Highlights of fraud research

According to a recent Kroll report, 70% of businesses reported at least one fraud in 2013—14. Research on fraud prevention provides findings and best practices for CPAs who work to prevent such crimes. This article summarizes recent research on fraud prevention and related topics from leading academic accounting journals.

AUDITOR ABILITY TO DETECT DECEPTION

Are auditors skilled at detecting client deception? D. Kip Holderness examines relevant academic literature, with a focus on client inquiries.

Holderness points out that generally accepted auditing standards require extensive client inquiry. Auditors are required to remain professionally skeptical when dealing with client management, particularly in the area of client inquiry, so that audit evidence can be critically assessed in determining whether the financial statements are free from material misstatement.

Research outside of the accounting discipline provides evidence that individuals are often unable to detect deception, with the untrained individual having an approximately 50% success rate and professionally trained and experienced individuals having a detection rate of around 75%. Nonverbal cues, such as the display of anxiety, provide little assistance except in cases of extreme stress. Verbal cues can be slightly more helpful, as deceivers tend to provide less detail than nondeceivers.

Recent research in the accounting field provides similar results regarding the importance of observing verbal cues, asking open-ended questions, and enhancing listening skills. The built-in challenge of the auditor/client relationship, where the auditor acts as both adviser and evaluator, also affects the auditor’s deception detection skills.

Prior studies show that predominantly inexperienced audit staff are assigned to perform client inquiries, thus revealing a “social mismatch” in the audit process due to the tendency of individuals to trust others to be truthful. Having client experience does not appear to enhance auditors’ detection skills. In fact, studies have found that familiarity decreases accuracy, affecting auditors’ ability to exhibit professional skepticism in a long-term auditor/client relationship.

Holderness also reviews research on computer-mediated communication. Some researchers state that online communications may make deception detection easier because it involves fewer interpersonal cues, resulting in an increased focus on facts. Others, however, believe the lack of such cues interferes with the auditor’s face-to-face opportunities for interpersonal observations, professional judgment, and skepticism. Email has been shown to hinder probing questions, thus inhibiting a robust client inquiry. Studies show that perpetrators of deception, on the other hand, prefer face-to-face and telephone interactions over electronic communication.

This work provides valuable guidance for auditors when performing and training individuals tasked with client inquiries. “Detecting Deception in Client Inquiries: A Review and Implications for Future Research” was published in the Journal of Forensic & Investigative Accounting in 2014.

THE EFFECT OF LAWSUITS ON ACCOUNTING MISSTATEMENTS

Numerous studies examine the causes of lawsuits against audit firms. In a recent article, researchers Clive Lennox and Bing Li extend and expand prior research to analyze the positive consequences of lawsuits on subsequent audit quality.

Lennox and Li analyzed 830 lawsuits involving financial reporting issues occurring over a 10-year period. They found a statistically significant reduction in the likelihood of an accounting misstatement three years after litigation, compared with firms that had not experienced a lawsuit in the prior three years.

The authors’ research suggests that both audit quality and client selection policies are enhanced following lawsuits due to changes in the organizations’ audit approaches. “Accounting Misstatements Following Lawsuits Against Auditors” was published in the February 2014 issue of the Journal of Accounting and Economics.

INTERNAL AUDITOR INDEPENDENCE

Internal auditors have a distinct advantage over external auditors in detecting fraud because they’re involved with organizations on a daily basis. Thus, they become more familiar with their organizations’ environments, control procedures, and financial reporting systems, putting them in a stronger position to detect financial statement fraud.

However, because internal auditors are often hired by, and may even report to, management, they are not entirely independent and may not feel free to investigate or report on allegations of fraud committed by upper management.

In their article, “Internal Auditor as Accounting Fraud Buster,” published in the January 2014 IUP Journal of Accounting Research & Audit Practices, Gopal Krishna Agarwal and Yajulu Medury recommend addressing this problem by introducing the novel concept that organizations use an independent third party to appoint internal auditors. They suggest that regulators, creditors, or governments assign internal auditors, or that these three groups create a central regulatory body to appoint them.

The authors also present a list of criteria needed by internal auditors to enhance effectiveness. These skills include an extensive study of the organization’s environment (including systems, procedures, internal controls, management, and employees); use of well-thought-out audit programs; engagement in two-way communication with management at regular intervals; establishing the consequences of fraud with all levels of management; and neutral third-party appointment.

INCENTIVES TO REPORT FRAUD

The most common way frauds are detected is through employee tips, according to the Association of Certified Fraud Examiners. But employees are often hesitant to report their suspicions out of fear of retaliation both within the company and publicly.

Authors Alisa G. Brink, D. Jordan Lowe, and Lisa M. Victoravich report the results of an experiment in which they tested whether implementing financial incentives for internal reporting of suspicious information increased the likelihood of employees to report fraud internally rather than externally. They used two kinds of evidence: strong evidence that indicated conclusively that a fraud was occurring and weak evidence that circumstantially indicated a fraud might or might not be occurring.

The researchers provided their experimental subjects with a written case describing a hypothetical manufacturing company where the controller discovers that the CFO is committing fraud. The researchers then divided the subjects into four experimental groups: Half the subjects were provided with information that the evidence was conclusive (strong), and the other half of the subjects were provided with information that the evidence was circumstantial (weak). Next, each group was split further into two additional groups: one that had internal financial incentives to blow the whistle, and one without internal financial incentives. The researchers then asked if the participants would be likely to report the fraudulent behavior and whether they would report it internally or externally.

Results indicated that, even when no financial incentives are offered to report internally, employees still prefer to report internally, regardless of whether they have weak or strong evidence for fraud. However, when offered financial incentives for reporting internally, employees preferred to report internally if the evidence was weak, but externally if the evidence was strong. The authors posit that financial incentives offered for internal reporting tend to replace the intrinsic incentives (such as ethics and company loyalty) that would otherwise encourage employees to report internally. In addition, they suggest that employees may believe that reporting externally is only worth the risk of potential public criticism and retaliation if there is a strong likelihood (e.g., the evidence is strong) of receiving a substantial reward.

These results have implications for audit committees, which should carefully consider the potential unintended consequences of offering internal financial rewards for employees to report suspicious information internally rather than externally, as such incentives may not have the company’s desired effect.

The August 2013 article, “The Effect of Evidence Strength and Internal Rewards on Intentions to Report Fraud in the Dodd-Frank Regulatory Environment” was published in Auditing: A Journal of Practice & Theory.

AUDITOR REACTIONS TO NONFINANCIAL MEASURES

Auditing standards and current research suggest that auditors can use nonfinancial measures (e.g., the number of a company’s retail outlets or number of employees) in financial statement auditing. But do auditors identify and appropriately analyze inconsistencies between financial and nonfinancial measures? For example, would auditors recognize the increased risk of financial statement misstatement if they saw that the number of a company’s retail outlets decreased but its sales revenue increased?

Joseph F. Brazel, Keith L. Jones, and Douglas F. Prawitt discuss the results of two experiments that ask these questions in their article “Auditors’ Reactions to Inconsistencies Between Financial and Nonfinancial Measures: The Interactive Effects of Fraud Risk Assessment and a Decision Prompt.” In their first experiment, they investigated whether auditors used nonfinancial information when performing analytical procedures to develop expectations for sales revenues. They split a group of 110 audit seniors-in-charge into two groups, providing one with nonfinancial information consistent with the financial information in a sample case. The other group received inconsistent nonfinancial information. Regardless of which group they were in, less than one-third of the auditors used the nonfinancial measures to develop their expectations. Additionally, only one out of 21 auditors in the “inconsistent” group noted a material difference in the account balance.

For their second experiment, the researchers provided the auditors with a prompt asking them to compare the nonfinancial measures with the prior year’s sales information. They again split the auditors into two groups, giving one group an overall fraud risk assessment of the client as “high risk” while the other group was told the client was “low risk.” The results showed that auditors in the “high risk” client group were more likely to react to the inconsistent nonfinancial information.

These findings indicate that auditors are able to react appropriately to inconsistent nonfinancial information when provided with a prompt, suggesting that auditors can be trained to use nonfinancial information to assist in the detection of fraud. The results also highlight the importance of accurate fraud risk assessment during the planning stage of an audit. To help detect potential fraud, auditors should consider ways to increase their use of nonfinancial information in their audit procedures.

The article was published in Behavioral Research in Accounting in Spring 2014.

PROFESSIONAL SKEPTICISM

Professional skepticism is the trademark of a good auditor and an essential attribute that must be finely tuned when he or she makes decisions regarding an entity’s ability to continue as a going concern.

Reports from the PCAOB and the SEC express concerns that audit deficiencies often result from the influence of management’s potentially biased earnings forecasts. Researchers Mei Feng and Chan Li examine this issue in their article “Are Auditors Professionally Skeptical? Evidence From Auditors’ Going-Concern Opinions and Management Earnings Forecasts,” published in the December 2014 Journal of Accounting Research. Feng and Li investigated the audit reports of financially distressed firms over a 10-year period, including almost 38,000 observations of firms that reported either a net loss or negative operating cash flows.

The researchers focused their study on 1,054 cases where a management forecast was issued within the 30 days prior to the audit report to ensure auditors had access to current and relevant forecasts during their audit engagement. Within the sample, 39 firms received a going concern opinion, and 33 filed for bankruptcy.

The first research question the authors tested was whether auditors were overly reliant on potentially biased management forecasts when deciding whether to issue a going concern opinion. Results were negative, suggesting that auditors appropriately used professional skepticism and did not overly rely on information provided by management.

The authors also wanted to determine whether auditors placed less weight on management forecasts that were likely to be overly optimistic. To test this question, they divided the sample of management forecasts into those that were likely to be less credible (i.e., the forecast was more likely to be optimistic) versus those that were likely to be more credible (i.e., those that did not fall into the optimistic category). Management forecasts were classified as optimistic if the managers had previously issued optimistic forecasts within the prior two years or if the forecast was for high earnings or a large increase in earnings. Results indicated that auditors took the credibility of management forecasts into account when making decisions relating to a going concern opinion and placed less weight on forecasts they viewed as less credible.

These findings confirm that auditors continue to exercise appropriate professional skepticism when facing overly optimistic earnings forecasts and provide guidance for auditors in situations where management forecasts appear to be biased.

About the authors

Cynthia E. Bolt-Lee (boltc@citadel.edu) is an associate professor of accounting at The Citadel in Charleston, S.C. Sara Kern (kern@gonzaga.edu) is an associate professor of accounting at Gonzaga University in Spokane, Wash.

To comment on this article or to suggest an idea for another article, contact Courtney L. Vien, associate editor, at cvien@aicpa.org or 919-402-4125.

The Pathways Commission was created by the American Accounting Association and the AICPA to study the future structure of higher education for the accounting profession and develop recommendations to engage and retain the strongest possible community of students, academics, practitioners, and other knowledgeable leaders in the practice and study of accounting. Recommendation No. 1 of the Pathways Commission report was to “build a learned profession for the future by purposeful integration of accounting research, education, and practice for students, accounting practitioners, and educators.” The dissemination of practice- related research to practitioners supports this recommendation. This article supports the Pathways Commission’s efforts. It summarizes the findings and observations from recently published research in prominent accounting, auditing, and business academic journals.

AICPA RESOURCES

JofA articles

• “Forensic Interviews: Plan to Succeed,” Aug. 2015, page 34
• “I’m Not Biased, Am I?” Feb. 2015, page 26
• “Are Organizations Hindering Employee Whistleblowing?” Dec. 2014, page 42
• “Defining Roles in Prevention of Financial Reporting Fraud,” Nov. 17, 2014
• “Lessons From an $8 Million Fraud,” Aug. 2014, page 32

Publications

• Essentials of Forensic Accounting (#PFF1401P, paperback; #PFF1401E, ebook)
• Financial Reporting Fraud: A Practical Guide to Detection and Internal Control, 2nd Edition (#029890, paperback; #029890e, ebook)
• Forensic and Valuation Services Library (#PFVSCOLLO, one-year online access)
• The Guide to Investigating Business Fraud (#056558, paperback)

CPE self-study

• Auditing for Internal Fraud (#743292, text)
• Common Investigative Techniques (#159957, one-year online access)
• Fraud Prevention, Detection, and Response (#159966, one-year online access)
• Fraud Risk Management (#165337, one-year online access)
• Fraud Update: Detecting and Preventing the Top Ten Fraud Schemes (#741202, text; #158010, one-year online access)
• Fundamentals of Forensic Accounting Certificate Program (#159950, two-year online access)

Conference

• Forensic & Valuation Services Conference, Nov. 8—10, Las Vegas or online

Video webcast

• “Fraud: Recent Findings, Red Flags and Corruption Schemes,” Nov. 24, 1 p.m. ET (#VCL4FRAU015); Dec. 21, 10:30 a.m. ET (#VCL4FRAU016); Jan. 7, 2016, 1 p.m. ET (#VCL4FRAU017)

For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077

Online tools

• Deterring and Detecting Financial Reporting Fraud, aicpa.org (member login required)
• Fraud Prevention, Detection and Response, aicpa.org

Forensic and Valuation Services Center

The Forensic and Valuation Services Center provides CPAs with a vast array of resources, tools, and information about forensic accounting and business valuation services in one convenient location. The FVS Center also provides special member benefits to FVS Section and Certified in Financial Forensics (CFF) and Accredited in Business Valuation (ABV) credential holders. Visit aicpa.org/FVS. Members with a specialization in financial forensics may be interested in applying for the CFF credential. Information about the CFF credential is available at aicpa.org/CFF. Members with a specialization in business valuation may be interested in applying for the ABV credential. Information about the ABV credential is available at aicpa.org/ABV.