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Detection of Fraud by Auditors: Review

Introduction

This paper supports the view that auditors play a vital role in the fight against corruption in any business. Therefore, the study seeks to describe the process of fraud detection by auditors and how to curb the vice in organizations. The objective of the research is to develop an understanding of the role of auditors in the detection and control of fraud in organizations. The paper exposes the degree in which auditors comply with auditing standards when they encounter instances of fraud within organizations. The research reviews literature from diverse accounting studies to provide a broad perspective of the topic and present a sound and valid argument of the central premises under discussion (Bunget & Dumitrescu, 2009).

The issue of fraud

Fraud may refer to the intentional deception of prompting an individual to provide property or a legal right. The United Kingdom Association of Fraud Examiners defines fraud as the use of one’s job occupation for individual enrichment. This aspect involves the deliberate misuse or misappropriation of organizational assets or resources. In addition, the Federal Bureau of Investigation (FBI) expounds that fraud is the illegal conversion of money or property through unacceptable practices or false pretence. The actions may include larcenies and improper checks. They may exclude the actions of forgery or counterfeiting. Fraud can be a kind of corruption by an individual or group for the sake of self-gratification. It involves the action and concealment of theft. Fraud also denotes the transformation of stolen resources into individual assets. Corporate financial disasters may be frequent. They can affect the freedom of auditors in the process of fraud detection. Certain financial organizations may record positive economic gains but undergo bankruptcy within a short span. This fact may be as a result of inadequate detection of fraud and other several financial improprieties. Questions continue to arise on why auditors fail to detect different forms of irregularities and fraud. However, literature on accounting points to a deviation between the auditing profession and the so called “perception gap”. This concept explores the duty of an audit in the detection of irregularities and fraud. The principal role of the auditor is to conduct an independent examination and communication of professional opinion relating to the financial statements organizations release.

Yuhao Li (2010) reports in his research that during the case analysis of the Enron Scam, the “expectation gap in auditing” appreciates that stakeholders and the public have a differing perspective of the role of auditors and the companies’ audit records. Li reveals that the public has misconceptions that remain a significant liability to the audit profession. He exposes the misunderstanding of people about the role of auditors in the control of corporate fraud within the context of the public and corporate organizations. The research examines the need to communicate the role of auditors to the public and corporate world (Li, 2010).

The rationale of this research

Auditors perform crucial and varying functions in financial organizations. They play a role in stopping and regulating corporate fraud and financial improprieties. Scholars argue on the roles and responsibilities of auditors. Many economists argue that challenges facing most organizations may be related to incompetent auditors. They point out that most businesses fail because auditors do not perform their functions efficiently. For example, organizations believe that auditors should carry the responsibility of financial scandals in the corporate world. Researchers need to conduct further studies to create an efficient strategy of responding to this issue. This study examines the mandate of auditors concerning the detection and control of fraud. It can also illustrate fraud as a concept of the expectation gap. This idea can be employed in differentiating an individual’s perspective from a group one.

Aims and objectives

This paper evaluates the functions of auditors in the detection and control of corporate frauds. The research explores the concept of fraud and the importance of efficient auditing. It explains the role of auditors in financial environmental transformation, the nature of corporate fraud, and measures auditors should enact to regulate the detection and control of fraud. In addition, the paper evaluates arguments as to whether the auditing profession can transform from the ancient approach of auditing performed at the end of the financial year to a contemporary one where it runs concurrently with the financial year of operations. It also reviews prospective interventions that can improve the efficacy of auditing.

Literature review

Companies and organizations need to conduct financial audits to verify their accounts. Audits ensure that organizational stakeholders have a firm grip of the running of the company. They affirm that the investment of the stakeholders is safe. Accounting scholars seek to transform the concept of auditing in order to assert its relevance to contemporary times. Government agencies continue to exert pressure on auditing firms to redefine the auditing profession. Stakeholders often question whether auditors have the capability to provide essential information that can lead to detection of fraud. This fact is due to the corporate failure experienced in different organizations in matters that relate to auditing of accounts. The cost of corporate fraud is rising within the scope of business across the globe. It leads to the high cost of products and reduction of corporate profits. Auditors need to enact measures that can improve the confidence and validity of financial accounts.

Meanings of auditing and auditor

Auditing refers to an exercise that enables an auditor to explain a decision on the appropriateness of financial statements. Auditing interrogates the validity of financial records and their relevance to set accounting structures. Therefore, an auditor is a person who provides a report on whether the financial statement of an organization reflects a valid and fair account.

The history of the auditor’s function in relation to fraud

The Capital Markets Authority regularly reviews the concept of auditing. The ancient objective of auditing underscored the need to promote accurate and honest accounting primarily in the public domain and institutions and government services. Economic and industrial revolutions led to the broadening of the concept of auditing. Contemporary auditing integrates practical aspects of ancient auditing. The purpose of traditional auditing was to prevent and detect fraud. The goal of the framework of the audit activity was to authenticate and regulate the role of officers in charge of finances. The rise of the industrial revolution led to a transformation of the auditing profession and the separation of business owners from individuals running the enterprises. However, the overall purpose of auditing remained the same. It was still playing the function of verifying financial transactions to check on fraudulent deals. The expansion of business and separation of business agents and owners auditing adopted a role of a control system rather than that of evaluating financial records. The rising complexity of businesses provides room for the evolution of the auditing concept. Auditors’ roles continue to shift towards expression of credibility and confidence in financial statements. The role involves shifting from detection of simple errors and fraud to expression of professional decisions on financial reports and accounting (Ramos, 2009). The increase in financial scams inspires audit agencies to interrogate the principles and practices of the auditing profession. Organizations engage in the formulation of additional responsibilities for auditors. The responsibilities may reinforce the skills and knowledge in the detection and reporting of fraud.

Description and varieties of fraud

The role of the auditor involves forming an opinion on the validity of financial accounts that organizations present. The international standards on auditing examine the responsibility of the auditor in the detection and control of fraud. This paper outlines various categories of fraud. Fraud may assume the form of corruption or impropriation of funds within an organization. This category may be termed as a fraud against a business enterprise. Fraud can also be grouped according to financial reporting. In addition, external fraud involves corrupt practices perpetrated by individuals or groups against a given organization.

Fraud may be practiced by non-employees, management and staff. Government agencies refer to management misappropriations as the most diverse categories of fraud from employees. They occur when the management uses its power to regulate internal matters and organizational funds. In most cases, financial accounting occurs at the top hierarchy of an organization. Senior management staff may be responsible for controlling the categories of fraud. Management fraud can at times happen without detection because the management usually plays an oversight role in the organization. This aspect makes detection of fraud from other junior levels challenging.

Management fraud

Management fraud remains one of the most fraudulent areas of organizational fraud. This fact may be as a result of conflicting interests or fear of organizational embarrassment when people report cases of fraud. Individuals who are not part of the management of an organization can also be part of management’s fraud plans. Management fraud comprises of many characteristics. The common characteristic involves diversion of company profits rather than their reinvestment Research indicates that the average management fraud loss is about 8 times more than the standard employee fraud loss. The effect of management fraud is significant and may not show in organizational accounts because fraud happens “off the books” of account. In addition, the high ranking nature of the management in an organization makes it difficult to probe it because of the existence of mutual trust between the employee and organization. Non-management staff can also facilitate fraud. For instance, accomplices especially in bidding situations can be examples of non-management assistance in the perpetration of fraud.

How does fraud occur?

Fraud occurs when there are motivating factors that may support it. Three factors may motivate the occurrence of fraud. They include opportunity, pressure and rationalization. Opportunity can be the chance that may allow an individual or organization to conduct financial impropriety. Pressure may be the incentive for conduction of the misappropriation. Rationalization may refer to the unethical frame of mind that allows the actor to conduct fraud.

Fraud happens when an individual or a group of people makes an invalid representation about a fundamental factor intentionally. The victim who receives the representation believes the invalid representation of the issue. The victim relies and acts upon the invalid representation of the records. In addition, the victim suffers financial loss or resources because of relying upon and acting according to the record of the invalid representation.

Fraud triangle

Fraud triangle

Indicators that can make fraud detectable

Several indicators can promote detection of fraud. The course of fraud detection may include clear observation of financial anomalies in the profit and loss financial statements. For instance, diversion of profits in these accounts can be a clear indicator of possible cases of fraud in the organization. Fraud may spread from one department of the organization to another. When one detects fraud in the management level, there can be prospects of occurrence fraud in other parts of the organization. This fact is because of the complex linkages of fraud that make it similar to a food chain in an ecosystem. Lifestyle manifestations can also be indicators of organizational fraud. In most cases, people conduct fraud to improve their standards of living. Therefore, a sudden rise in lifestyle statuses of people can be indicative of fraud within an organization. Certain organizations may use middlemen to perpetrate fraudulent transactions. The existence of a myriad of middlemen between an organization and suppliers or clients without rational explanations or financial gain can be indicative of fraud. In addition, organizational changes that may affect corporation margin can be indicators of the existence of fraud. Other indicators may comprise of bankruptcies or notable discrepancies between contract quotations and the actual market realities. High amounts of confidential and personal mails sent to senior staff can also attract the attention of auditors as indicators of fraud.

Indicators that may show financial reporting fraud may include significant off-the-book transactions. The transactions may be associated to the improper application of the disclosure rule. The presence of unsupported journal accounts can be an indication of corruption. These records may have an effect on the credit balance or alterations in the reflection of economic status like regression, inventory condition and provisions. Inadequate transparent financial accounts or alterations in accounting principles of a favorable framework may indicate corporate fraud. In addition, risky operating margins coupled with debatable ones that do not tally with organizational results from operations may also be a sign of fraud (Ramos, 2009).

Role of the auditor in investigating and detecting fraud

Organizations need to control fraud to realize their financial objectives. Investigation and detection of fraud constitute the fundamental roles of an auditor. Detection and investigation of fraud may be different terms in meaning. Recognition of fraud occurs as the first instance. At this stage, the auditor acquires the knowledge of possible existence of fraud in an organization. The auditor then proceeds to determine the prospects of the fraud. This stage involves the process of detection. Fraud recognition ought to happen early to provide auditors with sufficient time for running adequate investigation throughout the organizational financial statements. The process of investigation may comprise of a separate phase from detection in the fraud chain. It may entail verification of records and assessment of bank reconciliations and confirmation of receivables. Auditors need to pay attention to the fraud chain after detection to find out the duration and mechanism of action. They should also find out the valid identity or possible middlemen’s’ company that can provide essential information on fraud. The process of fraud may entail the use of corporate resources efficiently to obtain essential data (Deju, 2012).

The role of an auditor in the detection of fraud may include conducting staff interviews to find facts that can lead to the detection of fraud. Auditors assume the responsibility of reporting corruption to relevant bodies according to accounting requirements and policies.

An auditor needs to have specific characteristics to perform his duties efficiently. He or she should be accountable, objective, independent and competent to perform his duties. In addition, he must show integrity and rigor in his responsibilities. An auditor needs to exercise a fair and independent judgment. He ought to be clear, efficient and complete in his or her communication. Auditors can evaluate the risks of material statements of financial reports because of checking fraud. The process of auditing must be cumulative and continuous (Mancino, 2007).

Summary

This research paper explains the challenge of corporate fraud and the role of auditors in combating the problem. It explains the prevalence of the issue of fraud and how it manifests in different categories. It discusses the different roles auditors play in the regulation of different forms of fraud. The study presents different signs that can indicate possible fraudulent actions or transactions within an organization. It concludes with an emphasis on the need for auditors to take a central role in the management and regulation of fraud.

Conclusion

Corporate fraud continues to rise in modern times. The rise leads to the need to redefine the role of auditors in detection and prevention of fraud. The cost of fraud to business organizations and the public domain is enormous (Heidari &Wu, 2009). In addition, the application of digital technology increases the prospects of fraudulent transactions in organizations. However, it may provide a reasonable opportunity for improving detection and prevention of fraud. Comprehensive auditing needs to be enhanced in order to fight corporate fraud. Fraud remains a serious crime in financial accounting and organizations continue to pay a heavy price for its persistence. However, enactment of appropriate controls like effective auditing and working background and staff ethics can be efficient tools in combating fraud and other financial improprieties.

References

Bunget, O. C., & Dumitrescu, A. C. (2009). Detecting and Reporting the Frauds and Errors by the Auditor. Annales Universitatis Apulensis : Series Oeconomica, 11(1), 117-125.

Deju, M. (2012). Auditor’s mission in preventing and fighting against fraud. Economy Transdisciplinarity Cognition, 15(1), 40-44.

Heidari, M., &Wu, L. (2009). Framework for Pricing Interest Rates and Interest Rate Tools. Financial and Quantitative Analysis Journal, 44(3), 517-550.

Li, Y. (2010). The Case Analysis of the Scandal of Enron. International Journal of Business Management, 5(10), 25-47.

Mancino, J. (2007). The Auditor and Fraud. Journal of Accountancy, 183(4), 32-34.

Ramos, M. (2009). Auditors’ Responsibility for Fraud Detection. Journal of Accountancy, 171(2), 49-60.