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Fraud Detection: An Historical Overview of Auditor Responsibility and Characteristics of Fraud

Dr. Donald K. McConnell Jr.

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Evolution of the Auditor’s Fraud Detection Responsibilities Circa 1900: fraud detection the auditor’s

primary responsibility The late 1930s: McKesson and Robbins-

Did the auditor’s miss something? The mid-1960s: a “Catch-22”fraud

detection scenario Treadway committee findings led to SAS

53: the first defined responsibilities for detecting “irregularities”

Contemporary responsibilities: SAS 82 (AU 316) –a watershed event

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Report of the National Commission on Fraudulent Financial Reporting

Commonly referred to as the Treadway Committee Report (1987)

The Committee of Sponsoring Organizations (COSO) AICPA AAA FEI IIA IMA

Charge: identify environmental factors present when highest management level fraud occurs

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The Most Important Findings A proper “tone at the top” (corporate

environment or corporate culture) is the most important factor in combating fraud for the entity

Almost all management level fraud involved three types of schemes: Improper revenue recognition schemes Overvalued assets Improperly capitalized expenditures

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Improper Revenue Recognition Schemes Fraudulent sales Bill and hold arrangements Improper sales cut off’s Parking lot transactions Sales with liberal rights of return Channel stuffing

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Overvalued Assets Assets management knows should

be written down Examples:

Inventories Accounts receivable Impaired fixed assets

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Improperly Capitalized Expenditures “Creative” asset theory regarding

future benefit Expenditures booked as assets,

which should have been expensed WCOM capitalized ordinary line

expenses as fixed assets

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Other Treadway Committee Report Findings Perpetrators almost always had complete,

accurate audit trails Highest level management rarely embezzles Rarely does management fraud involved

manipulated financial data or incomplete records

Most management fraud was committed in the area of Accounting estimates

Accounting estimates are: Hard to develop, and easy to manipulate Hard to control Hard to audit

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What Is the Auditor’s Greatest Nightmare?

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What is the Auditor’s Fraud Detection Responsibility? The auditor has a responsibility to plan

and perform the audit to obtain REASONABALE ASSURANCE about whether the financial statements are free of MATERIAL misstatement, whether caused by fraud or error. (SAS 99.01)

That responsibility is couched by the terms Reasonable assurance and material

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Fraud Is a Broad Legal Concept: the Auditor’s Interest Is in Fraudulent Acts Causing Financial Statements to Be Materially Misstated

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Fraud Schemes Generally Involve: Pressure or incentive to commit

fraud (SAS 99.07) Perceived opportunity Attitudes/Rationalization (per

ACFE) These three elements form what

CFE’s call “A Fraud Triangle”

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Misstatements Arising from Fraudulent Financial Reporting [“Fraud for the Entity”]:

Intentional Misstatements or Omissions of Amounts or Disclosures in Financial Statements

Involving Manipulation, Falsification, or Alteration of Accounting Records or Documents,

Misrepresentation or Intentional Omissions, or Intentional Misapplication of Generally

Accepted Accounting Principles. (SAS 99.06)

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Misstatements Arising from Misappropriation of Assets [“Fraud Against the Entity”]

involves theft of entity assets wherein the effect of the theft causes financial statements not to be in conformity with GAAP. (SAS 99.06)

Examples include: Embezzlement of cash Purchasing kick back schemes Theft of small, valuable, marketable

assets (computer chips or small fixed assets)

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The Auditor is Interested in Fraud Which has the Effect of Causing the Financial Statements to be Materially Misstated; not just in Material Fraud

Doesn’t all material fraud cause the financial statements to materially misstated?An example where this isn’t the case.

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Fraud Schemes Typically Have Certain Characteristics (Au 316.07)

The schemes typically are concealed

Fraud can involve collusion, which is difficult to detect in an audit

Falsified documentation: Traditional auditors not expected to be experts in ascertaining authenticity

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Other Characteristics of Fraud All big frauds started as little ones Often occur through serendipity Fraudsters consider it a

“borrowing” Most embezzlers would be truly

appalled if accused of being a thief!

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What Does a Typical Fraudster Look like? You and me! They are often intelligent Almost always well-respected,

TRUSTED employees Often male, over 50, college-

educated

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Profile of a Typical Management Fraudster Glibness or

superficial charm Grandiose sense

of self worth or egocentric

Pathological liar Lack of remorse

or guilt

Shallow emotions Callousness or

lack of empathy Failure to accept

responsibility for their actions

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Motives for “Fraud for The Entity” Reach or exceed quotas or goals Meet regulatory requirements Manipulate stock price/value Maintain corporate ability to borrow Personal ambition

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Profile of a Typical Employee Fraudster Lifestyle does not

fit income Has access to

money or assets Problems at

home Problems dealing

with pressures Heavily indebted

Real or imagined grievances

Takes little or no vacation

Works odd hours Low morale Drug or gambling

problems Personality

changes

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Motives for “Fraud against the Entity” Enhance lifestyle Cure financial problems Revenge against the company Cure perceived injustice Ego-”beat the system” Personal ambition

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Various Fraud Issues Are auditors expected to seek out such indicators

of personal financial stress and company/employee conflict?

No, but an awareness of the following should be considered: Employee layoffs are anticipated Employees with access to assets susceptible to

defalcation exhibit: Unusual behavioral changes Lifestyle changes Appear disgruntled Known personal financial pressures

Is most fraud detected internally [internal auditors, hot lines] or by external audits?