Can Auditors Be Trusted To Detect Fraud?

Foreword from ShareInvestor

This article “Can Auditors Be Trusted To Detect Fraud?” by Cai HaoXiang was first published in The Business Times on 01 Sep 2014 and is reproduced in this blog in its entirety.

The simple answer is no. So, caveat emptor

As long as there is money to be made, dishonest businessmen have tried every conceivable means to manipulate financial statements to give a false impression of their company’s health.

There are many ways to deceive investors, the end-consumer of financial statements. They range from relatively mild “window- dressing” techniques to mask falling revenues or excessive expenses, to outright fraud by faking receipts and documents.

Every year, a listed company’s financials are subject to review by an external auditor. This is to give the investing public additional assurance that a company’s financial statements are reliable.

An audit is a costly and time-consuming process. Audit fees can run from the tens of thousands of dollars for a small private company to the hundreds of thousands for a larger listed company, to millions of dollars for the bigger listed firms reporting billions of dollars in revenue.

Auditors, for example, might have to spend time interviewing management, visiting company store outlets, counting inventory, and checking bank statements to verify claims.

In practice, however, it is impossible to check every statement, receipt, voucher or bill. And auditors don’t do that; they go through a sample of source documents, rather than every one.

Also, if auditors are given well-forged documents to pore through, as they have in past scandals, nothing may smell fishy.

If you have friends who are auditors, they might tell you that their work is an art as well as a science. Passing an opinion on a company’s statements requires judgment on whether the statements are compatible with accounting frameworks.

If there are improperly presented numbers, one also has to decide whether the misstatement is material or not, in the context of the company’s earnings, debt situation or cash flows.

Sometimes, misstatements deemed too small to matter might even be offset against each other such that no change needs to be made to a company’s financial statements.

The profession is also susceptible to conflicts of interest. Sure, auditors have reputations to keep and are not likely to shy away from pointing out fraudulent practices just for the sake of some fees.

But auditors are also incentivised to want continued business from a client year after year. Over time, they also become closer to management.

Any issues with financial statements could be worked out behind the scenes. Auditors might not want to object to every questionable practice, especially if it is minor.

At the extreme, auditors might freely allow aggressive accounting techniques.

A famous case in history involves energy giant Enron, which perpetuated accounting fraud and went bankrupt in 2001. Its auditor, Arthur Andersen, was caught up in the scandal and convicted of criminal charges.

Even though the conviction was later overturned, most of its customers had left the audit giant by then. The damage to its brand name proved too much for the firm to recover from.

Regulators have tried ways to increase auditor independence. One of the most contentious is the institution of mandatory audit rotation.

Supporters of the rule argue that it will allow a fresh set of eyes to spot issues, and avoid the risk of an incumbent audit firm losing objectivity by being too close to the audited company.

The knowledge that a new audit firm will take over the audit will cause the incumbent firm to be more careful with its work to avoid being embarrassed, goes the argument.

A few months ago, the European Parliament voted in favour of rules to force European-listed companies to appoint new auditors every 10 years. However, a similar effort in the US failed to gain traction.

Over here, the Monetary Authority of Singapore (MAS) put out rules in 2002 to require local banks to change auditors every five years. But they suspended those rules in 2008 amid the global financial crisis to avoid market disruption.

Some audit firms are against being compulsorily rotated. An Ernst & Young report in 2013 argued that audit firms can best perform when they have a long-term working relationship with the company.

They can better understand their clients’ business, which can be in a specialised industry. Changing auditors for companies with complex global operations can be costly and inefficient if the existing audit firm has already established a network.

By staying on for longer, auditors can gain their clients’ respect and trust to better resolve issues with management, Ernst & Young argued.

It is also important to note that, contrary to popular perception, auditors stress that their job is not to detect fraud.

As they remind investors in every report, their responsibility is to express an opinion on whether financial statements are free from material misstatement.

It is the management’s responsibility to prepare financial statements to give a true and fair view in accordance with laws and regulations.

Auditors also point out that it is the management’s responsibility to have a system of internal controls to protect assets against unauthorised use.

Auditors are, however, required to obtain an understanding of a company’s internal controls relevant to their audit of the company, when identifying and assessing the risks of material misstatement.

Unstated, perhaps, is the age-old dictum of caveat emptor: Let the buyer beware.

Ultimately, the onus is on investors to read through the disclosures given by a company in its financial statements and annual reports, and to make their own judgement on whether the company can be trusted.

As The Economist magazine put it in a December 2013 article: “Auditors have a conflict of interest at the heart of their business – they are paid by the companies they are supposed to assess objectively. Unless that changes, there will be no substitute for investors doing their own due diligence.”

Falling profits, pressure to meet investor expectations, lucrative management stock options, combined with a complicated business model, are just some of the conditions under which fraud could occur.

Let the investor beware.