Auditing for Internal Fraud

This course provides an auditor with the tools to identify fraud schemes. It trains CPAs to focus their analytical and substantive tests on the fraud triangle when evaluating internal controls. It also illustrates the latest in fraud prevention and detection programs implemented by industry leaders.

Objectives: 

• Develop fraud audit program
• Design fraud prevention and detection programs
• Identify critical indicators of fraud schemes
• Evaluate gaps in internal controls
• Understand the auditor's professional responsibilities

Prerequisite:  None

The Evolution of Fraudulent
Activity and the Response of the
Accounting Profession

Learning Objectives

After studying this chapter, you should be able to

• Understand the continued threat posed by fraudulent activity.
• Discuss the various pronouncements made by the accounting profession in response to the continued threats of fraudulent activity.
• Improve comprehension of the changes instituted by Statement on Auditing Standards No. 99.

Introduction

The accounting profession continues to respond to the ever present perplexity created by fraudulent activity in a business environment. The accountant continues to be faced with the dilemma of identifying their responsibility in this process and answering the questions: How can I efficiently search for fraudulent activity? How do I report this discovery and to whom? The latest auditing standard (SAS No. 99) provides a clearer understanding of the role of the accountant in the process of fraud detection.

The American economic system continues to be plagued with the persistent problem of fraud, embezzlement, deception and the intentional manipulation of business records. The early part of the 20th Century saw the development of massive oil fraud schemes and Ponzi schemes; the war years brought profiteering, the ‘60s saw the evolution of land fraud in the west, the ‘80s brought the massive savings and loan/bank crisis while the ‘90s provided health care fraud and concerns about the potential of fraud on the Internet. The year 2000-2001 heralded the financial and professional crisis that has shaken the foundation of the accounting profession. The realization that a major accounting firm could be a significant factor in fraudulent activity that began to surface during this time span has taken a toll on the confidence level of many, many CPAs. The never ending pattern seems to be one of continually evolving fraudulent activity that flows from one era to another becoming more and more complex along the way. The level of frustration with this pattern continues to worsen among the public, the government, and the accounting profession.

The public and the government continue to cry out for stronger measures to stem the tide of this tenacious pattern of deceit in the business community. More needs to be done to break the cycle of questionable business ethics in American business by identifying and punishing the worst offenders.

While the problems seem evident, developing a solution seems a little more murky. A number of factors, some of them obvious, create barriers to a sustained attack on deception and fraud in business activity; they are as follows:

• Our natural instinct, both personally and professionally, to trust the verbal comments and work product of other business people.
• Personality characteristics that cause us to avoid controversy or conflict in business settings which can affect our willingness to confront questionable or deceptive business activity.
• Our own, or the clients’, unwillingness to commit the time, resources, and energy to pursue those transactions that seem highly unusual or questionable.
• The difficulty in ferreting out deceptive business activity that is hidden within a complex and voluminous computerized business environment.
• The intense pressure faced by offices and employees to meet or exceed financial goals of the company.
• An apparent “lack of interest” in prosecution and/or official sanction by law enforcement or regulatory agencies. The perception is that only the most flagrant or blatantly obvious violations receive official scrutiny, leaving many other questionable or deceptive acts festering in the shadows.

The public and many in government see this task as the role of the accounting profession. The perception is that a CPA’s intimate knowledge of business records and their intuitive skills at solving problems make them primarily responsible for accomplishing this daunting task. While this widely accepted attitude may be wrong, it does not lessen the fact that the accounting profession is viewed by the public as fulfilling the role of policeman to the American business environment.

The accounting profession, through the AICPA and other oversight organizations, has attempted to clarify the role of the accounting professional in the public’s eye of the public, government, and the individual accountant. The process has led to the issuance of statements and policy positions which are all designed to clarify the role of the accountant in the continuing attack on fraudulent activity. Several of the more recent and far-reaching actions by the profession are set forth in the following section of this chapter.

Treadway Commission

The National Commission on Fraudulent Financial Reporting, more commonly referred to as the Treadway Commission, was formed in 1985 to inspect, analyze, and make recommendations in what appeared, at that time to be an alarming increase in fraudulent corporate financial reporting. The Treadway Commission studied the financial information reporting system over the period from October 1985 to September 1987 and issued a report of findings and recommendations in October 1987.

The Commission made a number of recommendations designed for (1) the public company, (2) the independent public accountant, (3) Securities and Exchange Commission, and (4) the field of education for the accountant. A synopsis of the recommendations for two of them, the public company and the independent public accountant, are set forth as follows:

I. Recommendation for the Public Company

• The tone of management as set by the company officials
• Careful design of the internal accounting and auditing functions
• An audit committee composed of independent directors
• Management and audit committee reports describing the activity and the effectiveness of internal control measures
• More public dialogue by management when seeking a second opinion on a significant accounting issue

II. Recommendations for the Independent Public Accountant

• Improved recognition of the independent public accountant’s responsibility for detecting fraudulent financial reporting
• Required review procedures to mark high-risk fraudulent financial reporting areas
• Improved audit quality
• Clearer communication in written audit reports concerning the limitations on the absolutes of finding fraud
• Reorganization of the Auditing Standards Board of the AICPA

Statement on Auditing Standard No. 54
(Illegal Acts by Clients)

In April of 1988, SAS No. 54 was issued to assist the independent auditor (in the consideration that should be given to the possibility) of illegal acts by the client. The implication is that management, or persons acting on behalf of management, is willing to commit some act in order to intentionally confuse or mislead the audit team. SAS No. 54 classifies illegal acts within two broad categories: (1) acts with a direct and material affect on financial statements of the entity, and (2) other acts with a material, but more indirect effect on the statements. The auditor should be alert to the existence of illegal acts while performing such tests as

• Reading minutes of the meetings of the organization.
• Performing substantive tests of the details of selected transactions.
• Analyzing large payments for unspecified services to consultants, affiliates, or employees.
• Reviewing sales commissions, agents’ fees, purchases, or other classifications that appear in excess of the normal payment for services received.
• Examining the files concerning litigation, claims, lawsuits, including correspondence and invoices from the attorney.

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