AUDITORS LIABILITY

IN DETECTING FRAUD,
FRAUD SCHEMES AND RED
FLAGS

AUDITORS LIABILITY
The responsibility of auditors to safeguard public

interest has increased as the number of investors

increase and also the stakeholders also demand
more accountability.
When auditors agree to perform audits they purport
to be experts in assessing the fairness of the financial
statements.
Even if the audit is performed at the highest level of
quality, the firm can still be sued and incur substantial
legal cost.
Even if the firm wins the case the reputation is
tarnished.

AUDITORS LIABILITY

It is not only auditors who are being sued, students

sue lectures, patients sue doctors etc.
The following are the factors which lead to
increased litigation.
Liability environment and the laws. The deep pocket
theory i.e. sue those who can pay.
Pressure to reduce audit time and fees
Some investors view audit as an insurance policy
Law firm payments i.e. contingent fee payment
(payment made only if the case is won)
Increased complexity of audits

AUDITORS LIABILITY
Causes of legal action
Breach of contract- fails to perform
contractual duty e.g. if hired to find fraud and
you dont.
Negligence- failure to exercise reasonable
care thus causing harm to investors
Involvement in fraud- intentional concealment
or misrepresentation of material fact.

AUDITORS LIABILITY
Minimizing liability exposures.
Policies to help assure auditor independence
Partner rotation- brings fresh approach
Restrictions on non-audit services
Audit independence programs
Sound quality controls
Integrity and objectivity
Personnel management
Continuance and engagements of clients
monitoring

AUDITORS LIABILITY

Review programs
External inspectors
Peer reviews
Continuing education
Defensive auditing
Means taking special action to avoid litigation e.g.
Issuing engagement letter- cornerstone of every
defense. It states the scope.
Screening clients
Not taking engagements they cant handle.
Maintaining accurate audit documentation
Appropriate insurance

Detecting Fraud
There has been numerous examples of fraud

cases and alleged auditor negligence such as

the cases of:
Enron- Arthur Andersen
Xerox- KPMG
WorldCom- Arthur Andersen
These scandals are synonymous with
fraudulent financial reporting.

Detecting Fraud
In many of the cases against the auditors, the

auditors failed to obtain appropriate evidence

or failed to recognize and follow up on the red
flags.
Historically, external auditors have counted
on the internal controls as the main defense
against fraud, but this cannot work if
managers themselves can override the
controls

Detecting Fraud
Fraud can be divided into three main

categories:
Asset misappropriation
Fraudulent financial reporting
corruption

Detection Methods
To reduce the risk of having frauds occurring

the auditors should use such practices as:

Horizontal and vertical analysis
Conducting frequent ratio analysis, including
assessment of trends over periods of several
years.
Rigorously applying the guidance of SAS
No.99 to all audit exercises.

Statement of Auditing Standards

SAS- is an auditing statement issued by

Auditing Standard Board of the American

Institute of Certified Public Accountants
(AICPA)
To serve as a cornerstone of anti-fraud
program AICPA issued SAS No.82:
consideration of fraud in financial statements
audit.
It was then superseded by SAS No.99:
consideration of fraud in financial statement
fraud.

SAS No. 99
SAS 99 defines fraud as an intentional act

that results in a material misstatement in

financial statements.
There are two types of fraud considered:
misstatements arising from fraudulent
financial reporting (e.g. falsification of
accounting records) and misstatements
arising from misappropriation of assets (e.g.
theft of assets or fraudulent expenditures).

SAS No. 99
The standard describes the fraud triangle. Generally,

the three fraud triangle conditions are present when

fraud occurs
First, there is an incentive or pressure that provides a
reason to commit fraud
Second, there is an opportunity for fraud to be
perpetrated (e.g. absence of controls, ineffective
controls, or the ability of management to override
controls.)
Third, the individuals committing the fraud possess
an attitude that enables them to rationalize the fraud.

SAS No. 99- Requirements

Requires brainstorming sessions to discuss how and

where the entitys financial statements might be

exposed to material misstatement due to fraud.
This requirement is a new concept in audit standards
and it has two primary objectives.
The first objective is that the engagement team will
have an opportunity for the seasoned team members
to share their experiences with the client and how a
fraud might be perpetrated and concealed.
The second objective is to set the proper tone at the
top for conducting the engagement. The
brainstorming session is to be conducted in a manner
that models the proper degree of professional
skepticism and sets the culture for the entire audit.

SAS No. 99- Requirements

Requires the auditor to gather information

necessary to identify risks of material

misstatement due to fraud by the following
Making inquiries of management and others
within the entity
Considering the results of analytical
procedures performed in planning the audit.
Considering fraud risk factors.
Considering certain other information

SAS No. 99- Requirements

Requires the auditor to use the information

gathered to identify risks that may result in a

material misstatement.
This section provides guidance and support on how
to identify and assess risks.
It challenges auditors to change the way they think
about assessing fraud risks.
Auditors should identify risks and synthesize how
those risks could lead to a material misstatement.
This section specifically requires that improper
revenue recognition and management override of
controls be considered.

SAS No. 99- Requirements

Requires the auditor to evaluate the

entitys programs and controls that

address the identified risks of material
misstatement.
SAS 99 provides specific examples of
programs and controls for both large and
small businesses.
The auditor should consider which controls
mitigate the identified fraud risks.

SAS No. 99- Requirements

Requires the auditor to assess the risks of

material misstatement due to fraud throughout

the audit and to evaluate at the completion of the
audit whether the accumulated results of auditing
procedures and other observations affect the
assessment.
The standard provides examples of conditions that
may be identified during the audit that might indicate
fraud
One example is management denying the auditors
access to key IT operations staff including security,
operations, and systems development personnel.
The auditors must determine whether the results of
their tests affect their assessment.

SAS No. 99- Requirements

Provides guidance regarding the auditors

communications about fraud to

management, the audit committee, and
others.
The standard requires that any evidence that
fraud may exist must be communicated to
management and others.

SAS No. 99- Criticism

1) The primary criticism of the standard is that many

procedures are suggested rather than required

For example, it is suggested that auditors consider
surprise procedures like showing up unannounced
for an inventory count
In actual practice auditors often tell clients which
inventory locations they are going to observe.
Telling clients which locations are going to be
audited makes it easier to commit inventory fraud.

SAS No. 99- Criticism

2) A similar criticism is that SAS 99 doesnt close

expectation gaps.
The guidelines and suggestions provided in the
standard increase expectations on the profession.
As a result, auditors must consider the requirements
of SAS 99 as the minimum level of work required to
detect fraud.
They must be prepared to defend any decision not
to pursue one of the recommended procedures
listed in SAS 99.

Schemes, Red flags and Questions to

ask?
The opportunity for misstatement exist on

every financial statement, a handful of culprits

account for the majority of the cases.
The managers need to be familiar with these
culprits and know which red flags might
indicate the presence.
Overstating or improper recognizing revenues
is a common form of financial statement fraud

Revenue
The schemes are:
Recording gross rather than net sales
Recording revenues of other companies while

actually a middleman
Recording sales that never took place.
Recording future sales in the current period
Recording sales of products which are on
consignment.

Revenue
Red flags
Increased revenues without a corresponding

increase in cash flow, especially overtime.

Unusual or highly complex transactions,
particularly those that are close to the year
end.
Unusual growth in the number of days in
receivables.
Strong revenue growth when peer companies
are experiencing weak sales.

Revenue
Questions to ask
Why did revenues increase sharply during the end of

the period compared with prior-year and current-year

results and the budget forecast?
How does revenue growth compared with that of
peers during the same period? If substantially higher,
does the explanation make sense?
Did receivables increase due to a particular
customer? If so, should a reserve be established?

Understating expenses
Schemes
Reporting cost of sales as a non-operating

expense so it does not negatively affect gross

margin
Capitalizing operating expenses, recording
them as assets on the balance sheet instead
of as expenses on the income statement
Not recording some expenses at all, or not
recording expenses in the proper period

Understating expenses
Red flags
Unusual increases in income or income in excess of

industry peers
Significant unexplained increases in fixed assets
Recurring negative cash flows from operations while
reporting earnings and earnings growth
Allowances for sales returns, warranty claims, etc.,
that are shrinking in percentage terms or are
otherwise out of line with those of industry peers

Understating expenses
Questions to ask
Why did gross margin (by location, product

and geographic area) increase during year

end or period-end compared with the prior
year and current-year budget forecast?
Does the explanation make sense?

Improper asset valuations

Asset write-downs following the disclosure of

faulty reserve reports should make all

company managers pay special attention to
how they report their most important hard
assets.
Schemes
Manipulating reserves
Changing useful lives of assets
Failing to take a write-down when needed
Manipulating estimates of fair market value

Improper asset valuations

Red flags
Recurring negative cash flows from

operations while reporting earnings and

earnings growth
Significant declines in customer demand and
increasing business failures in either the
industry or the overall economy
Assets, liabilities, revenues or expenses
based on significant estimates that involve
subjective judgments.

Improper asset valuations

Questions to ask
How is the overall economy affecting customer

demand and business? Declines in both could be a

signal that there might be an asset impairment issue
involving inventory or allowance reserves.
For areas where there are significant estimates, what
is the method used to determine the estimate?
Is this method consistent with that of prior periods?
What supporting documentation is available to
support the calculation?

Other Schemes
The following are also schemes used to cook the

books
Schemes
Smoothing of earnings: Often referred to as using
cookie jar reserves, this involves overestimating
liabilities during good periods and storing away
funds for future use against declining revenues
Disclosing information improperly, especially
concerning related-party transactions and loans to
management Executing highly complex transactions,
particularly those dealing with structured finance,
special-purpose entities and off-balance sheet
structures, and unusual counterparties

Other Schemes
Red flags
Domineering management
Decision to fix accounting in the next
period
No apparent business purpose
Reality of transaction differs from accounting or tax

result
Significant related-party transactions
Multiple memos rationalizing an aggressive
accounting treatment

Other Schemes
Questions to ask
Is there an overly aggressive push by management to meet

previously disclosed revenues or earnings targets?

Can management explain the business purpose for entities that
are outside the consolidated financial statements?
Were there significant adjustments made at the end of the
period?
Has there been an unusual focus on achieving a certain
accounting treatment?
Does the business purpose make sense?
Does the preferred accounting treatment allow the company to
meet certain targets?
Has there been a change in the method of calculating the
reserve estimates for any item from that used in the prior
quarter or prior years? If so, why?

When fraud is suspected

Red flags will result in answers that make perfect

sense. But when they dont, its time to consider two

actions: notifying the audit committee and calling in
the forensic accountants.
Forensic accountants are the crime scene
investigators of the financial world. They have
extensive experience examining the DNA of financial
statements; sifting through email records, documents
and data entries; and conducting extensive interviews
to uncover and explain the most complex financial
statement fraud.

 END