Category Archives: External Auditing

Structure & Scope

T.J. Jones presented himself as a turnaround specialist to the Chairman of the Board of Central State Corporation, a medium sized, public company, a mid-western manufacturer of computer equipment, who hired him to take over a large, but under-performing division of the company.  Jones immediately set out lofty goals for sales and profits and very quickly replaced all the existing senior staff of the division with new hires loyal to himself. To meet his inflated goals, two of Jones’s managers, in addition to legitimate equipment sales, shipped bricks to distributors and recorded some as sales of equipment to retail distributors and some as inventory out on consignment. No real products left the plant for these “special sales.” The theory was that actual sales would inevitably grow, and the bricks could be replaced later with real products. In the meantime, the unwitting distributors thought they were holding consignment inventory in the unopened cartons.

The result was that overstated sales and accounts receivable quickly caused overstated net income, retained earnings, current assets, working capital, and total assets. Prior to the manipulation, annual sales of the division were $135 million. During the two falsification years of the fraud, sales were $185 million and $362 million. Net income went up from a loss of $20 million to $23 million (income), then to $31 million (income); and the gross margin percent went from 6 percent to 28 percent. The revenue and profit figures outpaced the performance of Central State’s industry category. The accounts receivable collection period grew to 94 days, while it was 70 days elsewhere in the industry.

All the paperwork was in order because the two hand-picked managers had falsified the sales and consignment invoices, even though they did not have customer purchase orders for all the false sales. Shipping papers were in order, and several co-operating shipping employees knew that not every box shipped contained disk drives. Company accounting and control procedures required customer purchase orders or contracts evidencing real orders. A sales invoice was supposed to indicate the products and their prices, and shipping documents were supposed to indicate actual shipment. Sales were always charged to a customer’s account receivable.  During the actual operation of the fraud there were no glaring control omissions that would have pointed to financial fraud. Alert auditors might have noticed the high tension created by concentration on meeting profit goals. Normal selection of sales transactions with vouching to customer orders and shipping documents might have turned up a missing customer order. Otherwise, the paperwork would have seemed to be in order. The problem lay in Jones’ and his managers’ power to override controls and to instruct some shipping staff to send dummy boxes.  Confirmations of distributors’ accounts receivable may have elicited exception responses. The problem was to have a large enough confirmation sample to pick up some of these distributors or to be skeptical enough to send a special sample of confirmations to distributors who took the “sales” near the end of the accounting period. Observation of inventory could have included some routine inspection of goods not on the company’s premises.

The overstatements were not detected. The auditor’s annual confirmation sample was typically small and did not contain any of the false shipments. Tests of detail transactions did not turn up any missing customer orders. The inventory out on consignment was audited by obtaining a written confirmation from the holders, who apparently over the entire period of the fraud had not opened even one of the affected boxes. The remarkable financial performance was attributed to good management.

The fraud was revealed by one of Jones’ subordinate managers who was arrested on an unrelated drug charge and volunteered as a cooperating witness in exchange for the dropping of the drug charge.

This hypothetical case is a good example of the initial situation confronting management when a fraud affecting the financial statements comes to light, often with little or no warning. Everyone involved with company management will have a strong intuitive sense that an investigation is necessary; but the fact is that the company has now lost faith in the validity of its own public disclosures of financial performance.

That will need to be fixed. And it is not enough to simply alert markets that previously issued financial results are wrong; outsiders will want to know what the correct numbers should have been. The only way to find out is to dig into the numbers and distinguish the falsified results from the real ones. Beyond the need to set the numbers straight, the company will need to identify those complicit in the fraud and deal with them. This is not only a quest for justice but the need to restore credibility, and the company will be unable to do so until outsiders are satisfied that the wrongdoing executives and staff have been identified and removed.  Thus, the company needs an audit report on its financial statements. The need for a new audit report arises from the likelihood that, once a company’s financial statements have been found to be unreliable, the company’s external auditor will want to pull its existing, inaccurate,  report.

As a practical matter, pulling its report involves the external auditor’s recommendation that the company issue a press release that previously issued financial statements are not to be relied upon. Once the company issues such a press release, it will be out of compliance with any number of SEC regulations. It will no longer satisfy the threshold prerequisites for trading on the company’s securities exchange. It will be viewed by many, and certainly the plaintiff class action bar, as coming close to having admitted wrongdoing. And everyone on the outside, not to mention its own board of directors, will want answers fast. A critical step in the restoration of important business relationships and a return to compliance with regulatory requirements is the new auditor’s report. And, where fraudulent financial reporting has been discovered, an in-depth and comprehensive investigation is often the only way to get one.

A critical issue at the outset of a financial fraud investigation is its structure and scope. A key attribute for which the external auditor, as well as the SEC, will be on the lookout is that the investigation is overseen by the audit committee. In public companies, it is the audit committee that has explicit legal responsibility for oversight of financial reporting, and accounting fraud falls squarely within the orbit of financial reporting.  In addition, the audit committee, as a matter of statutory design, is structured to be independent and possessed of a level of financial sophistication that makes it the most viable subset of the board of directors to oversee the investigative efforts in this case. It’s also the audit committee that has the statutory power to engage and pay outside advisers even without the consent of management, a statutory power that can be vital if management, or part of management, as in our hypothetical case above, is a participant in the fraud.

The audit committee’s role is to oversee the investigation, not actually conduct it. For that it needs to look to outside professionals, and there are two types. The one is the outside counsel to the audit committee. If the audit committee has not already engaged outside counsel, it needs to do so. It’s audit committee counsel who will conduct the interviews, comb through the financial records, and present factual findings for audit committee consideration. Individual audit committee members may choose to sit in on interviews, and that is their choice. But it’s audit committee counsel who will conduct the investigation. The other group of professionals is the forensic accountants and/or CFEs.  Audit committee counsel, while knowledgeable of financial reporting obligations and investigative techniques, will probably not possess a sufficiently detailed knowledge of accounting systems, generally accepted accounting principles
(GAAP), or computerized ledgers. For that, audit committee counsel is well advised look for help to the category of accountants and fraud examiners specifically trained in digging into financial records for evidence of fraud.

What exactly is the audit committee looking for in such an investigation? There are primarily two things. The first, obviously enough, is what the actual numbers should have been. Often fraudulent entries involve judgment calls where the operative question is not whether the number matches the underlying financial records but whether the judgment behind the number was exercised in good faith.  The operative question for the investigators is whether the executive exercised his judgment in good faith to make the best estimate allowed by reasonably available information. Sometimes it’s not so easy to tell.

Beyond the correct numbers, the second thing for which the investigators are looking is executive complicity. In other words: who did it? Again, the good faith of those potentially involved comes into play. The investigators are not seeking simply whether executives reported financial results that turned out to be wrong. The issue rather is whether the executives tried to get them right. If they did and made an honest mistake or estimated incorrectly, that does not sound like fraud and may not even be a violation of GAAP to begin with. The main point here is that, when it comes to executive complicity, the investigators are ordinarily looking for evidence of wrongful intent (scienter). In other words, they are looking for an intentional misapplication of GAAP or an approach to GAAP that is so reckless as to constitute the equivalent of an intentional misapplication.

The scope of the investigation, then, should not pose too difficult an issue at the outset.  Initially, the scope will be largely defined by the potential improprieties that have been uncovered. The tricky question becomes: how far should the investigators go beyond the suspicious entries? The judgment calls here are formidable. One of the key issues involves the expectations of the external auditor and, beyond that, the SEC. If the scope is not sufficiently broad, the investigation may not be satisfactory to either one. Indeed, an insufficient scope can place the external auditor in a particularly awkward spot insofar as the SEC may subsequently fault not only the audit committee for inadequate scope but the external auditor’s acceptance of the audit committee’s investigative report.

An additional complicating factor involves the way fraud starts and grows. A critical issue to consider is that, overtime, as the Central State example illustrates, the manipulations will often get increasingly aggressive as the perpetrators spread the fraud throughout many line items so that no single account stands out as unusual but a substantial number are affected. For example, to prevent the distortion of accounts receivable from getting too large, Jones and his accomplices spread the fraud into inventory, then asset capitalization, then net income. The spread of the fraud is analogous to pouring a glass of water on a tabletop. It can spread everywhere without getting too deep in any one place.

So, once fraudulent financial reporting has been identified, even in just a few entries, the investigators will want to consider the possibility that it’s a symptom of a broader problem. If the investigators have been lucky enough to nip it in the bud, that may be the end of it.  Unfortunately, if the fraud has gotten big enough to be detected in the first place, such a limited size cannot be assumed. Even where the fraud ostensibly starts out small the need for a broader scope has got to be considered.

The scope of the investigation, therefore, can start out with its parameters guided by the suspicious entries revealed at the outset. In most cases, though, it will need to broaden to ensure that additional areas are not affected as well. Throughout the investigation, moreover, the scope will have to remain flexible. The investigators will have to stay on the lookout for additional clues, and will have to follow where they lead. Faced with an ostensibly ever-widening scope, initial audit committee frustration is both to be expected and understandable. But there is just no practical alternative.

Assessing the Unknown

Some level of uncertainty and risk must exist in any fraud examination involving financial statement fraud. For example, there may be uncertainty about the competence of management and the accounting staff, about the effectiveness of internal controls, about the quality of evidence, and so on. These uncertainties or risks are commonly classified as inherent risks, control risks, or detection risks.

Assessing the degree of risk present and identifying the areas of highest risk are critical initial steps in detecting financial statement fraud. The auditor specifically evaluates fraud risk factors when assessing the degree of risk and approaches this risk assessment with a high level of professional skepticism, setting aside any prior beliefs about management’s integrity.  Knowledge of the circumstances that can increase the likelihood of fraud, as well as other risk factors, should aid in this assessment.

SAS 99 identifies fraud risk categories that auditors and fraud examiners may evaluate in assessing the risk of fraud. The three main categories of fraud risk factors related to fraudulent financial reporting are management characteristics, industry characteristics and operating characteristics including financial stability.

Management characteristics pertain to management’s abilities, pressures, style, and attitude as they have to do with internal control and the financial reporting process. These characteristics include management’s motivation to engage in fraudulent financial reporting – for instance, compensation contingent on achieving aggressive financial targets; excessive involvement of non-financial management in the selection of accounting principles or estimates; high turnover of senior management, counsel, or board members; strained relationship between management and external auditors; and any known history of securities violations.

Industry characteristics pertain to the economic and regulatory environment in which the entity operates, ranging from stable features of that environment to changing features such as new accounting or regulatory requirements, increased competition, market saturation, or adoption by the company of more aggressive accounting policies to keep pace with the industry.

Operating characteristics and financial stability encompass items such as the nature and complexity of the entity and its transactions, the geographic areas in which it operates, the number of locations where transactions are recorded and disbursements made, the entity’s financial condition, and its profitability. Again, the fraud examiner would look for potential risk factors, such as significant pressure on the company to obtain additional capital, threats of bankruptcy, or hostile take-over.

The two primary categories of fraud risk factors related to asset misappropriation are susceptibility of assets to misappropriation and adequacy of controls.  Susceptibility of assets to misappropriation refers to the nature or type of an entity’s assets and the degree to which they are subject to theft or a fraudulent scheme.  A company with inventories or fixed assets that includes items of small size, high value, or high demand often is more susceptible, as is a company with easily convertible assets such as diamonds, computer chips or large amounts of cash receipts or cash on hand.  Cash misappropriation is also included  in this category through fraudulent schemes such as vendor fraud. Adequacy of controls refers to the ability of controls to prevent or detect misappropriations of assets, owning to the design, implementation and monitoring of such controls.

SAS 99 discusses fraud risk factors in the context of the fraud triangle which we’ve often discussed on this blog.  SAS 99 also suggests that the auditor consider the following attributes of risk:

–Type of risk that may be present – that is fraudulent financial reporting, asset misappropriation and/or corruption.

–Significance of risk – that is whether it could result in a material misstatement.

–Likelihood of the risk

–Pervasiveness of the risk – that is whether it relates to the financial statements as whole or to just particular accounts, transactions or assertions.

Finally, management selection and application of accounting principles are important factors for the examiner to consider.

Team Work is Hard Work

From reading posts and comments posted to LinkedIn, it seems that a number of our Chapter members and guests from time to time find themselves involved in internal fraud investigations either as members of internal or external audit units or as sole practitioners.  As CFE’s we know that we can make significant contributions to a financial crime investigation, if we can work effectively, as team members, with the victim company’s internal and external auditors, as well as with other constituents involved in resolving allegations or suspicions of internal fraud. In addition to a thorough knowledge of accounting and auditing, CFE’s bring to bear a variety of skills, including interviewing, data mining and analysis.  We also know that some auditors assume that simply auditing more transactions, with the use of standard procedures, increases the likelihood that fraud will be found. While this can prove to be true in some cases, when there is suspicion of actual fraud, the introduction of competent forensic accounting investigators may be more likely to resolve the issue and bring it to a successful conclusion.

Within the boundaries of an investigation, we CFE’s typically deal with numerous constituencies, each with a different interest and each viewing the situation from a different perspective. These parties to the investigation may well attempt to influence the investigative process, favor their individual concerns, and react to events and findings in terms of personal biases. CFE’s thus often have the task of conveying to all constituencies that the results of the investigation will be more reliable if all participants and interested parties work together as a team and contribute their specific expertise or insight with objectivity. In the highly-charged environment created by a financial crime investigation, the forensic accounting investigator can make a huge contribution just by displaying and encouraging the balance and level headedness which comes from his or her detailed familiarity with the mechanics of the standard types of financial fraud.

The ACFE recommends that all parties with a stake in the process, management, audit committee, auditors, and legal counsel, should always consider including forensic accounting investigators in the front-end process of decision making about an investigation. One of the key initial decisions is, usually, the degree to which the forensic accounting investigators can work with and rely on the work of others, specifically, the internal and external auditors. Another common front-end decision is whether CFE’s—with their knowledge of accounting systems, controls, and typical fraud schemes, may be added to the team that eventually evaluates the organization’s business processes to strengthen the controls that allowed the fraud to occur. Management may at first be inclined to push for a quick result because it feels the company will be further damaged if it continues to operate under a shadow.

Senior executives may be unable or in some cases unwilling to see the full scope of issues and may attempt to limit the investigation, sometimes as a matter of self-protection, or they may seek to persuade the CFE that the issues at hand are immaterial. Whatever happened, it happened on their watch, and they may understandably be very sensitive to the CFE’s intrusion into their domain. Any defensiveness on the part of management should be defused as quickly and as thoroughly as possible, usually through empathy and consideration on the part of the forensic accounting investigator. The party or entity engaging the forensic accounting investigator, for example, the audit committee, management, or counsel, should be committed to a thorough investigation of all issues and is ultimately responsible for the investigation. The committee may engage CFE’s and forensic accounting investigators directly and look to them for guidance, or it may ask outside counsel to engage the CFE, who usually will work at counsel’s direction in fulfilling counsel’s responsibilities to the audit committee.

Every CFE should strive to bring independence and objectivity to the investigation and strive to assist each of the interested parties to achieve their unique but related objectives. As to the CFE’s  objectives, those are determined by the scope of work and the desire to meet the goals of whoever retained their services. Regardless of the differing interests of the various constituencies, forensic accounting investigators must typically answer the following questions:

  • Who is involved?
  • Could there be coconspirators?
  • Was the perpetrator instructed by a higher supervisor not currently a target of the investigation?
  • How much is at issue or what is the total impact on the financial statements?
  • Over what period did this occur?
  • Have we identified all material schemes?
  • How did this happen?
  • How was it identified, and could it have been detected earlier?
  • What can be done to deter a recurrence?

CFE’s should always keep in mind that they are primarily fact finders and not typically engaged to reach or provide conclusions, or, more formally, opinions. This differs from the financial auditor’s role. The financial auditor is presented with the books and records to be audited and determines the nature, extent, and timing of audit procedures. On one hand, the financial statements are management’s responsibility, and an auditor confirms they have been prepared in accordance with generally accepted accounting principles after completing these procedures and assessing the results. The CFE or forensic accounting investigator, on the other hand, commands a different set of skills and works at the direction of an employer that may be management, the audit committee, counsel, or an auditing firm itself.

Teaming with all concerned parties together with the internal and external auditors, the forensic accounting investigator should strive to bring independence and objectivity to the investigation and strive to assist each of the interested parties to achieve each team member’s unique but related objectives; management understandably may be eager to bring the investigation to a quick conclusion. The chief financial officer may be defensive over the fact that his or her organization allowed this to happen;   the board of directors, through the independent members of its audit committee, is likely to focus on conducting a thorough and complete investigation, but its members may lack the experience needed to assess the effort. In addition, they may be concerned about their personal reputations and liability. The board is likely to look to legal counsel and in some cases, to forensic accounting investigators to define the parameters of the project;  as to counsel, in most investigations in which counsel is involved, they are responsible for the overall conduct of the investigation and will assign and allocate resources accordingly; the internal auditor may have a variety of objectives, including not alienating management, staying on schedule to complete the annual audit plan, and not opening the internal audit team to criticism. The internal audit team may also feel embarrassed, angry, and defensive that it did not detect the wrongdoing; the external auditor may have several concerns, including whether the investigative team will conduct an investigation of adequate scope, whether the situation suggests retaining forensic accountants from the auditors’ firm, whether forensic accountants should be added to the audit team, and even whether the investigation will implicate the quality of past audits.

In summary, team work is complex, hard work.  While fraud is not an everyday occurrence at most companies, boards and auditing firms should anticipate the need to conduct a financial fraud investigation at some time in the future.  CFE’s can be an integral part of the planning for such investigations and can be of great help in designing the pre-planned team work protocols that ensure that, if a fraud exists, there is a high probability that it will be identified completely and dealt with in a timely and appropriate manner.

Inside and Out

college-studentsI had quite a good time a little over a month ago, addressing a senior auditing class at the University of Richmond on the topic of how fraud examiners and forensic accountants can work jointly together, primarily with a client’s internal auditors and, secondarily with its external auditors, to substantially strengthen any fraud investigation assignment.

Internal and external auditors each play an important role in the governance structure of their client organizations. Like CFEs, both groups have mutual interests regarding the effectiveness of internal financial controls, and both adhere to ethical codes and professional standards set by their respective professional bodies. Additionally, as I told the very lively class, both types of auditors operate independently of the activities they audit, and they’re expected to have extensive knowledge about the business, industry, and strategic risks faced by the organizations they serve. Yet, with all their similarities, internal auditing and external auditing are two distinct functions that have numerous differences. The Institute of Internal Auditors (IAA) defines internal auditing as “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.” Internal auditors in the public sector (where I spent most of my audit career as a CIA) place an additional emphasis on providing assurance on performance and compliance with policies and procedures. Concerned with all aspects of the organization – both financial and non-financial – the internal auditors focus on future events because of their continuous review and evaluation of controls and processes.

In contrast, external auditing provides an independent opinion of a company’s financial statements and fair presentation. This type of auditing encompasses whether the statements conform with Generally Accepted Accounting Principles, whether they fairly present the financial position of the organization, whether the results of operations for a given period are represented accurately, and whether the financial statements have been affected materially (i.e., whether they include a misstatement that is likely to influence the economic decisions of financial statement users). External auditing’s approach is mainly historical in nature, although some forward-looking improvements may be suggested in the auditors’ recommendations to management based on the analysis of controls during a financial statement audit.

I emphasized to the students that these definitions alone pinpoint the key distinctions that separate the two audit approaches. However, internal auditing is much broader and more encompassing than external auditing. Its value resides in the function’s ability to look at the underlying operations that drive the financial numbers before those numbers hit the books. For instance, when considering “sales” as a line item in a set of financial statements, the external audit focuses primarily on the existence, completeness, accuracy, classification, timing, posting and summarization of sales numbers. The internal audit goes beyond these assertions and looks at sales operations in a much broader context by asking questions regarding the target market, sales plan, organizational structure of the sales department, qualifications of sales personnel, effectiveness of sales operations, measurement of sales performance, and compliance with sales policies.

These types of questions probe the very core of sales operations and can greatly impact the sales numbers recorded in financial statements. For example, assuming a sales number of $6 million, the external auditor has merely to render an opinion regarding the validity of that number. The internal auditor, however, can ask whether the number could  have really been $12 million, if only the right market had been targeted, and if operations had been effective in the first place. It’s this emersion in detail and the overall knowledge of operations that makes the internal auditor such a strong partner for the fraud examiner in any joint investigation.

Internal auditors represent an integral part of the organization – their primary clients are management and the board. Although historically internal auditors reported to the chief financial officer or other senior management staff, for the last two decades internal auditing has reported directly to the audit committee of the board of directors, which helps strengthen auditor independence and objectivity. Today, internal audit functions, for the most part, follow this reporting relationship, which is consistent with the IIA’s Standard on Organizational Independence.

The chief audit executive’s (CAE’s) appointment is normally meant to be permanent, unless he or she resigns or is dismissed. In some quasi and intergovernmental organizations, CAEs are given tenured positions – five-year appointments, for example – to enhance independence.  Conversely, external auditors are not part of the organization, but are engaged by it. Their objectives are set primarily by statute and by their main client, the board of directors. External auditors are appointed by the board, and they submit an annual report to the company’s shareholders. The appointment is meant to extend for a specified time – external auditors can be re-appointed at the company’s annual general meeting. In some jurisdictions, there are limits on an external auditor’s length of service, often five or seven years.

In general, internal audit functions are not mandatory for organizations. Instead, their installment is left up to individual organizations’ discretion but internal auditing is mandatory in some cases. Companies listed on the New York Stock Exchange must have an internal audit function, whether in-house or outsourced.  An external audit is legally required for many companies, particularly those listed on a public exchange. External audits of some government agencies are also legislated, requiring government auditors to submit the audit report to their respective legislature.

The necessary qualifications for an internal auditor rest solely on the judgment of the employer. Although internal auditors are often qualified as accountants, some are qualified engineers, sales personnel, production engineers, and management personnel who have moved through the ranks of the organization with a sound knowledge of its operations and have garnered experience that makes them abundantly qualified to perform internal auditing. Annually, more and more internal auditors hold the IIA’s Certified Internal Auditor designation, which demonstrates competency and professionalism in the field of internal auditing. Because of their continuous investigation into all the organization’s operating systems, internal auditors who remain in the same organization for many years constitute a unique resource to the CFE of comprehensive and current knowledge of the organization and its operations.

External auditors are required to understand errors and irregularities, assess risk of occurrence, design audits to provide reasonable assurance of material detection, and report on such findings. In most countries, auditors of public companies must be members of a body of professional accountants recognized by law – for example, the Institute of Chartered Accountants in England and Wales, American Institute of Certified Public Accountants, or Canadian Institute of Chartered Accountants.  Because external auditors’ scope of work is narrowly focused on financial statement auditing, and they come into the organization only once or twice a year, their knowledge of the organization’s operations is unlikely to be as extensive as that of the internal auditors.

Those entering the CFE profession need to realize that patterns of business growth, globalization, and corporate scandals have changed the thrust of the internal audit profession in recent years. In its early years, internal auditing focused on protection oriented objectives and emphasized compliance with accounting and operational procedures, verification of calculation accuracy, fraud detection and protection of assets. Gradually, new dimensions were added that ranged from an evaluation of financial and compliance risks to an assessment of business risks, ethics and corporate governance. These changes have only increased the gap between the disciplines of internal and external auditing. Yet, despite their differences, internal auditing and external auditing no longer work in competition, as was the case before the U.S. Sarbanes-Oxley Act was enacted, when a company’s external auditors would sometimes compete with in-house audit departments for internal audit work. Regulations like Sarbanes-Oxley prohibited the external auditor from providing both external and internal audit services to the same company. Today all CFEs can benefit from the complementary skills, areas of expertise, and perspectives of both the external and the internal auditors.  The ACFE recommends that to strengthen the fraud prevention program they should meet periodically to discuss common interests (like the fraud prevention program), strive to understand each other’s scope of work and methods, discuss audit coverage and scheduling to minimize redundancies, jointly assess areas of fraud risk, and provide access to each other’s reports, programs, and work papers.

In summary, fulfilling its oversight responsibilities for assurance, the board also should require internal and external auditors to coordinate their audit work to increase the economy, efficiency, and effectiveness of the overall audit process. Despite some similarities, a world of difference exists between internal auditing and external auditing. Nonetheless, both audit types, and the respective services they provide, are essential to maintaining an effective governance structure. With a greater understanding of the unique perspective of each, CFEs can maximize the aggregate contribution or each to our joint investigations and thereby ensure organizational success.