Who Is Responsible for Preventing and Detecting Fraud

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Introduction

Many first time auditors when they begin working at the CPA firm of T.R. Klein and Company are approached by the intimidating president of the company and asked “Why do we plan audits?” The answer to the question is simple. The reason why auditors plan audits is because they are required to.  The objective of Auditing Standard No. 9 is to assist the auditor in planning an audit in order the audit to run smoothly and detect any fraud that may be present. Auditing Standard No. 9 also establishes the requirements that go into planning an audit.  (Auditing Standard No. 9). This is an important stage of the audit as it sets the tone of the audit, identifies the areas of risk, assesses the level risk and plans the audit procedures that address the level of risk. Another reason this step is important, especially after the fraud scandals that led to the implementation of Sarbanes Oxley Act of 2002, is the perception by the investors and the public that auditors are solely responsible for detecting and reporting fraud if it is occurring in the company.  

Problem Statement

There are gaps in the investing public’s perception of the auditor’s responsibility to detect fraud. This perception has changed over the years along with the change in the business industry.  Accounting firms have had to take on greater responsibilities in their services.  Along with this increased responsibility, increased oversight by government regulators and litigations against auditors has increased.  Based on the information regarding fraud that is known today, it’s difficult to believe that auditors would have the sole responsibility to detect fraud that may be occurring in a company.  The responsibility should be shared by those who are active in the revenue generating operations of the company, the upper level managers and the Board of Director. This paper will address question as to who is responsible for detecting and reporting fraud. Is it both the auditor and management, or is the responsibility strictly the auditors? What is the responsibility of the management in regards of preventing and detecting fraud? Have these responsibilities changed since the passage of Sarbanes Oxley Act of 2002?

History of Issues

        The auditors’ responsibility has changed over the course of the years and depends on the type of audit that is being conducted. It’s important to see the how the auditor’s responsibilities were viewed and changed before the big fraud scandals. For example,  in 1980, the authors of the article, “Auditors and the Detection of Fraud” (Romney, Albrecht, & Cherrington, 1980) noted there was an increase of concern in business and accounting communities regarding the increase of management fraud and the dollar amount of the fraud.  There was an increased concerned that investors thought it was the auditor’s responsibility to detect fraud.  Also in response to this increased level of fraud, the American Institute of CPAS, (AICPA) created the Commissions on Auditor’s Responsibilities, which is also referred to as the Cohen Group.   This group developed recommendations on appropriate responsibilities the auditors should have.  In 1980, the Cohen group concluded that auditors had the “duty to search for fraud, and should be expected to detect those frauds that the exercises of professional skill and care would normally uncover”. (Romney et al. 1980, p. 63). Additionally, the commissioner of the group stated, “audit should be designed to provide reasonable assurance that they financial statements are not affected by material fraud.” (Romney et al 1980, p. 63).  The commission also concludes that in order for auditors to successfully detect fraud, they must understand the type of person and identify the opportunities that are present that would facilitate fraudulent behavior.  For the auditor to complete these responsibilities, it will take time and money.  An obstacle in completing these tasks would lead to increased audit fees that are passed onto the company.  While larger companies may be more willing to incur the cost, smaller companies may not.

In response to concerns of the investing public and users of the financial statements, The National Commission on Fraudulent Financial Reporting was established in 1985 and funded by the AICPA, the American Accounting Association and other prominent accounting and auditing organizations.  The purpose of the Commission was to study the reasons behind management related fraud and to examiner the role the auditor has in detecting fraud, especially focusing on whether the detection of fraudulent financial reporting was actually a part of the auditor’s plan and test work, and other areas of concern that includes whether the techniques auditors use to detect fraud can be improved and what accounting standards and procedures can reduce the occurrence of fraud.  The Commission found that in many of the reporting cases against auditors brought forward by the Securities Exchange Commission, (SEC), the auditors did not recognize internal control weaknesses or properly adjust the audit plan when weaknesses were found.  In instances where internal controls weaknesses were known, auditors did not analyze the effect of the weakness.  As part of the forty-nine (49) recommendations set forth by the commission, one of the recommendations to the AICPA was to revise auditing standards to restate the auditor’s responsibility for the detection of fraudulent financial reporting.  These recommendation states auditors should be required to (1) take steps to assess the potential for fraudulent financial reporting and (2) design test to provide reasonable assurance of detection.  Additional recommendations included guidance for assessing risk and establishing procedures when high risk areas are found. (Leary, 1990, p. 240)