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.

The Initially Immaterial Financial Fraud

At one point during our recent two-day seminar ‘Conducting Internal Investigations’ an attendee asked Gerry Zack, our speaker, why some types of frauds, but specifically financial frauds, can go on so long without detection. A very good question and one that Gerry eloquently answered.

First, consider the audit committee. Under modern systems of internal control and corporate governance, it’s the audit committee that’s supposed to be at the vanguard in the prevention and detection of financial fraud. What kinds of failures do we typically see at the audit committee level when financial fraud is given an opportunity to develop and grow undetected? According to Gerry, there is no single answer, but several audit committee inadequacies are candidates. One inadequacy potentially stems from the fact that the members of the audit committee are not always genuinely independent. To be sure, they’re required by the rules to attain some level of technical independence, but the subtleties of human interaction cannot always be effectively governed by rules. Even where technical independence exists, it may be that one or more members in substance, if not in form, have ties to the CEO or others that make any meaningful degree of independence awkward if not impossible.

Another inadequacy is that audit committee members are not always terribly knowledgeable, particularly in the ways that modern (often on-line, cloud based) financial reporting systems can be corrupted. Sometimes, companies that are most susceptible to the demands of analyst earnings expectations are new, entrepreneurial companies that have recently gone public and that have engaged in an epic struggle to get outside analysts just to notice them in the first place. Such a newly hatched public company may not have exceedingly sophisticated or experienced fiscal management, let alone the luxury of sophisticated and mature outside directors on its audit committee. Rather, the audit committee members may have been added to the board in the first place because of industry expertise, because they were friends or even relatives of management, or simply because they were available.

A third inadequacy is that audit committee members are not always clear on exactly what they’re supposed to do. Although modern audit committees seem to have a general understanding that their focus should be oversight of the financial reporting system, for many committee members that “oversight” can translate into listening to the outside auditor several times a year. A complicating problem is a trend in corporate governance involving the placement of additional responsibilities (enterprise risk management is a timely example) upon the shoulders of the audit committee even though those responsibilities may be only tangentially related, or not at all related, to the process of financial reporting.

Again, according to Gerry, some or all the previously mentioned audit committee inadequacies may be found in companies that have experienced financial fraud. Almost always there will be an additional one. That is that the audit committee, no matter how independent, sophisticated, or active, will have functioned largely in ignorance. It will not have had a clue as to what was happening within the organization. The reason is that a typical audit committee (and the problem here is much broader than newly public startups) will get most of its information from management and from the outside auditor. Rarely is management going to voluntarily reveal financial manipulations. And, relying primarily on the outside auditor for the discovery of fraud is chancy at best. Even the most sophisticated and attentive of audit committee members have had the misfortune of accounting irregularities that have unexpectedly surfaced on their watch. This unfortunate lack of access to candid information on the part of the audit committee directs attention to the second in the triumvirate of fraud preventers, the internal audit department.

It may be that the internal audit department has historically been one of the least understood, and most ineffectively used, of all vehicles to combat financial fraud. Theoretically, internal audit is perfectly positioned to nip in the bud an accounting irregularity problem. The internal auditors are trained in financial reporting and accounting. The internal auditors should have a vivid understanding as to how financial fraud begins and grows. Unlike the outside auditor, internal auditors work at the company full time. And, theoretically, the internal auditors should be able to plug themselves into the financial reporting environment and report directly to the audit committee the problems they have seen and heard. The reason these theoretical vehicles for the detection and prevention of financial fraud have not been effective is that, where massive financial frauds have surfaced, the internal audit department has often been somewhere between nonfunctional and nonexistent.. Whatever the explanation, (lack of independence, unfortunate reporting arrangements, under-staffing or under-funding) in many cases where massive financial fraud has surfaced, a viable internal audit function is often nowhere to be found.

That, of course, leaves the outside auditor, which, for most public companies, means some of the largest accounting firms in the world. Indeed, it is frequently the inclination of those learning of an accounting irregularity problem to point to a failure by the outside auditor as the principal explanation. Criticisms made against the accounting profession have included compromised independence, a transformation in the audit function away from data assurance, the use of immature and inexperienced audit staff for important audit functions, and the perceived use by the large accounting firms of audit as a loss leader rather than a viable professional engagement in itself. Each of these reasons is certainly worthy of consideration and inquiry, but the fundamental explanation for the failure of the outside auditor to detect financial fraud lies in the way that fraudulent financial reporting typically begins and grows. Most important is the fact that the fraud almost inevitably starts out very small, well beneath the radar screen of the materiality thresholds of a normal audit, and almost inevitably begins with issues of quarterly reporting. Quarterly reporting has historically been a subject of less intense audit scrutiny, for the auditor has been mainly concerned with financial performance for the entire year. The combined effect of the small size of an accounting irregularity at its origin and the fact that it begins with an allocation of financial results over quarters almost guarantees that, at least at the outset, the fraud will have a good chance of escaping outside auditor detection.

These two attributes of financial fraud at the outset are compounded by another problem that enables it to escape auditor detection. That problem is that, at root, massive financial fraud stems from a certain type of corporate environment. Thus, detection poses a challenge to the auditor. The typical audit may involve fieldwork at the company once a year. That once-a-year period may last for only a month or two. During the fieldwork, the individual accountants are typically sequestered in a conference room. In dealing with these accountants, moreover, employees are frequently on their guard. There exists, accordingly, limited opportunity for the outside auditor to get plugged into the all-important corporate environment and culture, which is where financial fraud has its origins.

As the fraud inevitably grows, of course, its materiality increases as does the number of individuals involved. Correspondingly, also increasing is the susceptibility of the fraud to outside auditor detection. However, at the point where the fraud approaches the thresholds at which outside auditor detection becomes a realistic possibility, deception of the auditor becomes one of the preoccupations of the perpetrators. False schedules, forged documents, manipulated accounting entries, fabrications and lies at all levels, each of these becomes a vehicle for perpetrating the fraud during the annual interlude of audit testing. Ultimately, the fraud almost inevitably becomes too large to continue to escape discovery, and auditor detection at some point is by no means unusual. The problem is that, by the time the fraud is sufficiently large, it has probably gone on for years. That is not to exonerate the audit profession, and commendable reforms have been put in place over the last decade. These include a greater emphasis on fraud, involvement of the outside auditor in quarterly data, the reduction of materiality thresholds, and a greater effort on the part of the profession to assess the corporate culture and environment. Nonetheless, compared to, say, the potential for early fraud detection possessed by the internal audit department, the outside auditor is at a noticeable disadvantage.

Having been missed for so long by so many, how does the fraud typically surface? There are several ways. Sometimes there’s a change in personnel, from either a corporate acquisition or a change in management, and the new hires stumble onto the problem. Sometimes the fraud, which quarter to quarter is mathematically incapable of staying the same, grows to the point where it can no longer be hidden from the outside auditor. Sometimes detection results when the conscience of one of the accounting department people gets the better of him or her. All along s/he wanted to tell somebody, and it gets to the point where s/he can’t stand it anymore and s/he does. Then you have a whistleblower. There are exceptions to all of this. But in almost any large financial fraud, as Gerry told us, one will see some or all these elements. We need only change the names of the companies and of the industry.

Inside and Out

I 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.