Enhancing Fraud Detection Through Education

By Mary-Jo Kranacher and Lorraine Stern

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SAS 99

Although the responsibility for preventing fraud ultimately lies with directors and officers, it is becoming clearer that auditors must be prepared to detect fraud. Shortly after Congress passed the Sarbanes-Oxley Act in July 2002, the Auditing Standards Board (ASB) issued SAS 99, Consideration of Fraud in Financial Statements, which set a new fraud standard for auditors. It requires that auditors assess the risk that fraud may have occurred and materially affected the financial statements. This standard has redefined the audit function, which will continue to evolve as the Public Company Accounting Oversight Board (PCAOB) considers additional changes.

SAS 99 requires that auditors discuss with management, and others, whether they are aware of any fraud. According to a 1999 Committee of Sponsoring Organizations of the Treadway Commission (COSO) study, CEOs, usually aided by their CFOs, perpetrate 75% of all frauds. Auditors have traditionally been hesitant to ask probing questions of management for fear that doing so might offend the very people who had engaged them. This conflict of interest has led to a crisis of confidence in our financial reporting system.

Critics of SAS 99 point to its heavy reliance on the “red flag” approach, which has not been proven to be effective in identifying fraud. The “Examples of Fraud Risk Factors” listed in the Appendix of SAS 99 seem all-encompassing, yet there is a lack of empirical evidence to confirm that these factors are correlated with the detection of fraudulent activity. Auditors should learn about the various types of fraud that may occur, and be able to develop a reasoning process to detect them. This new standard is a positive step toward reducing fraud, if only because the perceived increase in the likelihood of detection serves as a deterrent. It puts the accounting profession and others on notice that auditors will actively search for fraud while conducting an audit.

According to the Report to the Nation on Occupational Fraud and Abuse (2004), occupational fraud and abuse occurs “when an individual uses their occupation for personal enrichment through the deliberate misuse or misapplication of their employer’s economic resources.” This study, published by the Association of Certified Fraud Examiners, estimated the total cost of occupational fraud to organizations at approximately $600 billion annually. Recent corporate scandals have placed a higher degree of visibility and liability on the independent audit function. To enhance the fraud detection abilities of auditors and begin to rebuild public confidence in them, accounting education must be expanded.

The 150-hour requirement provides new opportunities to address the additional responsibilities imposed by SAS 99. As of February 1, 2003, 41 of the 54 U.S. licensing jurisdictions have implemented a requirement of 150 semester-hours of education for eligibility to take the Uniform CPA Examination. New York, which is one of seven other states that have adopted the requirement but not yet put it into effect, will implement the new requirement as of August 1, 2009. The AICPA and the National Association of State Boards of Accountancy (NASBA) have endorsed general guidelines that allow flexibility in the content covered in the extra 30 hours of educational programs. Although most accounting programs include courses covering financial accounting, auditing, taxation, and management accounting, occupational fraud remains a relatively underaddressed subject in academe.

Education That Builds Investigative Skills

To control fraud, an auditor needs to understand the psychology of individuals’ behavior as well as the environment in which they operate. The current environment requires new CPAs, as well as seasoned professionals, to acquire supplementary investigative and analytical skills. Because the majority of frauds are uncovered as a result of tips from employees and others, Sarbanes-Oxley has required public companies to establish anonymous hotlines for employees and others to report any questionable procedures without fear of retaliation. The best clues come directly from people; therefore, effective interviewing skills are essential for an auditor to uncover fraud. Partnering with faculty in various disciplines to develop courses in criminology, psychology, business writing, critical thinking, and ethics could qualitatively improve the education and ability of accounting students.

Historically, the typical undergraduate auditing class has focused on how to identify errors and omissions that might materially affect the financial statements, with only a cursory coverage of fraud. Because fraud usually entails concealment, a different set of skills is needed to detect this crime. Much can be learned from fraud examination and forensic accounting. In discussions involving the risk factors for fraud, three conditions are routinely cited: incentives/pressures, perceived opportunities, and attitudes/rationalizations. These elements were first identified by Donald R. Cressey, a preeminent sociologist and criminologist. His hypothesis of the “fraud triangle” remains one of the benchmark theories in fraud criminology. Pressure, such as financial or economic need, provides the motivation for the act. Perceived opportunity may be the result of poor or nonexistent internal controls, which give access to the perpetrator. Rationalization allows an individual to adjust the perception of what she is doing. For example, fraudsters might reason that they are only borrowing money they plan to pay back. Auditors should be trained to recognize and detect these elements and to understand the psychology of motivation and rationalization, as well as detect weaknesses in the internal controls of an organization.

Current auditors have a wealth of possibilities available to learn about fraud detection and deterrence, in the form of continuing professional education courses (CPE). Improving the auditor’s ability to detect fraud will lend technical competence and credibility to the financial reporting process.

Rather than narrowing the focus toward specialization, SAS 99 calls for expanding the educational background of auditors. Greater educational background will help auditors recognize and assess the pressures that can lead to fraud, obtain the necessary information, organize and evaluate the data, and report conclusions of fraud investigations.