Sep 10 2012

Why Auditors Fail To Detect Frauds?

When media reports a new fraud, the first few thoughts of public are – “What were the auditors doing? How did they miss it? Were they involved?” The auditors get labelled as morons, conspirators or criminals. Generally most people jump to the conclusion that auditors had malafide intentions and became accomplices to get more business. While this may be true in some cases, auditors need the benefit of doubt. They sometimes genuinely miss the cases despite their best effort to diligently perform their duties. This post is an attempt to explain why auditors miss the frauds.

I want to share a joke with you before I explain. Two drunkards were walking on a railway track. The first said to other – “I am really tired, I hope the steps will end soon.” The second replied – ‘Yeah. I wish they had put the handrails at a better height, my back is killing me.”

1. Auditors responsibility to detect frauds

We can laugh at this, but if I say most of us don’t see clearly, there will a lot of angry reactions. So I am not saying anything, and am requesting you to watch this video.

Now did you see the moon walking bear?

Auditors have the same problem. They have to to give a true and fair opinion on the financial statements. They are not required to focus on detecting frauds. Hence, the audit programs are not designed to conduct tests to  detect fraud symptoms and probability. Therefore, with no specific coverage auditors fail at detecting frauds. Extract from Section 143 of New Companies Bill is given below:

“The auditor shall make a report to the members of the company on the accounts examined by him and on every financial statements which are required by or under this Act to be laid before the company in general meeting and the report shall after taking into account the provisions of this Act, the accounting and auditing standards and matters which are required to be included in the audit report under the provisions of this Act or any rules made thereunder or under any order made under sub-section (11) and to the best of his information and knowledge, the said accounts, financial statements give a true and fair view of the state of the company’s affairs as at the end of its financial year and profit or loss and cash flow for the year and such other matters as may be prescribed.”

2. Auditors punishment on failure

The second question frequently debated is – “Should auditors be punished if they fail to detect frauds?” Section 147, clause 4 of New Companies Bill states auditor’s liabilities in respect to fraud in the following words:

“Where, in case of audit of a company being conducted by an audit firm, it is proved that the partner or partners of the audit firm has or have acted in a fraudulent manner or abetted or colluded in any fraud by, or in relation to or by, the company or its directors or officers, the liability, whether civil or criminal as provided in this Act or in any other law for the time being in force, for such act shall be of the partner or partners of the audit firm and of the firm jointly and severally and such partner or partners of the audit firm shall also be punishable in the manner as provided in section 447.”

This clause puts auditors on shaky ground. It is difficult to prove innocence once a fraud is detected. How can an auditor state – “I did my work properly, saw these documents, looked at the same audit evidence but didn’t find anything wrong with it.” Most will jump to the conclusion that the auditor knowingly ignored all the evidence. So here is another video. Watch it, and then you will see how this situation can occur.

According to various experiments, 75% of the people failed to observe the person swap in the experiment.

Think of this from an audit evidence perspective. An auditor is checking 100 vouchers with supports. One voucher among the 100 is fraudulent. What is the probability of the auditor noticing it? One can safely assume that it will be less than 25%.

Is it surprising that auditors fail to detect frauds after seeing these experiments. Though they are trained, they are human. The same psychology works with them too.

Closing thoughts

The success rate of detecting frauds will be higher when the auditors – external and internal – have specific responsibility to detect frauds. Without the specific responsibility, regulators can continue to complain and investors will share their anguish, however all will be futile. The laws need to be devised to hold someone responsibly for detecting frauds. What is your opinion?

A modified version of this article was published in the Middle East Accountant Magazine.

10 comments on “Why Auditors Fail To Detect Frauds?”

  1. Excellent thoughts Sonia!
    I would add as well that auditors (external as well as internal) do not have the knowledge and experience to be spot on with fraud detection, they are not trained to detect fraud instantly. They will learn, hopefully, on the job and by experience and if they are willing will invest time to learn more about the subject.
    To my view it would already help if the auditor will put him/herself in the shoes of the thief to try to figure out what he/she could do wrong, these can be eye-openers!

  2. Great . I am agreed with you sonia to hold some responsibilty to detect frauds. But with little variation i would add that if you hold some responsibilty on auditors to detect frauds, you have to re-define ‘reasonable assurance’ defination. Why everyone put blame on auditor when fraud occurs. Auditor has already given his/her reasonable assurance about realiabilty of the statements or operation. That means auditors is giving assurance with the probabilty of fraud that can occur.

  3. Very good thought provoking article.

    If a premeditated murder takes place, one cannot blame police why he failed to prevent murder. all he can do only to find out who did the murder and how?. However if the same police is assigned to a person to protect and he fails to protect, then he can be blamed. Similarly my view is that fraud is committed by persons who goes all out not to make it visible. Only the Fraud examiner can find out who did it and how and then to introduce control to prevent it. At the time of giving assignment, nobody says that Auditor is responsible if fraud is not traced. He is given an assignment only to give opinion that the accounts present true and fair view. Please note it is only an auditor’s opinon and not an authentic declaration. only if at the time of assigning the job it is demanded that the auditor is responsible if fraud is not deducted and he agrees to take up with this clause he can be blamed.

  4. Hello Sonia,

    The questions you have raised were doing the rounds for a very long time. The auditors are to give an opinion on the state of affairs of a company – the Balance Sheet as well as the results of operations – Profit and Loss. They give their opinion as to the “True and Fair view” of he state of affairs at a specified date and the profit or loss for a particular period, made by the company. Earlier, the auditors were to report as “True and Correct view” instead of “True and Fair view”. Several cases went to the courts for the determination of the diligence of the auditors. One such case was the Royal Mail Steam Packet Company’s Case. As a result of which, the Companies Act of England was amended in 1948 to require the auditor to state inter alia whether the statements of account are true and fair. The implications of the substitution of “true and fair” need to be understood. There has been a shift of emphasis from arithmetical accuracy to the question of reliability to the financial statements. A statement may be reliable even though there are some errors or even frauds, provided they are not so big as to vitiate the picture. The word “correct” was somewhat misplaced as the accounting largely consists of estimates. So it all depends on the terms of appointment of the auditors and objectives of the function of auditing – the primary objective being the auditor’s duty to report to the owners whether the balance sheet gives a true and fair view of the Company’s state of affairs and the profit and loss account gives a correct figure of profit of loss for the financial year; and the secondary objective or the incidental objective, incidental to the satisfaction of the main objective, being detection and prevention of frauds and detection and prevention of errors.

    The duties of the Statutory Auditors have all been well defined in the corporate legislation governing the audit of corporates. With the developments that are taking place in the commercial and technological worlds, the perpetration of frauds also has taken up the new dimensions in right earnest. So, we could find occurrences of such frauds even with the tight regulations that govern the running of corporates and so are the SOX and other requirements.

    The objectives of Internal Audit are quite different from those of the Statutory Auditors. In the present conditions, the emphasis is more on the risk evaluation and governance aspects of a company. The combined ‘Governance, Risk and Compliance’ exercise takes a very effective initiative for the prevention of any unexpected situation in the working of a company. These aspects are all pervasive and the management must ensure that all these aspects are the responsibility of everyone in the company. The Internal Auditors ensure that these norms are effectively followed. Besides, the traditional ‘Internal Control’ aspect would ensure that the occurrence of fraud is prevented or detected early.

    The final reminder for the common man is that there has to be matching developments in control regime in line with the technological innovations since the fraudsters are much faster in adapting the ‘technology’ for their purposes. There is an old movie song in one of the southern states of India that sings, if the culprits do not correct themselves, it is not possible to eradicate theft and fraud!

    Good luck!

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