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FOR THE PRACTICING AUDITOR What do auditors believe are the best ways to spot fraud?

The Warning Signs of Fraudulent Financial Reporting BY VICKY B.

HEIMAN-HOFFMAN, KIMBERLY P.

MORGAN AND JAMES M.

PATTON ne frequently cited cause of audit failure is audit teams' lack of aware- ness of the warning signs of fraud. If auditors better understood these signs and applied professional skepticism, their risk of not detecting fraud would decrease. To improve their understanding of the signs, auditors may tind it helpful to laiow what other au- ditors thought was important in alert- ing them to possible fraud.

This article reports the results of a survey that identifies tlie perceptions of a group of practicing auditors con- cerning the relative importance of some commonly cited frand warnings.

The 130 auditors who participated were from several offices of one of the six largest accounting firms. We asked them to rank 30 commonly cited po- tential warning signs as to tlieir relative importance in spotting fraudulent fi- nancial reporting. The exhibit on page 77 lists them in descending order of importance to the auditor.

RED FLAGS The auditors perceived client dishon- esty to be the most important red flag.

They also viewed as particularly risky clients tliat placed undue emphasis on meeting cjuantitative targets, engaged in opinion shopping and were very aggressive in their financial reporting.

In addition, auditors thought a weak control environment to be another very important warning sign.

Overall, the survey's fmdings are consistent with the results of other re- search. For example, a study of large .md midsize U.S. companies by KPMG Peat Marwick (see "Combat- ing Fraud: Know the Facts," JofA, Sept.95.

page 20) revealed the num- ber-one action companies took to re- duce fraud was reviewing and improving their internal controls.

Thus, corporate America seems to agree that a weak control environment is an important indicator of fraud.

FOLLOWING A PATTERN?

Our survey revealed an interesting pattern: Auditors generally perceived "attitude" factors to be more impor- tant warning signs than "situational" factors. For example, dishonest, hos- tile, aggressive and unreasonable man- agement attitudes were considered more significant than economic con- ditions and adverse environmental or industry conditions. These auditor perceptions are consistent with several academic studies that found closer links between attitude factors and the occurrence of fraud than between sit- uational factors and fraud.

IMPLICATIONS FOR AUDITORS Auditors are justifiably concerned about their potential legal liability for failing to detect fraudulent financial reporting in audit engagements. The auditing standards issued in the late ]9H()s to reduce the "expectation gap" between the services CPAs perform and those clients beheve CPAs provide increased auditors' responsibilities and the risks they f"ace. While Statement on Auditing Standards no. 53. The Au- ditor's Responsibility to Detect and Report Errors and Irregularities, directed audi- tors to do more work to uncover po- tential fraud, it did not provide as much specific guidance as auditors might like. For example, while SAS no.

53 lists a number of warning signs auditors might consider in assessing the risk the financial statements are materially misstated, it does not pro- vide operational guidance on how to use these signs.

Our survey provides evidence about risk flictors that a sample of au- ditors considered to be key signs of fraudulent fmancial reporting. While lOL'RNAl «f ACCOUNTANCY 75 Become an Accredited Asset Management Specialist...

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1952 FOR THE PRACTICING AUDITOR The ED calls for additional research, communication, training and education about fraud risk factors.

auditors should not use this evidence exclusively or .^pply it in a mechanical way, they can use the results as a start- ing point in their initial assessment of the risk of fraud in a particular audit situation.

For exatnple, auditors tnight construct a checklist of the most high- ly ranked warning signs to gtiide their prelitiiinary review of a potential client or iti their engagement plantiing.

Use ot such a checklist could help increase consistency in implementing auditing standards by ctisuring auditors do not overlook the fi-:uid risk factors getieral- ly considered to be most important.

If many ot the most significant signs are present in a specific setting, auditors should he more vigilant. Auditors also should use professional judgment iti considering the possibility of combin- ing important risk factors rather than just considering them individu;illy.

Tht' American Itistitute of C^PAs audititig standards board has acknt>wl- edged the need for increased opera- tional guidance on fmancial statement audits and fraud.

The Miiy l'J'J6 expo- sure draft.

Consideration of Fraud in a Fitiancial Statement Aiitiit.

reaffirms and clarifies the auditor's responsibilities.

It also provides guidance on how to doc- utnent the risk assessment process atid how to respotid appropriately to the assessed level of risk.

The ED lists 38 examples of factors auditors might wish to consider iti assessing fraud risk.

However, as in SAS no. 53, the ED does tiot give any indication of the rel- ative importance of the factors. Given the current state of knowledge about such matters, it is logical not to in- clude such guidance. However, the ASB does call for additional research, comniutiicatioti, training and educa- tion aboitt fraud risk factors.

The evi- detice from our survey is a first step iti this process.

WHArS REALLY IMPORTANT Ktiowitig the most important warning signs should help auditors do a better job of assessing fraud risk. While cur- rent and proposed auditing statidards require auditors to m.ikc this assess- ment, they do tiot provide guidance on the relative importance of particu- lar signs.

By seeing which factors oth- er auditors considered to be the tnost itnportant, practicing auditors can as- sess the risk of fraud in their own audit engagements more efficiently and consistently.

H EXECUTIVE SUMMARY • WHILE EXISTING AUDITING STANDARDS require auditors to do tnore work to uncover potential frauds, they do not provide as much specif- ic guidance as auditors would like. Statement on Audititig Standards no. 53 and the recetit exposure dratt on fraud list warning signs auditors tnight consider, but do tiot itidicatc their relative importance.

• THE LACK OE AWAIi^NESS OF THE WAIUNING signs of fraud is a frequently cited cause of audit failure. If auditors better understood the signs and applied professional skepticism, they would decrease their risk of not df tectinii; fraud.

• A SURVEY OF 130 AUDITC^RS ASKED THEM to rank 30 cotn- tnonly cited warning signals of fraud according to their relative importance.

The auditors ranked clietit dishonesty- as the tnost important factor.

• THE SURVEY REVEALED AN INTERESTING patterti. Auditors generally perceived "attitude" factors to be tnore itnportatit warning signs of fraud than "situadonal" factors.

V1C:KY B. HEIMAN-HOFFMAN, CPA, PhD. is associate professor of busitie^s administnition at the K.itz Graduate School of Business, Utiiversity of I'ittsburyli.

KIMBERLY P. MORGAN, CPA, is a PhD candidate at the Utnversity of PitV buriih. JAMES M. PATTON, CPA, PhD, is professor of business administration at the Katz GiMduatc Schi)ol of Business.

76 Jt)URNAL at AC:COUNTANCY Cl.tober IV'Jf. FOR THE PRACTICING AUDITOR Auditors' Rankings of the Relative Importance of Fraud Warning Signs Auditors' rankings' 1 2 3 4 5 6 7 S 9 10 11 12 13.5 13.5 15 16 17 18 19 20 21 22 23 24 25 26.5 26.5 28 29 30 Fraud warning signs Managers have lied to the auditors or have been overly evasive in response to audit inquiries.

The auditor's experience with management indicates a degree of dishonesty.

Management places undue emphasis on meeting earnings projections or other quantitative targets.

Management has engaged in frequent disputes with auditors, particularly about aggressive application of accounting principles that increase earnings.

The client has engaged in opinion shopping.

Management's attitude toward financial reporting is unduly aggressive.

The client has a weak control environment.

A substantial portion of management compensation depends on meetmg quantified targets.

Management displays significant disrespect for regulatory bodies.

Management operating and financial decisions are dominated by a single person or a few persons acting in concert.

Client managers display a hostile attitude toward the auditors.

Management displays a propensity to take undue risks.

There are frequent and significant difficult-to-audit transactions.

Key managers are considered highly unreasonable.

The client's organization is decentralized without adequate monitoring.

Management and/or key accounting personnel turnover is high.

Client personnel display significant resentment of authority.

Management places undue pressure on the auditors, particularly through the fee structure or the imposition of unreasonable deadlines.

The client's profitability is inadequate or inconsistent relative to its industry, The client is confronted with adverse legal circumstances.

Management exhibits undue concern with the need to maintain or improve the image/reputation of the entity.

There are adverse conditions in the client's industry or external environment.

Accounting personnel exhibit inexperience or laxity in performing their duties.

The client entered into one or a few specific transactions that have a material effect on the financial statements.

Client management is inexperienced.

The client is in a period of rapid growth.

This is a new client with no prior audit history or insufficient information from the predecessor auditor.

The client is subject to significant contractual commitments.

The client's operating results are highly sensitive to economic factors (inflation, interest rates, unemployment, etc.).

The client recently entered into a significant number of acquisition transactions.

' Auddors' Rankings are based on the average ot the ranks assigned by ttie participants m our study. Rank 1 is most diagnostic; 30 is least diagnostic.

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