Even with all of the publicity surrounding the issue of financial fraud in the last decade or two, most auditors, investors and other professionals still do not “get it” when it comes to detecting fraud. Traditional financial statement audits were never designed to detect fraud. The audit is simply a process by which auditors check the company’s math and application of accounting rules.
Fraud is rarely detected by financial statement audits because they are not designed to do so. Occasionally, fraud is detected by auditors, but they could increase their chances of finding fraud if they changed their audit procedures.
This article discusses the seven most common ways fraud is hidden from auditors. By highlighting these issues, professionals can better understand the issues related to detecting fraud and can avoid a false sense of security when examining audited financial statements.
1. Use key accounts
Fraudsters can use several key types of accounts to hide fraud. Accounts with a high volume of low-dollar transactions (like “supplies” or “miscellaneous”) are more difficult to audit or verify because of the volume of transactions. Accounts that the auditors may not understand, such as research and development costs or warranty reserve, may be a good hiding place because the auditors may not know enough to be able to find problems.
Accounts that require the use of estimates and management’s judgment, such as reserves, may be an attractive and easy place to hide fraud. The estimates are difficult to audit, and the auditors often do not have sufficient knowledge to effectively challenge the estimates.
2. Hide a needle in a haystack
Auditors select a sample of transactions, test those for accuracy, and make judgments about the overall accuracy of the financial statements based on the sample. Many transactions are not selected for testing, and a fraudulent transaction is often a needle in a haystack. The fraudster has a good chance that the transaction will never be discovered, as the auditors have no idea whether fraud has occurred, what kind of fraud might have been perpetrated, or where it is hidden in the financial statements. The odds are simply stacked in favor of the fraudster.
3. Plan around scope and announced procedures
Auditors are notorious for repeating their testing from year to year, focusing on the same accounts or types of transactions, and using dollar thresholds that the audit clients are intimately familiar with. When employees know exactly which risks and accounts the auditors will target, the effectiveness of audit testing goes down. Fraudsters can book accounting entries in a way that will avoid scrutiny. They can also do things like move inventory between locations after they know which sites the auditors will visit. Employees can prepare false documentation in advance of predictable audit requests.
4. Pretend to be conservative
Conservatism is one of the most basic accounting principles, and when auditors believe management has been conservative, they are likely to apply less scrutiny to the numbers. The company knows what the auditors want to hear, and telling auditors that the estimates are very conservative will help the audit proceed smoothly.
5. Call it earnings management
Is earnings management really fraud? It is a process by which the company takes advantage of the accounting rules in a way that paints the best picture of the company’s finances. Some may argue that earnings management falls into a gray area, but most times it is fraud.
Common techniques include recognizing revenue early, booking fictitious sales based on anticipated activity, failure to book expenses or accruals, engaging in channel stuffing, or using round-tripping. These types of things are very difficult for auditors to detect, so they are an attractive way to commit financial fraud.
6. Exploit inexperienced auditors
Audits rely heavily on relatively inexperienced auditors to do the bulk of the field work. While this may make economic sense in terms of controlling the cost of audits, it is a terrible practice from a quality control standpoint.
Young auditors often do not know which questions to ask, and are usually reluctant to ask difficult questions or challenge management’s assertions. They are easily manipulated, influenced and misled because of their inexperience. They often lack a true understanding of business and financial statements, as these are things that take time to learn in the real world. Most auditors lack an in-depth understanding of fraud schemes and how they are carried out. This makes it easier to get away with fraud.
7. Use social engineering
Auditors can be swayed by employees who appear cooperative, want to help the auditors with their work, and generally offer the answers the auditors want to hear. When the auditors suggest adjustments to the accounting records, fraudsters who cooperate and make the adjustments will be viewed more favorably. This leaves the door open for the fraudsters to commit fraud in other areas of the financial statements, as the auditors are focused on the adjustments they already found.
Making audits more effective
Audits have never been designed to detect fraud, and unless there is a massive change in the business of auditing, they never will detect fraud at a meaningful rate. But there are things auditors can do to be more effective in detecting fraud.
- Know the business. A better understanding of the business being audited will help auditors be more effective. Younger auditors need better training and supervision, and classroom work cannot take the place of actual experience in the field.
- Use basic techniques that can make a difference. Auditors should use basic techniques, such as the element of surprise. They should vary their procedures and scopes from year to year, and surprise procedures should be conducted throughout the year as well as during the audit.
- Consider potential scenarios. Auditors should spend more time evaluating how fraud could be committed at the company.
- Put experienced auditors in the field. Those who know the most about business and financial statements need to be more involved in the field to help auditors learn more. Inexperienced auditors need the support of the more experienced auditors so they can confidently ask difficult questions and challenge suspected methods or transactions. While this may change the cost structure of audits, it may be one of the best ways to help auditors find more fraud.
Be sure to protect you and your company by looking beyond the same old standards of detecting fraud.