Auditing for Fraud Detection

OVERVIEW

Auditing for fraud can be very challenging. It has the aura of detective work – finding things people want to keep hidden. However, auditing and fraud examination are not easy. They should only be pursued by persons who have proper training and experience. Thus, fraud awareness for independent auditors and internal auditors became more importance in modern era. Nowadays, the responsibility for detecting fraud largely has fallen to the auditing profession.

As a forensic auditor or fraud investigator it is upmost important to identify nature, signs, prevention, detection, and reaction of frauds that can enable you to perform financial statement audits with awareness of fraud possibilities. Users of audited financial statements generally believe that one of the main objectives of audits is fraud detection. Since most of the frauds can be detected from the financial statements, financial statement auditors need to understand fraud and potential fraud situations, and they need to know how to ask the right kinds of questions during an audit.

Several kinds of ''fraud'' are defined in laws, while others are matters of general understanding. Following examples of acts and devices often involved in financial frauds. Collectively, these are known as white-collar crime – the misdeeds done by people who wear ties to work and steal with a pencil or a computer terminal.

• Owners / Managers - Insider Trading and Related Party Transactions
• Stockholders / Creditors - Fraudulent financial statements, securities fraud
• Customers - False advertising, shirt shipments, defective products, price fixing, shoplifting, false refunds, false credit cards and hot checks
• Government - Tax evasion, contract cost padding, false benefit claims
• Employees - Expense account padding, embezzlement, theft of cash and property, kickbacks, padded payroll
• Suppliers / consultants - Double billing, false invoices, employee bribery
• Competitors - Theft of trade secrets, employee bribery
• Insurers - False loss claims

Basically, a fraud consists of knowingly making material misrepresentations of fact, with the intent of inducing someone to believe the falsehood and act upon it and, thus, suffer a loss or damage. This definition encompasses all the varieties by which people can lie, cheat, steal, and dupe other people. Fraudulent financial reporting can be defined as intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements.

THE ART OF FRAUD AWARENESS AUDITING

Fraud examination work combines the expertise of auditors and criminal investigators. Some fraud examiners are fond of saying that their successes are the result of accident, hunches, or luck. Nothing can be further from the reality. Successes come from experience, logic, and the ability to see things that are not obvious. Fraud awareness auditing, broadly speaking, involves familiarity with many elements: the human element, organizational behavior, knowledge of common fraud schemes, evidence and its sources, standards of proof, and sensitivity to red flags.

Independent auditors of financial statements and fraud examiners approach their work differently. While many differences exist, these are some of the most important and obvious ones:

• Financial auditors follow a program/procedural approach designed to accomplish a fairly standard job, while fraud examiners float in a mind-set of sensitivity to the unusual where nothing is standard.
• Financial auditors make note of errors and omissions, while fraud examiners focus as well on exceptions, oddities, and patterns of conduct.
• Financial auditors assess control risk in general and specific terms to design other audit procedures, while fraud examiners habitually "think like a crook'' to imagine ways controls could be subverted for fraudulent purposes.
• Financial auditors use a concept of materiality (dollar size big enough to matter) that is usually much higher than the amounts that fraud examiners consider worth pursuing. Financial auditors use materiality as a measure of importance one year at a time, whereas fraud examiners think of a cumulative materiality. (Theft of $20,000 per year may not loom large each year, but after a 15-year fraud career, $300,000 is a considerable loss.)
• Financial audits are based on theories of financial accounting and auditing logic, while fraud examination has a theory of behavioral motive, opportunity, and integrity.

Some aspects of audit methodology make a big difference in the fraud discovery success experience. Financial auditors often utilize inductive reasoning – that is, they sample accounting data, derive audit findings, and project ("induct'') the finding to a conclusion about the population of data sampled. Fraud examiners often enjoy the expensive luxury of utilizing deductive reasoning – that is, after being tipped off that a certain type of loss occurred or probably occurred, they can identify the suspects, make observations (stakeouts), conduct interviews, eliminate dead-end results, and concentrate on running the fraudster to ground. They can conduct covert activities that usually are not in the financial auditors' tool kit. The "expensive luxury'' of the deductive approach involves surveying a wide array of information and information sources, eliminating the extraneous, and retaining the selection that proves the fraud.

FRAUD PREVENTION

Accountants and auditors have often been exhorted to be the leaders in fraud prevention by employing their skills in designing "tight'' control systems. This strategy is, at best, a short-run solution to a large and pervasive problem. Business activity is built on the trust that people at all levels will do their jobs properly. Effective long-run prevention measures are complex and difficult, involving the elimination of the causes of fraud by mitigating the effect of motive, opportunity, and lack of integrity. Following preventing action can be taken to mitigate the possible frauds.

• Managing people pressures in the workplace
• Strengthening control procedures
• Regular employee monitoring
• Integrity by example and enforcement

FRAUD DETECTION

Since an organization cannot prevent all fraud, its auditors, accountants, and security personnel must be acquainted with some detection techniques. Frauds consist of the fraud act itself, the conversion of assets to the fraudster's use, and the cover-up. Catching people in the fraud act is difficult and unusual. The act of conversion is equally difficult to observe, since it typically takes place in secret away from the organization's offices (e.g., fencing stolen inventory). Many frauds are investigated by noticing signs and signals of fraud, then following the trail of missing, mutilated, or false documents that are part of the accounting records cover-up. There have signs and signals in terms of red flags, oddities, and unusual events. Following major red flags needs to

Employee Fraud

Employee fraud can involve high-level executives and people below the top executive levels. Observation of persons' habits and lifestyle and changes in habits and lifestyles may reveal some red flags. Personality red flags are difficult because honest people sometimes show them and they often are hidden from view. It is easier to notice changes, especially when a person changes his or her lifestyle or spends more money than the salary justifies – for example, on homes, furniture, jewelry, clothes, boats, autos, vacations, and the like.

Often, auditors can notice telltale hints of the cover-up. These generally appear in the accounting records. The key is to notice exceptions and oddities, such as transactions that are: at odd times of the day, month, season; too many or too few; in the wrong branch location; in amounts too high, too low, too consistent, too different. Exceptions and oddities like these can appear: Missing documents, Cash shortages and overages, Excessive voids and credit memos, Customer complaints, Common names or addresses for refunds, Adjustments to receivables and payables, General ledger does not balance, Increased past due receivables, Inventory shortages, Increased scrap, Alterations on documents, Duplicate payments, Employees cannot be found, Second endorsements on checks, Documents photocopied and Dormant accounts become active.

Management Fraud (Fraudulent Financial Reporting)

Fraud that affects financial statements and causes them to be materially misleading often arises from the perceived need to "get through a difficult period." The difficult period may be characterized by cash shortage, increased competition, cost overruns, and similar events that cause financial difficulty. Managers usually view these conditions as "temporary," believing they can be overcome by getting a new loan, selling stock, or otherwise buying time to recover. In the meantime, falsified financial statements are used to "benefit the company."

By both fraud and "creative accounting," companies have caused financial statements to be materially misleading by overstating revenues and assets, understating expenses and liabilities, and giving disclosures that are misleading or that omit important information. Generally, fraudulent financial statements show financial performance and ratios that are better than current industry experience or better than the company's own history. Sometimes the performance meets exactly the targets announced by management months earlier.

Because of the double-entry bookkeeping system, fraudulent accounting entries always affect two accounts and two places in financial statements. Since many frauds involve improper recognition of assets, there is a theory of the "dangling debit," which is an asset amount that can be investigated and found to be false or questionable. Frauds may involve the omission of liabilities, but the matter of finding and investigating the "dangling credit" is normally very difficult. It "dangles" off the books. Misleading disclosures also present difficulty, mainly because they involve words and messages instead of numbers. Omissions may be hard to notice, and misleading inferences may be very subtle.

A client's far-removed illegal acts may cause financial statements to be misleading, and external auditors are advised to be aware of following circumstances that might indicate them. Unauthorized transactions, Government investigations, Regulatory reports of violations, Payments to consultants, affiliates, employees for unspecified services, Excessive sales commissions and agent's fees, Unusually large cash payments, Unexplained payments to government officials and Failure to file tax returns, to pay duties and fees.

INTERNAL CONTROL

An important feature of internal control is the separation of these duties and responsibilities: transaction authorization, recordkeeping, custody of, or access to, assets, and reconciliation of actual assets to the accounting records. Generally, a person who, acting alone or in a conspiracy, can perform two or more of these functions also can commit a fraud by taking assets, converting them, and covering up.

Fraud awareness auditing involves perceptions of the controls installed (or not installed) by a company, plus "thinking like a crook" to imagine ways and means of stealing. When controls are absent, the ways and means may be obvious. Otherwise, it might take some scheming to figure out how to steal from an organization.

Auditors need to know about the red flags – the telltale signs and indications that have accompanied many frauds. When studying a business operation, auditors' ability to "think like a crook" to devise ways to steal can help in the planning of procedures designed to determine whether it happened. Often, imaginative "extended procedures" can be employed to unearth evidence of fraudulent activity. However, technical and personal care must always be exercised because accusations of fraud are always taken very seriously. For this reason, after preliminary findings indicate fraud possibilities, auditors should enlist the cooperation of management and assist fraud examination professionals in bringing an investigation to a conclusion.