Fraud prevention and detection. External audits in the organisation of great companies

Inhaltsverzeichnis

Rationale

Research Objectives

Research questions

Literature review

External audit responsibility on fraud detection

External audit aid in preventing fraudulent activities

Research Methods

Conclusion/ Research outcome

References

Rationale

The logic behind this topic is that all companies may face the risk of fraudulent activities in the organisation. In the early 2000s, accounting fraud was a hot topic for the SEC when several famousfraud scandals at companies such as Enron, WorldCom and HealthSouth shook investor confidence in the financial market, (Kranacher, Riley & Wells, 2011). This fraudulent behaviour can lead to the collapse or severely damage a company’s reputation, (Halbouni, 2015). When fraud appears in a company, people will start asking who will be responsible forpreventing and detectingfraud. Shareholder or stakeholderwho read financial statements believes that external auditors play a critical role regarding the accuracy of the financialstatement ("SEC Announces Financial Fraud Cases", 2016). It is important to have high quality external auditor in detecting fraud and to investigate existing auditing procedures to prevent the possibility of fraud occurs.

Asare, Wright & Zimberlman (2015) noted that the role of the external auditor is to detect any frauds in the financial reporting and it is the expectation of the regulators and the financial statement users that the external auditors will be able to discover all the frauds that may take place. This expectations by the users of the financial statements and the regulators to issue a number of standards that can be used in detecting the frauds before they occur. Such standards include IAASB 2009, PCAOB 2002, AICPA 1988 and AICPA 1997 amongst others.

Many of the large organisations have experienced fraud of one form or the other in their years of operations. The frauds have had a very disturbing effect on the economy of the world leading to massive unemployment, especially for the middle and low income earners as well as great levels of suffering (Abdullahi & Mansor, 2015). To understand the motivations for the frauds, fraud triangle theory can be applied.

The Fraud Triangle Theory was developed in 1950 by Donald Cressey. Cressey is a criminologist who noted that to understand a fraud, you must understand the reason behind the fraud. His research focused on what drove people to breach the trust that they had been given by their organisations. In the research, he interviewed 250 career criminals for a period of five months. Cressey considered two main elements in the subjects: (a) they had accepted the position of the trust in good faith and (b) some circumstances made them to violate the trust that they had been given (Abdullahi & Mansor, 2015). He concluded that for a fraud or crime to take place, there must be three factors at play: pressure, opportunity and rationalisation. See Figure 1 below for the Fraud Triangle. Cressey further stated that:

Trust violators, when they conceive of themselves as having a financial problem that is non-shareable and have knowledge or awareness that this problem can be secretly resolved by a violation of the position of financial trust. Also they are able to apply to their own conduct in that situation verbalizations which enable them to adjust their conceptions of themselves as trusted persons with their conceptions of themselves as users of the entrusted funds or property (Abdullahi & Mansor, 2015, p. 39).

Figure 1: Fraud Triangle as developed by Crassey in 1953

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Source: Crassey (1953) as cited in Abdullahi & Mansor, (2015, p. 39).

The top element of the diagram by Crassey represents the motive or the pressure to commit the fraud while the other two elements at the bottom are perceived to be the rationalisation and opportunity. The perceived pressure refers to the incentive, factors and motives that lead to the unethical conduct (Abdullahi & Mansor, 2015). Such factor may include both financial and non-financial pressures which may lead to the commission of a fraud. Research indicates that 95 percent of all the financial frauds that have been committed usually result from the financial pressures that an individual faces. The pressure can be employment stress, external pressure, or personal pressure (Abdullahi & Mansor, 2015). Vona (2008) as cited in Abdullahi & Mansor, (2015) brought forward a very important element in the fraud element. Family health and financial problems, personal debts, greed, leaving beyond the means of an individual, gambling and drug addiction are some of the factors that pressure an individual to commit a fraud.

The second element of the triangle is the perceived opportunity that is created by the ineffective governance and control system that allows the person to commit the fraud in the organisation. The perceived opportunity is created by the weaknesses in the internal controls thus allowing the individual to take advantage of the conditions available to them (Abdullahi & Mansor, 2015; Omar, Johari & Hasnan, 2015). The perceived opportunity in nature is perceived in that in some of the cases it cannot be real. However, the existence of the opportunity can be in the belief or the perception of the perpetrator. The fraud will most likely take place when the risk of being caught is lower. There are a number of factors that may lead to the existence of the opportunity for the perpetuation of the fraud for instance lax disciplinary actions, employee negligence, employees realising the weaknesses in the systems and thus taking advantage of such weaknesses and breach of policy. There are two main aspects of the opportunity: organisational conditions and inherent susceptibility of the firm to manipulation.

The final element of the fraud triangle is the rationalisation where the perpetrator comes up with an idea that is morally acceptable to themselves so that they can begin to engage in the unethical behaviour. Rationalisation refers to the excuses and justifications that the immoral behaviour or conduct is not a criminal activity (Mohamed & Handey-Schchelor, 2015). A fraud will most likely not occur if the individual cannot be able to justify the action. Some common justifications include: the employer is stealing from me, I had to take the money to cater for my family or I was simply borrowing the money. The persons who commit frauds have a mind-set that allows them to excuse or justify their actions because of their moral reasoning or personal integrity. The inclination to engage and commit a fraudulent activity is dependent on the personal attitudes and ethical values of an individual (Abdullahi & Mansor, 2015).

Research Objectives

The purpose of this research paper is to discuss critical role of external auditors in detercting and preventing fraudulent activities in orgisations. Through this research, we will see how effective the external audit is in detecting and preventing the fraudulent activities. By considering the methods that are used by the auditors in detecting and preventing the frauds and how effective such methods that are used are.

This research paper planned to use three key research questions to analyse the topic to achieve the research objective, as per following:

Research questions

1. What are the roles of external audit in the organization?
2. Do external audit responsibilities on fraud detection?
3. Do external audit aid in preventing the fraudulent activities?

Literature review

Overview of external audit role in the organization

External audit is an independent body which is not affiliated with the client’s company which is appointed by the company shareholder. External audit plays an important part in improving financial reporting and to ensure businesses are in compliance with the accounting framework. They act as an important role in identifying and protecting the organisation from fraudulent activities by performing the annual statutory audit of the financial account, providing an opinion on whether the accounts are true and fair reflection of the company’s financial position. External auditors often examine and evaluate all the internal controls that are put in place to manage financial risks which could affect the financial accounts and to assess whether they are working effectively, (Kranacher, Riley & Wells, 2011).

Kassem & Higson (2016) notes that auditors plays an important role in combating corruption in an organization. Rather than act as deterrents to the managements from engaging in the different irregularities, the auditors must make extra effort in detecting the various irregularities thus playing an important role in changing the perception of the management of the organisations. ISA 200 developed by the International Auditing and Assurance Standards Board (IAASB) and ISA 240 especially regarding what the audit needs to do in line with the stands and their responsibilities relating to the frauds. External auditors also detect the material misstatements in the financial statements whether such misstatements are a result of fraud or errors (Kanapickiene & Grundiene, 2015).

External audit responsibility on fraud detection

ISA 240 defines the external auditor’s responsibility in respect of fraud and error in the financial statements, (Iyer & Samociuk, 2016). Although IAS 240 clarifies that management is primarily responsible for the prevention and detection of fraud, the standard aim to ensure that auditors are responsible for fraud detection by providing reasonable assurance that the financial statement is free from material misstatement whether caused by error or fraud. SAS no. 99 reminds auditors should aim to have “professional scepticism” when carrying out audit engagement, and the audit should include some tests designed to detecting fraud, (Brickner& Pearson, 2003).

Gupta & Soral (2015) argued that auditors can be able to use Neural Networks in the identification of fraud in companies through the use of special software. The technique can be used by the auditors to be able to classify firms into fraudulent or non-fraudulent based the mining techniques that are available in SPSS 21. The technique allows for classifying, clustering, predicting, recognition of patterns and images as well as estimation. The elements of the financial statements such as the quick ratio, current ratio, debt to EBITDA ratio, financial leverage, Total Assets Turnover and Equity turnover amongst the other 33 financial statement indicators can be used by the external auditors to detect fraudulent activities. The paper is a clear indication that neural networks when applied by the external auditors can be used in the detection of the fraud that is occurring in an organisation (Farrell & Franco, 1999). However, the researchers indicated that they faced some limitations due to the small sample size that they applied. The other limitation that can be seen in the paper is the exclusive use of financial ratios without considering corporate governance and internal control which are all critical elements in the fraud triangle theory.

External auditors can also use financial ratios in the detection of fraud (Kanapickiene & Grundiene, 2015). Fraud can be detected through the use of the analysis of the financial ratios as financial difficulties are the main motivation for the managers to be able to engage in the activities of fraud. Research indicates that the higher levels of debt in an organisation can lead to the increase in the probability of fraud in the financial statements. There are a number of ratios that are used in the detection of fraud by the external auditors for instance the use of debt to asset rations, debt to equity ratio, and the total assets and total liabilities (Kanapickiene & Grundiene, 2015). Moreover, lower levels of liquidity may also act as an incentive for the top management of the organizations to engage in the fraud in the financial statements. Liquidity is measured through the consideration of the working capital as compared with the total assets (WC/ TA), the current assets against the current liabilities ratio (Kanapickiene & Grundiene, 2015). Therefore when the external auditor notes such anomalies in the financial ratios of the organisations, they will be able to detect any frauds that may be going on in the organisation. The external auditors can also use the profitability outcome and figures that are indicated in the financial statements released by the firm. The companies are usually motivated to engage in fraud due to the need to keep growing or to be seen to be growing (Kanapickiene & Grundiene, 2015). Profitability of the firm and the composition of the asset ratios can be used by the external auditors to detect the fraud in the organisation. Sales as compared to the total assets ratio, the net profit, the profit margin and return on assets (ROA) can also be manipulated by the firms to commit frauds. The external auditors can thus use such information to detect the fraud before they happen. Zamzami, Nusa & Timur (2016) noted that operational and performance audits, review and improvement of the internal control, reviews of cash and the development of ethical codes can all be used in the detection of frauds. Internal auditors must also be able to evaluate the probability of error, fraud and other cases of non-compliance (Halbouni, 2015).

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