| Auditing for Fraud: Toby J. F. Bishop, Partner, Arthur Andersen Introduction The Environment
In the last decade financial statement fraud has affected approximately 300 public companies in the U.S. (Beasley et al. 1999), costing millions of investors billions of dollars. One recent case involved investor losses of approximately $20 billion. Some factors suggest that such large losses may be indicative of a new environment—one that creates more risk for auditors. First, market capitalizations can be much greater these days. This is due to megamergers spurred by global competition and due to higher stock prices caused by investor speculation, stock pricing based on growth opportunities rather than past profits, and higher P/E ratios. Second, markets now absorb information about earnings surprises much more quickly (Ip 1998). Financial statement fraud may now destroy 50 percent of market capitalization overnight and 80 to 90 percent overall. This makes it easier to associate larger stock losses with particular events. Indicators about the frequency of financial statement fraud are ambiguous. However, surveys of the willingness of managers to “cook the books” suggest intentional misstatement is far more common than most people think. A survey of attendees at a conference sponsored by CFO magazine found that 45 percent had been asked to misrepresent financial results and 38 percent of that group did so (Barr 1998). A similar Business Week survey found that 67 percent of CFOs had been asked to misrepresent results and 12 percent did so (Shuster 1998). No professional services firm in the world has pockets deep enough to absorb litigation costs of the size and frequency that these trends suggest. In addition, political pressure from irate investors would drive regulators to take increasingly aggressive actions. The accounting profession should recognize this new environment and consider viable options for reducing the incidence of undetected material fraud not just incrementally but radically. Ideas from Other
Industries The Six Sigma program could provide a tool to reduce the incidence of fraud. Based on information from the Wall Street Journal, which reported 25 new cases of alleged material financial statement fraud at U.S. public companies in 1999, and Who Audits America (Harris 2000), which list 8,873 audits of U.S. public companies, the rate of such frauds is 2,818 DPMO—better than the traditional overall defect levels of most successful companies but well short of Six Sigma. The airline industry provides a stunning example of how quality can be improved over time to reach exceptional levels. In 1999 there were 11,160,000 U.S. scheduled airline flights of airplanes with ten or more seats and only two major accidents (NTSB 2000), or 0.18 DPMO, where major accidents are defined as those involving destruction of the airplane, multiple fatalities, or one fatality and substantial damage to the airplane. In 1996, NASA reported that “The history of aviation safety has been characterized by major quantum jumps in safety brought about by advances in technology, followed by years of marginal improvements” (NASA 1996). According to Boeing (2000), in 1959 the rate of hull loss and/or fatal accidents among U.S. and Canadian operators was 25 DPMO, so the reduction in accident rates since then is dramatic. This has been achieved through a massive and consistent focus on accident prevention. A number of safety breakthroughs and institutional protocols contributing to this improvement could be applied to auditing. First, cockpit automation presents pilots with a greater volume of information, but in a way that can be more easily scanned and understood. It also uses computers to perform some maneuvers automatically. These techniques could be used to automate certain audit tasks such as the analysis of financial statements and the benchmarking of business performance. The results could be integrated with other relevant information and presented to help the auditor make particular judgments, e.g., fraud risk and bankruptcy risk. Other systems could help auditors deal with information overload by serving up at the point of demand guidance to facilitate decision making. Second, flight management systems enable pilots to better manage the conduct of a flight, changing the pilot’s role to that of strategic planner and flight manager. General and flight-specific data is programmed into the system, which computes appropriate control settings and flight activities. These computations are adjusted if necessary during flight, based on data gathered from onboard sensors. Similarly, enhanced audit management software could help audit teams to program audit activities based on general requirements and client-specific activities. Audit activities could be adjusted “in-flight” based on data gathered during the audit, such as indicators of heightened fraud risk. Such systems could help auditors ensure that all relevant audit procedures are performed and that information from different audit areas is checked for inconsistencies. Third, ground proximity warning systems and long-range radar alert pilots to potential danger in time for them to take evasive action. Comparable tools can be used to analyze financial statements, comparing their characteristics with those of financial statements that have historically been associated with material fraud and flagging items that indicate potential “proximity” to fraud. Other tools could be developed to evaluate key aspects of a company’s corporate governance and compensation practices, providing a long-range warning about corporate environments that may be conducive to fraud. Fourth, flight simulators have “revolutionized pilot training and have been the single most important safety advance in training,” enabling pilots to gain experience in handling various situations that they might otherwise encounter for the first time in a real aircraft with real passengers onboard. Some of these flight situations are so rare that the majority of pilots may never encounter them, yet they must be ready to recognize them and react appropriately. Similarly, most auditors do not encounter material financial statement fraud during their careers. However, audit simulations conducted in laboratory settings mimicking the real world could enable auditors to build skills in identifying and detecting fraud. Such simulations could be delivered efficiently by using web-based training modules. Fifth, aviation safety improvements have been supported by investigations into airplane accidents and the accumulation of extensive data, enabling the identification of common factors that justify focused research and recommendations for improvements. Although legal, business, and economic issues have impaired the availability of financial statement fraud data, the profession should explore the feasibility of constructing a shared database containing factual information relating to all cases of publicly reported material financial statement frauds. Such data is vital to support research which could ultimately reduce the incidence of fraud. Finally, and arguably most important, the aviation industry has made a priority of installing and regularly evaluating appropriate preventive controls. The accounting profession could adopt more fully this approach and evaluate the anti-fraud controls established by the companies we audit. The auditor could be required to report, at least to the audit committee, on the existence, effectiveness, and potential improvement of the company’s internal controls designed to prevent and detect fraud. Many companies today fall well short of best practices in this area and research suggests that reports would lead to improved controls (Hermanson 2000). Amending auditing standards to require such an evaluation and communication would support auditors in implementing this sensitive measure. Given the narrow focus of the report, the incremental cost should be greatly outweighed by the benefits to investors. Concluding
Comments
If the investing public is to have a much safer investing experience, where financial statement fraud is as rare as major jetliner accidents, then corporations and auditors have no choice. In the public interest, we must both change and change now. About the Author
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