What Is the Auditor's Role in Finding Fraud?
The PCAOB is trying to figure out how to explain the answer to the
public.
In the
standard audit reports that accompany corporate financial statements, the
auditor's responsibility for detecting fraud is not discussed. Indeed, the
word fraud isn't mentioned at all. Yet whenever an accounting deception is
uncovered, one of the first questions investors ask is, "Where were the
auditors?"
The auditing profession
calls the discrepancy between what investors expect and what auditors do an
"expectations gap." In recent years, audit firms have attempted to
close the gap by educating the public on their role. Last May, for instance,
the Center for Audit Quality, the trade group for audit firms, issued a
brochure on public-company accounting that said auditors consider potential
areas of misconduct for a particular company when deciding what areas of a
business to review. However, the CAQ cautioned, "because auditors do not
examine every transaction and event, there is no guarantee that all material
misstatements, whether caused by error or fraud, will be detected."
Now,
the Public Company Accounting Oversight Board (PCAOB) is also trying to close
the expectations gap, based on a recommendation made more than a year ago by
a Treasury Department–appointed advisory group that studied the
auditing industry. The advisory group suggested that the audit report —
which is the sole communication between auditors and investors on a
particular company — explain the auditors' role and their limitations
in finding fraud.
Such
a clarification had been demanded by observers of the advisory group.
"If the discovery of material errors and fraud is not a major part of
what the audit is about, it is not clear what value-added service the auditor
offers the investor and capital markets," wrote Andrew Bailey, University of Illinois accountancy professor
emeritus.
Officially,
the PCAOB's rules require auditors to provide "reasonable
assurance" that the financial statements they've reviewed "are free
of material misstatement whether caused by error or fraud." However, the
language auditors use in their reports doesn't match the text of the rules.
In a meeting last week, the PCAOB's own advisory group suggested that auditor
reports be revised to add the phrase "whether caused by error or
fraud" to indicate that auditors do have some responsibility for
noticing fraud.
On
their own, audit reports don't tell investors how auditors reached their
conclusions beyond stating the general scope they worked under and that they
followed generally accepted auditing standards. Written in boilerplate
language, the reports are instead short summaries expressing that the
financial statements under review fairly present the company's operations and
cash flows.
Many
years ago, auditor reports included the term certify as if to guarantee the
reviewed financial statements with an external stamp of approval. But that
wording stopped being used in the 1930s, according to the PCAOB. Since then,
the reports have been considered to be opinions. However, the reports do
"not adequately reflect the amount of audit work and judgment" that
go into drawing those opinions, the Treasury advisory group concluded.
Some
investors, such as those who responded to a 2008 CFA Institute survey, would
like auditors to identify their clients' key risks as well as highlight areas
that could possibly have questionable estimates made by management.
"Investors want to know where the high risks are," said Mary
Hartman Morris, a California Public Employees' Retirement System investment
officer, at the PCAOB meeting.
However,
except for its investor members, the PCAOB's advisory group — which
also includes finance executives, accounting-firm representatives, and
accounting professors — generally refrained from recommending that
audit reports move in a more detailed direction. The group cited the complexity
of amending existing auditing standards, the possibility of increased
liability, and the uncertainty over whether doing so would provide true value
to investors. The group also largely passed over the idea of going beyond the
current "pass/fail" model for the audit report, such as by
instituting a grading system.
For
the most part, the advisory group discouraged the regulator from changing
auditors' responsibilities or adding new procedures to their workloads.
However, they seemed to agree that the public needs a more realistic view of
an auditor's job. For example, "some people seem to confuse falsified
documents, which the auditor can't authenticate, and falsified accounting
records, which auditors should authenticate," said Douglas Carmichael,
an accountancy professor at Ziklin School of Business at Baruch College.
As
the PCAOB contemplates a solution, the board may need to think more about
investors' wants rather than their expectations, suggested PCAOB board member
Charles Niemeier. "Investors are not satisfied with the status
quo," he said, "and I think that is justified, considering the
disclosure of financial problems tends to come after the fact."
In the meantime, the PCAOB
is working on establishing a financial-reporting fraud center for collecting
information on preventing and detecting fraud. The regulator published a job
posting for a director last month.
Article
by Sarah Johnson, article was earlier published in one of the reputed website.
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