stability or profitability
of the client. Or management
may be under excessive pressure
to perform and meet the require-
ments or expectations of the
firms own sales or profitability
targets, or to meet the expecta-
tions of external parties, includ-
ing lenders, analysts, and stock-
holders. Opportunities for fraud
also arise due to inherent risk
within the industry. The nature or
complexity of the entitys opera-
tions also provides opportunities
to engage in fraudulent financial
reporting. This is exacerbated by
poor internal control systemsin
particular, ineffective accounting
and control of information sys-
temsa dominating management
style, and lack of segregation of
duties among the employees.
Attitudes of or rationaliza-
tions by board members, manage-
ment, or employees arise due to
many factors. They include a lack
of communication or ineffective
management communication;
ineffective implementation, sup-
port, or enforcement of the enti-
tys values or ethical standards;
nonfinancial managements
excessive participation in or pre-
occupation with the selection of
accounting policies or the deter-
mination of significant estimates;
a known history of violations of
securities laws or other laws and
regulations; excessive manage-
ment interest in maintaining or
increasing the entitys stock price
fraud. These procedures include
conducting surprise inventory
or cash counts and performing
substantive tests on potential
fraud risk areas. However, the
watchdogs failed to meet these
requirements and faced the con-
sequences of the Enron fiasco
and the demise of Arthur Ander-
sen. To restore public confidence
and to limit the auditors respon-
sibilities on fraud detection,
Congress passed the Sarbanes-
Oxley Act (SOX) and created
the PCAOB. Though the PCAOB
does not require the auditors to
detect fraud, it requires exter-
nal auditors to report specific
situations and events relating
to fraud and illegal acts to the
clients audit committee as well
as to the authorized authorities.
These authorized authorities
include relevant government
agencies like the IRS, fraud
investigators, and federal and
state governments. As the exter-
nal pressure mounted, the Inter-
national Auditing and Assur-
ance Standards Board issued
the International Standard on
Auditing (ISA) 240, The Audi-
tors Responsibilities Relating
to Fraud in an Audit of Finan-
cial Statements, in December
2009, stating that management
is responsible for detecting
fraud while the auditors are not.
This is in line with an auditors
objective: to conduct an audit in
accordance with ISAs to obtain
reasonable assurance that the
financial statements taken as
a whole are free from material
misstatement, whether caused
by fraud or error. Owing to the
inherent limitations of an audit,
there is an unavoidable risk that
some material misstatements
of the financial statements may
not be detected, even though the
audit is properly planned and
performed in accordance with
the ISAs.
audit profession over its failure
of fraud detection prompted the
POB to propose a number of rec-
ommendations to improve audi-
tors willingness to detect fraud.
The AICPA supported the POBs
recommendations to develop an
auditing standard that focused
solely on financial statement
fraud, and eventually formed
a fraud task force to formulate
SAS No. 82, Consideration of
Fraud in a Financial Statement
Audit, in February 1997. For the
first time, fraud was included in
the title of an auditing standard.
SAS No. 82 classifies
fraud into two distinct catego-
ries: intentional falsification of
financial statements and theft
of assets. It provides auditors
with a list of risk factors cov-
ering instances of fraudulent
financial reporting and misap-
propriation of assets that they
should assess during an audit,
and requires auditors to docu-
ment both the assessments on
fraud risk and modifications to
the audit plans. Though SAS No.
82 provides additional assurance
to the public that the external
auditors have taken extensive
steps to ensure that they did not
overlook any underlying fraud
and the financial statements are
free of material misstatements,
the Standard does not increase
the auditors responsibility for
detecting fraud beyond the key
concepts of materiality and rea-
sonable assurance.
In 2000, the SEC requested
POB to appoint a panel to
review firms audit effective-
ness. In the report, the panel
recommended that audit firms
hire forensic specialists to pro-
vide auditors with fraud-related
training, and that external
auditors perform forensic-type
procedures on every audit to
enhance the likelihood of detect-
ing material financial statement
PCAOB Standing Advisory Groups Questions Related to Fraud
No. Questions
SAS No. 99 related
1 Is it appropriate for stockholders to expect auditors to detect fraud that could have a material effect on
the financial statements?
2 Does SAS No. 99 appropriately describe the auditors responsibility for detecting fraud?
Risk and Fraud Risk Factors related
3 Is this list [SAS No. 99] of fraud risk factors helpful to the auditor?
4 Are there other significant fraud risk factors?
Revenue Recognition related
5 Should auditors presume that revenue recognition is a higher risk area demanding that the auditor
perform more extensive procedures?
6 If so, to overcome this presumption, should auditors be required to identify and document persuasive
supporting reasons that the risk of material misstatement due to fraud is remote?
7 Should a proposed standard on fraud include specific procedures that auditors would be required to
perform with respect to revenue recognition?
8 Should auditors be required to inquire of sales and marketing personnel and internal legal counsel about
their knowledge of the companys customary and unusual customer terms or conditions of sales?
9 Are there other practice problems you are aware of in this area?
Significant or Unusual Accruals related
10 Should auditors presume that significant or unusual accruals are a higher risk area demanding that the
auditor perform more extensive procedures?
12 Should auditors be required to test the activity within accrual accounts during the period and not just
the ending balances?
13 Should auditors be required to apply substantive tests of details (that is, not rely on analytical proce-
dures only) to corroborate the support for managements judgments and assumptions?
14 Should a proposed standard on fraud include other specific procedures that auditors would be required
to perform with respect to significant or unusual accruals?
Related Parties related
16 Should auditors presume that transactions with related parties are a higher risk area demanding that
the auditor perform more extensive procedures?
18 Should auditors be required not only to inquire of management, but also the entire board of directors,
about related parties and transactions with those parties?
Exhibit 1
(Continues)
PCAOB Standing Advisory Groups Questions Related to Fraud (Continued)
No. Questions
Estimates of Fair Value related
20 Should auditors presume that assets or liabilities valued using pricing models or similar methods are a
higher risk area demanding that the auditor perform more extensive procedures?
21 Should a proposed standard on fraud include specific procedures that auditors would be required to
perform with respect to such fair value estimates?
Analytical Procedures related
23 In performing and evaluating the results of analytical procedures, should auditors be required to
identify key performance indicators of the issuer and the issuers industry?
24 Should auditors be required to compare the key performance indicators to the same measures in prior peri-
ods, to budgets, to the experience of the industry as well as principal competitors within the industry?
25 Should auditors be required to compare nonfinancial information (such as operating statistics) with the
audited financial information?
26 Do auditors overrely on analytical procedures when used as substantive tests? That is, should auditors
be provided definitive direction as to when analytical procedures are appropriate and when
analytical procedures should not be used?
Quarterly Financial Information related
28 Should auditors be required to perform certain procedures with respect to the higher risk audit areas (that is,
revenue recognition, related parties, and other high-risk audit areas) while performing quarterly reviews?
29 Should a proposed standard provide specific direction for auditors to follow up each quarter on mate-
rial matters from the prior annual audit and quarterly reviews? (For example, if during the annual
audit the auditor has been told that a significant receivable will be collected within 60 days, then the
auditor should follow up on that matter in the first quarter of the next period.)
30 Should auditors be required to audit significant or unusual transactions concurrently with a review of
the quarterly financial information?
31 Although financial statements are not formally prepared for the fourth quarter, should auditors perform
certain procedures with respect to the financial information for the fourth quarter?
Journal Entries related
33 Should a proposed standard on fraud contain explicit imperatives or expectations with respect to the
review of journal entries?
34 If so, should specific direction about the review of journal entries be focused primarily on the review of
nonstandard journal entries as opposed to all journal entries?
35 Should auditors be expected to review journal entries at the close of each reporting periodthat is,
quarterly as well as annual reporting periods?
36 Should auditors be required to review postclosing journal entries, including top-side entries, for each
reporting period?
37 Should auditors be required to review consolidating journal entries for each reporting period?
Exhibit 1
(Continues)
PCAOB Standing Advisory Groups Questions Related to Fraud (Continued)
No. Questions
Discussions With the Audit Committee related
39 Should auditors be required to inquire of the audit committee about information on complaints and
concerns (from whistleblowers and others) that have been submitted to the board of directors or
audit committee?
40 Should auditors make such inquiries for each quarter and annual reporting period?
Detection of Illegal Acts related
41 Should a proposed standard on fraud include specific procedures for auditors to perform in discharging
their obligations under Section 10A?
42 Should a new standard on the auditors responsibility for the detection of illegal acts by their audit
clients also be considered?
Forensic Accountants in an Audit of Financial Statements related
44 Should a forensic specialist, whether employed by the auditors firm or engaged by the auditor, be
regarded as a member of the audit team? Would treating a forensic accountant as an SAS No.
73type specialist create an artificial distinction between the work necessary to detect fraud and the
work necessary to complete an audit?
45 What professional standards should apply to forensic accountants participating in an audit of financial
statements? Should auditors obtain the necessary skills to detect fraud, including forensic skills?
46 Is it acceptable for an auditor to assign responsibility to or otherwise use the work of a forensic spe-
cialist engaged by the company in an audit of financial statements and treat that persons work as
the work of a specialist under SAS No. 73, Using the Work of a Specialist (AU sec. 336)?
47 Can auditors obtain the reasonable assurance required by paragraph .02 of AU sec. 110, Responsibili-
ties and Functions of the Independent Auditor, without performing investigations to determine the
impact of alleged fraudulent activities on the financial statements?
48 What restrictions on the arrangements for the in-depth investigation would be necessary to avoid an
impairment of independence?
49 Does a forensic accountant employ an investigative mindset that is different from the professional
skepticism of an auditor of financial statements?
50 Are there other practice issues that should be addressed in an auditing standard on financial fraud?
beyond the three key conditions
including the need for forensic
specialists in an audit assignment.
CONCLUSION
The audit profession has
gone through a full circle of not
PCAOB on the development of
auditing and related professional
practice standards. This group
has compiled 50 questions that
help identify fraud and fraud risk
factors in the course of an audit
(see Exhibit 1) (PCAOB, 2004).
External auditors need to look
or earnings trend; and low morale
among senior management.
Apart from the preceding
audit guidance is the Standing
Advisory Group (SAG), a group
that consists of external audi-
tors, investors, and public com-
pany executives who advise the
Exhibit 1
statement audit. Statement on Audit-
ing Standards No. 99. New York, NY:
Author.
Association of Certified Fraud Examiners
(ACFE). (2008). Report to the nation
on occupational fraud abuse. Austin,
TX: Author.
Association of Certified Fraud Examiners
(ACFE). (2010). Report to the nations
on occupational fraud and abuse. Aus-
tin, TX: Author.
International Auditing and Assurance
Standards Board. (2009). The
auditors responsibilities relating to
fraud in an audit of financial state-
ments. International Standard on
Auditing (ISA) No. 240. New York,
NY: Author.
Public Oversight Board (POB). (1993).
In the public interest. Stamford, CT:
Author.
Public Company Accounting Oversight Board
(PCAOB). (2004, September 89).
PCAOB Standing Advisory Group meet-
ing: Financial fraud. Retrieved January
13, 2012, from http://pcaobus.org
/News/Events/Documents/09082004
_SAGMeeting/Fraud.pdf
Public Company Accounting Oversight
Board (PCAOB). (2007, January 22).
Observations on auditors implementa-
tion of PCAOB standards relating
to auditors responsibilities with
respect to fraud. PCAOB Release
No. 2007-001.
Seidler, L. J., Andrews, F., and Epstein, M.J.
(1977). The Equity Funding papers:
The Anatomy of a Fraud. New York,
NY: Wiley.
auditor and the client about fraud
detection and prevention.
NOTES
1. McKesson and Robbins was a wholesale
drug company acquired by F. Donald
Coster in 1926. Coster and his brothers
ran an elaborate accounting scheme to
inflate the companys reported assets for
more than a decade. By 1937, this trans-
lated into over $18 million of fictitious
sales and $19 million worth of nonexist-
ent assets.
2. The Equity Funding scandal involved
bookings of fictitious receivables and
income to inflate earnings per share to
net earnings expectations. Equity Fund-
ing sold insurance to fictitious customers
by selling phony policies. Although there
were sufficient red flags to cause audi-
tors to be more skeptical, they missed the
ongoing fraud including 64,000 phony
transactions with a face value of $2 bil-
lion, $25 million in counterfeit bonds, and
$100 million in missing assets.
REFERENCES
American Institute of Certified Public
Accountants (AICPA). (1939). Exten-
sion of auditing procedure. Statement
on Auditing Procedures No. 1. New
York, NY: Author.
American Institute of Certified Pub-
lic Accountants (AICPA). (2002).
Consideration of fraud in a financial
being responsible to being fully
responsible. Standard setters
and professional bodies have
responded to widely publicized
fraud cases. Standards are merely
guides to the profession, and the
auditors themselves need to exer-
cise due care and diligence in all
assignments. Though manage-
ment is responsible for design-
ing and implementing internal
control systems and detecting
fraud, the auditors need to assess
reliability of the control systems
and report fraud to appropriate
authorities. All these add value
to the audit reports and assure
the public that the reports are
doing what they were designed
to do.
Auditors need to constantly
review their resources, which
includes considering the needs
for forensic specialists and infor-
mation technology specialists in
major audits, and understanding
the clients business activities
by having interim audit visits
and holding regular meetings
with the clients. The two-way
exchanges help improve commu-
nications and educate both the
Gin Chong, professor of accounting at Prairie View A&M University (PVAMU) in Texas, is best known for
his research work on materiality and audit risk, fraud audits, firms performance measurements, and
governance and ethics. He has presented at various national and international conferences, published
over 100 scholarly publications, and is a recipient of several research awards. Professor Chong teaches
undergraduate and graduate courses on accounting, auditing, law and ethics, and accounting information
systems and control, and is a visiting professor of various universities in China and Europe. He has received
many teaching awards. His contact e-mail address is hgchong@pvamu.edu.

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