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.

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