Besides, auditors are required to perform risk assessment procedures in order to understand the entity and its environment including its internal control. Auditors should properly make inquires of management, those charged with governance and others inside the entity and obtain an understanding of how those charged with governance apply oversight of management’s processes for recognizing and responding to fraud risk and internal control established by management to reduce these risks. Further, auditors should consider whether one or more fraud risk factors are presents in information obtained. Any unusual or unexpected relationships that have been recognized in performing analytical procedures and other information that may help in recognizing fraud risks should also be taken into account. (Hong Kong Institute of Certified Public Accountants, 2008)
Auditors should interview employees in and outside management by giving them the opportunity to step forward regarding any fraud. Engagement team should check every areas, locations and accounts that might not be tested and plan audit tests that would not be predictable and expected by the client throughout an audit. (Moeller, R. R., 2004) Auditors can develop basic awareness of dishonesty and recognize someone’s lies by taking an active role in effective interviewing and learning to evaluate the interviewee. (Zikmund, P.E., 2008)
Auditors should identify and assess the fraud risks at the financial statement level, and at the assertion level for classes of transactions, account balances and disclosures. Auditors should also assess the design of entity’s relevant controls and verify whether they have been exercised to extent those assessed risks. Auditors should accordingly determine overall responses to address the assessed risks of material misstatement due to fraud at the financial statement level and should plan and perform further audit procedures to respond risks of management override of controls at assertion level. (Hong Kong Institute of Certified Public Accountants, 2008)
Auditors should evaluate whether analytical procedures that are carried out at or near the end of the audit when forming an overall conclusion as to whether the financial statement as a whole are consistent with the auditors’ knowledge of the business indicate a previously unrecognized risk of material misstatement due to fraud. (Hong Kong Institute of Certified Public Accountants, 2008)
If auditors have recognized fraud or obtained information that indicates fraud may exist, auditors should disclose fraud as soon as practicable to the proper level of management. Auditors should consider the professional and legal responsibilities and the possibility of withdrawing from the engagement if auditors come across anomalistic circumstances that is out of their ability to continue performing the audit as a result of misstatement resulting from fraud or suspected fraud. (Hong Kong Institute of Certified Public Accountants, 2008)
Required by HKSA 315, auditors should document: the documentation of the auditors’ understanding of entity and its environment and auditors’ assessment of material misstatement risks; auditors’ responses to the assessed material misstatement risks; communications made to management, those charged with governance, regulators and others about fraud; and the reasons for conclusion of presumption of material misstatement due to fraud related to revenue recognition is not applicable in the circumstances of the engagement.
Controversial Issue on Detection and Report of Fraud
The auditors’ responsibility for financial statements fraud detection has been an ongoing but controversial issue over the years. The very first SAS no. 1 provided that “The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statement are detect.” In other words, auditors were responsible for determining if the debits equaled the credits but not for detecting fraudulent activities. The public accounting profession stood by this position for many years. Even during the numerous financial frauds that led to the 1987 Treadway Commission Report on Fraudulent Financial Report, AICPA auditing statement regarding the detection of fraud did not change. (Moeller, R. R., 2004)
Despite a fairly regular clamor for change, audit standards regarding auditor responsibility for fraud remained unaltered until 1997. SAS no. 82 restated that “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” This revised but tighter standard was released, after much professional discussion, at about the peak of the dot-com bubble, when the public was concerned about how fast and how large their investments would surge forwards; there was not that much concern with fraud then. (Moeller, R. R., 2004)
Moving to more recent time with Enron, WorldCom, and the host of others, concerns about fraudulent financial reporting certainly have changed. Given Sarbanes-Oxley Act (SOA) and the new Public Corporation Accounting Oversight Board (PCABO), it was perhaps too late, but the AICAP released SAS no. 99 on the auditors’ responsibility for detecting fraudulent financial report in December 2002. With this new standard, auditors now are liable for providing reasonable assurance that financial statements are free of material misstatement, whether caused by error or fraud. (Moeller, R. R., 2004)
The society and the accountancy profession have different perceptions for auditors’ duty on errors and fraud. Auditors see their duties as an independent assessment of the entity’s financial statements and expression of opinion on the truth and fairness of the financial statements. (Lau, P. T. Y. and Millichamp, A. H., 2004) The design and execution of internal controls to avoid and uncover fraud is the primary responsibility of both with those charged with governance of the entity and with management. However, auditors’ responsibility to detect fraud is seen as being secondary to primary no matter the financial statements being “true and fair”. (Moore Stephen, 2007) The society tends to see auditors’ duties in terms of the detection and possibly prevention of fraud and error. (Lau, P. T. Y. and Millichamp, A. H., 2004)
The purpose of an audit of financial statements is to allow the auditors to express an opinion with reasonable assurance on the truth and fairness of the financial statements. Auditors should retain an attitude of professional skepticism and obtain adequate appropriate audit evidence to support their opinion with reasonable assurance. Regarding fraud and error, they should have sufficient evidence that no material misstatements, whether caused by fraud or error, have occurred or, if they have occurred, they have been either corrected and or been properly disclosed in the financial statements. (Lau, P. T. Y. and Millichamp, A. H., 2004)
However, auditors are not insurers or guarantors. Auditors cannot guarantee that all material misstatements have been detected because of the factors such as the use of professional judgment; the use of testing; the inherent limitations of internal control; and the accessibility of persuasive rather than conclusive facts influenced the nature of an audit. (Lau, P. T. Y. and Millichamp, A. H., 2004 and Moore Stephens, 2007) Particularly, auditors are limited to use indirect ways to determine whether fraud has arisen unless organizations or shareholders are willing to pay auditors to monitor all transactions of the organization. These methods include assessment of financial statements and records where the principal aim is to look for irregularities; make inquiries of employees, management and those charged with governance of an organization; and evaluate internal controls of an organization over the spending of funds. These methods obviously are practical, indeed essential, to preventing and detecting fraud. But they are not foolproof, nor can they be expected to be. (KPMG LLP, 2007) Hence, auditors can only express an opinion with reasonable assurance that the financial statements are free of material misstatement. (Lau, P. T. Y. and Millichamp, A. H., 2004 and Moore Stephens, 2007)
Apart from this, terms like “reasonable”, “material”, “professional skepticism”, “sufficient” and “brainstorming” stated in new rules and regulations that strengthening auditors to detect fraud during an audit might have different meanings vary in different mindset of auditors. Nevertheless, no matter what these terms mean to auditors will not matter if auditors failed to uncover fraud. (Zikmund, P.E., 2008)
The expectation gap arises because the society believes that the primary duty of auditors is to uncover all fraud, and accordingly, if auditors have failed to uncover fraud, auditors are usually assumed to be blunder. Given the inherent limitations of any outside party to determine the existence of fraud, the restrictions governing the procedures auditors are allowed to exercise, and the cost constraints of the audit itself, this assumption is not associated with the current auditing standards. (KPMG LLP, 2007)
Societal Expectation on Detecting and Reporting Fraud
Most people will tend to associate auditing with the search for fraud when asking about auditing. If the auditors fail to uncover fraud which subsequently comes to light, these same people will assume that the audit process has failed in some way. The society expect auditors to detect all corporate fraud as auditors have the legal right to investigate the organization, and all its records and seek for explanations and information from the employees and management of the organization. However, there is an inherent contradiction in the audit checking on untrustworthy directors and yet in many respects, auditors have to trust management assurance in the conduct of their work. (The Institute of Chartered Accountants in England and Wales, 2006)
In 1986, Louis Harris & Associates conducted a survey on the societal attitudes towards auditors. Auditors were found to have higher moral and ethical practice than other groups and were found to be performing better today than they ever did previously. They also were found to be slightly more responsible for the lawsuits facing independent auditors than any other group including the clients or the lawyers or general business. (Epstein, M. J., 1993)
The society expects that auditors should be trusted and relied upon for providing competent professional service, but they should not be providing seals of approval for events any more than they can provide the seal of approval for an investment in corporate shares. The societal expectations of what auditors can do are unrealistic, and the auditors are partly to blame. It is likely that the shareholders trust auditors much more than the management. (Epstein, M. J., 1993)
Auditors are expected to issue unqualified opinion unless every important thing has been reported or disclosed to investors and creditors; auditors have maintained independence and performed a “public watchdogs” function; the internal controls are effective; the financial statements are free of misstatement resulting from management fraud; the financial statement are free of misstatement intended to hid employee fraud; and no illegal operations is held within firm. (McEnroe, J. E. and Martens, S. C., 2001)
The liability crisis demands that a substantial effort be made to alter the societal attitudes and understanding of what auditors can do and what product they can deliver. The society believes that certain assurances are being provided and that auditors’ certificate at the end of a financial statement provides a guarantee of lack of fraud, an elimination of errors in the financial statements, and the continued economic viability and ultimate success of the business enterprise. (Epstein, M. J., 1993)
According to the national survey of investors stated in the research of Epstein, M. J. and Geiger, M. A. (1994) in respect of investors’ perception of various aspects of financial reporting issues, about 51% of the investors thought that reasonable assurance for material misstatement as a result of errors should be given. Approximately 47% of the investors wanted absolute assurance. Oppositely, over 70% of investors expect that auditors should provide absolute assurance that no material misstatement due to fraud would be detected from the audited financial statements. Investors apparently set the assurance standard of fraud detection higher than errors detection, in which both of them are beyond the existing professional standards. (Epstein, M. J. and Geiger, M. A., 1994)
In accordance with the survey conducted in 1989 regarding the perceptions of senior executives as to the auditors’ role in relation to fraud, over a third of business executives surveyed stated that their board of directors had not evaluated the exposure of their companies and over half believed that there was room to improve their business’s controls against fraud risk. About 20% of the respondents believed that the auditors should share the responsibility for preventing and detecting fraud with management. About 60% of the respondents believed that auditors should contribute more to preventing fraud. Over 90% of respondents would find it helpful if the audit were to provide an overall assessment of their company’s main defenses against fraud. (The Institute of Chartered Accountants in England and Wales, 2006)
Investors expect audited financial statements to provide an objective, truthful financial picture of an organization that could be relied on. Audited financial statements are used by a variety of people to make investment, loan and many other business decisions, and accordingly, auditors are seen as corporate detectives to discover fraud. (Tidwell, G. L. and Abrams, A. L., 1996) Furthermore, investors expect the auditors to contribute the solution on accounting problem by changing the way that auditors perform their services and recognizing the wide range of users that depend on its services. Auditors are expected to provide services including better corporate accountability and better information on the quality of corporate governance; better quantitative and qualitative data to evaluate corporate and management past performance and help forecast future performance; more information on critical nontraditional areas of reporting; and more information that will allow investors to make intelligent investment decision. (Epstein, M. J., 1993)
Possible Solutions on Fraud Detection
The field of fraud auditing is viewed as a way to bridge the expectations gap and allay external concerns about internal control and ethics in organizations. (Epstein, M. J., 1993) Numerous of audit standards regarding the expectations gap have increased the auditors’ role and responsibilities. To narrow the expectations gap, auditors should expand their role to reduce the societal expectations of auditors. (Giacomino, D. E., 1994)
The ability of the auditors and the efforts of the auditors are two variables that drive the expectation gap. (Zikmund, P.E., 2008) Deficiency in the fraud auditing and reporting standards; lack of motivation meeting with these standards; and lack of financial literacy, training and cognitive limitations or preference of financial statement users are the three factors that contribute to the perceived expectations gap. These factors, individually or jointly, can contribute to perceived expectation gap between preparers and users of the financial reports. (Rezaee, Z., 2002)
Auditors perform audit in alignment with societal expectations is highly probable to decrease the criticism and litigation against them and increase societal confidence in auditing and auditing profession. According to the research findings of Gowthorpe, C. and Porter, B. (2004), it suggested that auditors should strengthening their performance control; improving the quality control within firms; enhancing further education of auditors; introducing new and or revised auditing standards; and enhancing societal perceptive of the nature of audit and its inherent limitations through educating the society on the responsibilities of auditors in financial reporting in tightening the expectation gap. (Gowthorpe, C. and Porter, B., 2004)
Given that monitoring of auditors’ performance has been successfully in effecting improved performance, it is recommend that auditors should continue and strengthen this activity through persistence on even better performance and impose more rigorous sanctions when come across instances of sub-standard performance. (Gowthorpe, C. and Porter, B., 2004)
Although monitoring of auditors’ performance has facilitated in effecting enhanced performance, in order to make sure all auditors carry out their work to the required standard on every audit, monitoring activity should be supplemented by effective quality control systems within firms. Auditors should provide reasonable assurance in auditors’ report as to the appropriateness and adhere to auditing standards, ethical and other regulatory requirements. (Gowthorpe, C. and Porter, B., 2004)
However, dissatisfaction with the standard of performance of auditors’ responsibilities remain even the research of Gowthorpe, C. and Porter, B. (2004) shown that auditors’ performance improved quite markedly over the decade from 1989 to 1999. The research was noted that auditors have a “knowledge gap” concerning their existing responsibilities. Thus, to improve actual and perceived performance by auditors, further education for auditors is needed about responsibilities of auditors under regulations and case law, quasi-government rules and professional promulgation and the working standard for a further narrowing of the deficient performance portion of the performance gap (Gowthorpe, C. and Porter, B., 2004)
In addition, auditing standards need to be extended to cover the responsibilities that are cost-effective for auditors to perform. To meet with societal expectations and improve the audit function’s value in society, auditing profession better to accept the extension of their responsibilities through introducing new and or revised auditing standards to cover duties including: investigating and reporting on usefulness of organization internal financial controls; the fairness of financial forecasts included in financial statements; the sufficiency of risk management procedures; and comply with all corporate governance requirements in case of listed company. (Gowthorpe, C. and Porter, B., 2004)
It is obvious that the societal perception of the role of auditors is far different from the auditors’ perception of their role. (Epstein, M. J., 1993) Therefore, to reduce the expectation gap between auditors’ perception and societal perception, it is highly recommend that auditors should devote resource in enhancing public perceptive of the nature of audit and its inherent limitations by educating the society on the auditors’ responsibilities in financial reporting. (Gowthorpe, C. and Porter, B., 2004)
The only way to solve the liability crisis that presently faces the auditors is to address all of these problems simultaneously. The profession needs to bridge the expectations gap and be sure that the societal view and the court’s view of the auditors’ responsibilities are consistent with the auditors’ view of those responsibilities. Further, the auditors need to make it clear that an expansion and a reconciliation of these responsibilities apply and that an expansion and strengthening of the role of auditors are necessary to improve accounting disclosures for the benefit of both the organization and society. (Epstein, M. J., 1993)
Auditors are required to carry out journal entry testing during audit as journal entries are capable to undermine a financial statement audit. SAS no. 99 requires that auditors should plan and perform procedures for testing correctness of the journal entries recorded in the general ledger and other adjustments. To improve test effectiveness fulfilling the responsibilities stated in SAS no. 99, AICPA Practice Alert 2003-02 provides additional guidance to auditors about completing actual tests and utilizing computer-assisted audit tools (CAATs) such as Microsoft Access or Microsoft Excel, which are commonly use in today’s information technology environment, to assist them analyzing accounting system data during audit. By utilizing CAATs, auditors can identify the journal entries and the tests of other adjustments more efficiently. (Lanza, R. B. and Gilbert, S., 2007)
Although there are limitations in using CAATs for testing journal entries, it does not replace skilled auditors. Instead, it allows auditors to concentrate on the highest-risk journal entries selected from a full set of entries instead of on a random sample. By investing time to learn how to use the tools effectively, auditors will gain efficiencies that far beyond the time and cost of learning new tools. Dramatically, it can lengthen auditors’ capability to express their opinion truth and fairness on the financial reports. (Lanza, R. B. and Gilbert, S., 2007)
Conclusion
Auditors should use a skeptical eye to look for indicators of possible fraudulent activities in advance. They should look for what are called “red flags”. To help detect fraud, auditors also need to have understanding of why people commit fraud. An organization can have the red flag environment, but it will not necessarily be subject to fraudulent activities unless one or more employees decide to engage fraud. Fraud detection is harder when there is collusion between multiple persons. (Moeller, R. R., 2004)
Fraud has been from time immemorial, auditors in the past have claimed that detecting fraud was beyond their responsibilities. After a series of corporate failures and accounting scandals in the later 1990s and early 2000, the responsibilities of auditors have been increased in detecting fraud as well as preventing future fraud by providing controls recommendations. (Moeller, R. R., 2004)
Challenges of detecting fraud will likely remain a priority for the auditing profession as well as for standard-setting bodies for many years. Auditors must be able to count on an increased awareness of regulatory bodies and those responsible for governance toward financial statement fraud for its occurrence to be reduced and societal confidence to be restored. (Cormier, D. and Lapointe, P., 2005)
Although this is very difficult for auditors to take responsibility for disclosing all kinds of fraud, especially for collusive frauds and other complicated schemes, this is not a blanket excuse for auditors to abstain from detecting fraud. Auditors should develop suitable mindset, setting up forensic procedures and seeking for explanations and information about fraud to enhance the opportunities to detect fraud. (Zikmund, P.E., 2008)
Auditors should not stir up societal expectations greater than what they can be achieved by work done and not to perform work in a manner that betray societal expectations. (Gowthorpe, C. and Porter, B., 2004) Auditors should adherence to current auditing standards and be more cautious to the possibility of existing fraud in every audit they conduct. Auditors should expand their service offered including increase work volume in fraud detection and increase internal control audits and disclosures. Other than that, auditors should devote resource in enhancing society perceptive of the nature of audit and its inherent limitations by educating society on the auditors’ responsibilities in financial reporting (Epstein, M. J. and Geiger, M. A., 1994)
Auditors will subject to criticism and litigation if they fail to recognize societal expectations or acknowledge the extension of societal expectations and also undermine societal confidence in auditing and the auditing profession if the failure persists. Auditors better perform audit in alignment with societal expectations so as to abate the expectation gap and restore societal confidence in auditing and auditing profession. (Gowthorpe, C. and Porter, B., 2004)
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