Reporting corporate fraud

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"The role of the auditor in detecting and reporting corporate fraud"

The cost of fraud is increasingly affecting many businesses all around the world. Everybody is affected as a victim of fraud because of the high products costs and also because of low corporate profits. So in order to put an end or to reduce this practice, auditors (internal and external) are operating to help to enforce accountability and to set up confidence in financial reporting.

Therefore this paper will examine the origin of audit, its objective and purpose and will also provide the role of an auditor in detecting fraud and reporting fraud.

Overview on Auditing:

First of all, audit will be defined as "an exercise designed to enable an auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework" (the Institute of Chartered Accountants in England and Wales, 2008, P.6).

So an auditor is the qualified person who gives a conclusion whether the financial statement of a company 'shows a true and fair view'.

It is important to know that it exists the audit threshold, which is specific to each country or economic area, for example in the United Kingdom, all companies according to the Institute of Chartered Accountants in England and Wales (2008) are required to be audited except some very small companies and since 2004 exemption were extended to all companies which fulfil the following criteria:

  • the business must be qualified as small company under the 2006 companies act
  • the business's turnover must be less than £5.6 million
  • the company's gross assets (noncurrent assets and current assets) must not exceed £2.8 million.

Essentially after the industrial revolution (1750-1850), the management of companies moved from owners or sole traders to managers to make it more professional, therefore that where the need for auditors comes from in order to have independent auditors from management to report to owners.

In the United States of America the objectives of audit passed from detection of fraud at the beginning to fraud reporting on the actual financial condition of companies, whilst in the United Kingdom the primary purpose was to detect frauds and the errors.

Since then auditing has moved from fraud and error detection, to risk-based approach adopted since 1980 based on risk evaluation. Also the main purpose of the audit consists in helping to enforce accountability and promote confidence in financial reporting. Auditing as well provides mechanism for shareholders and stakeholders to help ensure that managers and directors are acting in company's best interest, because directors are mainly responsible for managing the affairs of the company on behalf of the shareholders (Wells, J. T., 2004)

DESCRIBTION AND VARIETIES OF FRAUD:

An auditor is in charge to draw conclusion whether a company's financial statements are free from material misstatement that could be due to fraud. Thus the International Standards on Auditing set out auditor's responsibility regarding fraud through the ISA240; which will take account of evaluating risks of material misstatement and will also involve finding out the sensitivity of the financial statements to material misstatement caused by fraud (the Institute of Chartered accountants in England and Wales, 2008).

Fraud is a word which is often use to cover a wide range of illegal acts, then according to O'Gara J. D., (2004) Fraud is the intentional and illegal act of deception or of manipulating accounts. It can be operated for the benefit or to the detriment of the corporate and by persons inside or outside the organization. It's also essential to mention that fraud is a deliberate deception for the gratification of an individual or group. However in this paper we will only be concerned by fraud that may be detected by auditors. Actually, we will classify fraud through two dimension which are whether the perpetuated fraud is for or against the organization and secondly to find out the class of the culpable or perpetrator.

Regarding the type of fraud it could either be:

  • Corruption or misappropriation within the business which case is a fraud against the business.
  • Fraud concerning the financial reporting which is considered as a fraud for the organization as well as the money laundering.
  • External fraud against the organization (for example false checks or credit card fraud), (O'Gara, 2004).

And for the perpetrator it could either be: management, employee or non employee. However management frauds are most of the time completely different from employees as management will be using positional power rather than taking advantage of internal control weaknesses. Most of the time financial reporting fraud occurs at the top of an organization and is run up by senior management the operating management is more likely to commit bribery and corruption as fraud rather than the others types, whilst administrative managers will go for asset-misappropriation.

For many others reasons , management fraud is under detected, and also when it's detected most frequently it remains not prosecuted, that why for internal auditors the primary responsibility will be recognition and detection ( O'Gara, J.D., 2004).

As stated above ,external and internal auditor remain different, thus that is why management frauds against the business are extremely difficult to detect for internal auditors and it s requires further perspectives than just normal accounting. So detecting management fraud remains the greatest challenge for those internal auditors because of its high impact on the business often even more significant than the other types as it is usually an off the books fraud (O'Gara, 2004).

FRAUD AGAINST THE ORGANIZATION:

Management fraud:

As mentioned earlier, the area of most management fraud against the organization, generally conflict of interest, is under reported, because it is the most embarrassing for a corporation. According to John D. O'Gara (2004) Management fraud could also involve non management individuals, and we will states below some common characteristic to those frauds:

  • Mainly relational fraud which could be for example to divert corporate profit rather than doing transactions which could be detected by auditors.
  • The average management fraud loss is 8 times the average employee- fraud loss ( excluding financial statement fraud)
  • The impact of the fraud is significant and essentially not apparent in the records (income statement or statement of financial position of the corporate) due to the fact that they are off the books.
  • Also the perpetrator is a higher in the corporation so making him a trusted employee.
  • Frequently other persons could facilitate management fraud for example some accomplice specially in bidding situation.

Also for most of the time, fraudulent misappropriations happen through fraudulent middlemen companies which are typically created for the sole purpose of fraud without any legitimate business purpose. In some cases the middlemen company is easily identifiable because of the volume of businesses or for its real position between suppliers and customers (Wells, J. T., 2004).

Some symptoms making the fraud detectable:

Some symptoms can help to find out the ongoing fraud situation in corporations such as:

  • Clear appearance of some anomalies in the profit and loss accounts, such as diverted profits.
  • Generally when there is fraud at the top, we could also see fraud further down just like food chain.
  • There are lifestyle manifestations of the fraud in most cases because individuals are engaged in fraud to make their personal business
  • The use of substantial middlemen companies, inserted between the corporation and its suppliers or its customers that are no economic benefit to the corporation.
  • The changes that can affect corporation margin and which are not supported by external or inherent economic conditions.
  • Inexplicable bankruptcies or significant gaps between market and contract prices.
  • It is important to mention that a high volume of personal and confidential mail sent to managers or senior managers could also pull auditors attention (O'Gara, J., D., 2004).

FRAUD FOR THE ORGANISATION:

Significant fraudulent financial reporting used to be done and what's surprising is that it does not specially result from a breakdown in the internal accounting control system, but it just comes as a confirmation that senior management uses positional leverage to overpower their corporate accounting control system. And it has been demonstrated that usually more corporate fraud begins at the top and one issue for the internal audit is the corporate accountability rather than the corporate accounting (O'Gara, J.D., 2004)

So, many questions arise to find out what is the role that internal auditor should play? The internal auditors should be an arm of corporate governance rather than a group of controllers or accountants (Wells, J.T., 2004).

Some symptoms of financial reporting fraud:

  • Considerable off the book businesses or transactions with related entities especially when disclosure rule is not properly respected.
  • Unsupported journal entries particularly around period end that can have effect on the income statement or changes in the statement of financial position such as provisions, depreciation or inventory
    valuation.
  • A lack of transparency of financial statements or changes in accounting principles to a favourable basis in order to make more benefit or to hide corporate profits
  • Volatile operating margins mixed with controversial margins which do not match with the corporate results from operations (O'Gara, J. D., 2004)

Role of the auditor in investigating, detecting and reporting:

In this part it is important to make a clear difference between recognition and detection and between detection and investigating.

So chronologically fraud recognition happens first because at that step auditor becomes aware of fraud possibility then followed by detection when he determines the probability of fraud (O'Gara, J.D., 2004).

Usually it is better when fraud recognition happens earlier so auditors could have more time to run deep investigation s through corporate financial statement.

Investigations constitute a separate stage from detection in the fraud chain as they will be concerned by:

  • Verifying inventories and checking bank reconciliations, also confirming receivables
  • When detected ,pay attention to fraud life circle to find out the duration and the mechanism
  • Determine the true identity or any middlemen company and also make himself available for employees that could bring more information than expected
  • Using corporate resources carefully and discreetly to obtain information
  • Interviewing employees, but in this situation the order does matter because it is advised to keep prime suspect for to end and not to let them know about any prior information from others employees
    interview (O'Gara, J.D., 2004).

After investigating stage when fraud is found then it will be time to report it in accordance of the Auditing standards.

Also an auditor should have these qualities stated below according to the Institute of Chartered Accountants in England and Wales (2008, P75):

  • "Accountability
  • Integrity
  • Objectivity and independence
  • Competence
  • Rigour
  • Judgement
  • Clear, complete and effective communication
  • Association
  • Providing value"

Conclusion:

Fraud is a major cost for corporation, that why auditors are operating to uncover typical fraud that could affect corporations. And also auditors are really close to corporations than any other adviser to try to help them and to eliminate fraud.

However auditing also has certain limitations that affect it on its way to investigate and track fraud.

References:

  • O'Gara, John D., (2004), Corporate Fraud case studies in Detection and Prevention, Hoboken: John Wiley & Sons
  • The Institute of Chartered Accountants in England and Wales, (2008), Audit and Assurance study manual, 2nd edition, Milton Keynes: Institute of Chartered Accountants in England and Wales
  • Wells, Joseph T., (2004), Corporate Fraud Handbook prevention and detection, Chichester: John Wiley & Sons
  • The Institute of Chartered Accountants in England and Wales, (2010), highlights, Online, Available at http://www.icaew.com/review/04highlights.html

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