The issue of fraud has been around for a long time leading to the collapse of most companies due to misleading financial reports and misappropriation of funds. He also questioned the integrity of some major players in the industry as well as major accounting firms. Unfortunately, fraud is not in any physical form so that it can be easily seen or caught. Refers to an intentional act by one or more individuals among management, those charged with governance, employees, or third parties that involves the use of deception to obtain an unfair or unlawful advantage.
According to the Association of Certified Fraud Examiners, fraud is defined as any intentional or willful act to deprive another person of property or money through deception, deception, or any other unfair means. Fraud is classified as follows:
-
Corruption: conflicts of interest, bribery, illegal extortion, and economic extortion.
-
Misappropriation of monetary assets: Theft, theft, check tampering, and fraudulent payments, including bill payment, payroll, and expense schemes.
-
Misappropriation of Non-Monetary Assets: Theft, false asset requisitions, destruction, removal, or improper use of records and equipment, improper disclosure of confidential information, and falsification or alteration of documents.
-
Fraudulent statements: financial reports, employment credentials, and external reports.
-
Fraudulent actions by customers, vendors or other parties include bribes or solicitations, fraudulent (not false) billing from a supplier or information from a customer.
Fraud involves a motive to commit fraud and a perceived opportunity to do so. A perceived opportunity for fraudulent financial reporting or misappropriation of assets may exist when an individual believes internal control can be circumvented, for example, because the individual is in a position of trust or has knowledge of certain weaknesses in the system of internal control. Fraud is generally fueled by three variables: pressure, opportunity, and justification as shown in the diagram.
There is a need to distinguish between fraud and error in the preparation of financial statements and reporting. The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional. Unlike a mistake, fraud is intentional and usually involves deliberate concealment of facts. Error refers to an inadvertent error in the financial statements, including the omission of an amount or disclosure.
Although fraud is a broad legal concept, the auditor is concerned with fraudulent acts that cause material misstatements in the financial statements, and there are two types of misstatements in considering fraud—misrepresentations resulting from fraudulent financial reporting and those arising from misappropriation of assets. (paragraph 3 of ISA 240)
Misappropriation of assets involves the theft of an entity’s assets and can be accomplished in a variety of ways (including receipts for misappropriation, theft of physical or intangible assets, or payment of the entity for goods and services not received). It is often accompanied by false or misleading records or documents to hide the fact that the assets are missing. Individuals may be motivated to misuse assets, for example, because individuals live beyond their means.
Fraudulent financial reporting may be committed because management is under pressure, from sources outside and within the entity, to meet an expected (and possibly unrealistic) profit target—especially since the consequences of management’s failure to meet financial targets can be significant. They involve intentional misrepresentations or omissions of amounts or disclosures in the financial statements to deceive users of the financial statements. Fraudulent financial reporting can be done through:
I. Deception, i.e. tampering, falsifying, or altering the accounting records or supporting documents from which the financial statements are prepared.
secondly. Intentional misrepresentation or omission from financial statements of events, transactions, or other important information.
Third. Intentionally misapplying accounting principles in relation to measurement, recognition, classification, presentation or disclosure.
The status of auditors in detecting and preventing fraud in financial reports
Auditors confirm that an audit does not guarantee that all material misstatements will be detected because of the limitations inherent in an audit and that they can only obtain reasonable assurance that material misstatements will be detected in the financial statements. The risk of not detecting a material misstatement due to fraud is also known to be higher than for misstatements resulting from error because fraud may involve complex, carefully orchestrated schemes designed to conceal them, such as forgery, intentional failure to record transactions, or the presentation of intentional misrepresentations to the auditor.
Such attempts at concealment may be more difficult to detect when they are accompanied by collusion, and thus the auditor’s ability to detect fraud depends on factors such as the skill of the offender, the frequency and extent of the manipulation, the degree of collusion involved, the relative size of the individual amounts manipulated, and the seniority involved. However, users of financial information expect auditors to take steps to detect fraud during an audit because they are often upset when fraud is not discovered and is later revealed by tip or accident while the resulting investigation or restatement of financial statements leads to negative consequences for the company and its employees.
Who is then responsible for detecting fraud in financial reporting?
The auditors’ responsibilities and roles in the audit are set out in the International Standards on Auditing (ISA) which serve as the “bible” for auditors in the performance of their duties and for ensuring that their reports comply with international standards. The provisions of the standard under consideration for this purpose are ISA 240 (i.e., the auditor’s responsibilities relating to fraud in the audit of financial statements) and ISA 315.
Paragraph 4 of ISA 240 addresses the responsibility for fraud prevention and detection and states that “the primary responsibility for preventing and detecting fraud rests with both those charged with governance of the entity and with management. It is important that management, through oversight of those charged with governance, place a strong emphasis on preventing fraud, which can reduce the chances of fraud occurring, and deterring fraud, which could lead to the potential for a culture of fraud on individuals not to engage in conduct. It can be enhanced through active oversight by those charged with governance. It includes oversight that Those charged with governance consider the possibility of override of controls or other improper influence on the financial reporting process, such as efforts by management to manage earnings in order to influence analysts’ perceptions regarding the entity’s performance and profitability.
Paragraph 5 also states, “The auditor conducting the audit in accordance with International Standards on Auditing is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether due to fraud or error. Because of the limitations inherent in an audit, there is an unavoidable risk that some material misstatement of the financial statements will not be detected, even though the audit was properly planned and performed.”
In addition, ISA 315 requires auditors to evaluate the effectiveness of the entity’s risk management framework in preventing misstatements, whether through fraud or otherwise, during the audit, and that auditors should consider the risks of misstatement from fraud or error on each significant account balance, recognizing material categories of transactions included in it, in order to identify specific risks and if material misstatements are found because other audit evidence can be obtained from management.
These letters indicate that the directors are responsible for ensuring that the company maintains appropriate accounting records that disclose with reasonable accuracy at any time the financial position of the company as well as the responsibility to protect the company’s assets and to take reasonable steps to prevent and detect fraud and other irregularities and that the auditors’ responsibility is to express an opinion on whether the summary financial statements are consistent, in all material respects, with the audited financial statements conducted in accordance with their International Standards on Auditing. For this reason, all annual financial reports have clearly defined responsibilities of board members and auditors.
Conclusion
It can clearly be concluded that auditors only play a complementary role in detecting and preventing fraud in financial reporting and that the ultimate responsibility rests with those charged with governance.
However, the Institute of Internal Auditors (IIA) Standard 1210.A2 requires auditors to possess “adequate knowledge” to identify indicators of fraud meaning that while auditors are not expected to develop these skills to the level of a fraud examiner, they should attempt to become more competent through training, practical experience, reading professional literature, brainstorming, and using fraud detection skills during the audit so that they are aware of the impact of statements on fraud accuracy and financial error.