Some Colour to Fraud Investigation

Lisa Weaver, the examiner of P7, wrote the article about forensic auditing in Student Accountant in 2008. I can not say it is the most jolly reading in the world, but I still  recommend it to all accountancy students for effective preparation to exam or job interview in forensic department.

In fact the fraud is highly tested area in all accountancy certification exams, in  ACCA (F8, P1,P7) and US CPA. I would like to add some “colour” to the considerations about fraud investigation engagements.

Types of Fraud

Ms Weaver kindly mentioned for us that there are three types of fraud:

·        corruption,

·        asset misappropriation,

·        financial statements fraud.

According to PwC’s report “Global Economic Crime Survey” her statement is very close to reality. I highly recommend to read that report, because it is quite interesting and practical product. PwC gives a table of the most popular economic crimes, which is in line with Weaver’s article:

Lets dive in financial statement fraud.

Financial Statement Fraud

Elliot and Elliot in their book state that inventory valuation gives lots of opportunities for creative accounting. Inferring from Treadway Comission Report they consider that ‘fraud often involved overstatement of revenues and assets with inventory fraud’ featuring understating bad debt allowances, overstating value of inventory. There are several groups of inventory related fraud: year-end manipulations, purchases not recorded (cut-off issues), fictitious transfers of non-existent inventory, carrying obsolete inventory at a cost, reducing cost of goods sold by adjusting journal entries.

Fraud and Bankruptcies

Gaughan, referring to Dun & Bradstreet research, noted than in 2000s number of bankruptcies related with fraud significantly increased. WorldCom, Enron, Adelfia, Refco, Parmalat were ‘brought down by management fraud’. He also mentioned BancruptcyData.com table of the largest bankruptcies. I have found it’s updated version since he has written his book, here it is:

As we already know accounting fraud (so called, ‘Repo 105’) was also involved in Lehman’s case. Though it was not the primary reason for their collapse, but still conceal of fraud contributed to the overall situation. This is how Sikka describes this case in his article:

‘Lehman’s own accounting personnel described Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end”, but the bank received a clean bill of health from auditors Ernst & Young. The insolvency examiner was critical of auditors and protracted litigation will follow.’

By The Way

There is a special certification of specialists in fraud investigations which is carried out by Association of Certified Fraud Examiners. CFEs are the guys, just like us, accountants J However, additionally to common accountancy subjects they study things as criminology and have special training to present evidence in court.

By the way, have you ever been involved in fraud investigations or may be you performed fraud investigation procedures within audit engagements? Please share information. 

References

Elliot, B. and Elliot, J. (2007). Financial Accounting and Reporting. 11^th Edition. Pearson Education Ltd.

BankruptcyData.com (2010). Site Link:

 http://www.bankruptcydata.com/Research/Largest_Overall_All-Time.pdf

Gaughan, P.A. (2007). Mergers, Acquisitions and Corporate Restructurings. Forth Edition. John Wiley and Sons Inc.

PwC. (2009) Global Economic Crime Survey: Economic Crime in a Downturn. November 2009, PwC

Sikka, P. (2011).The EU man cometh. PQ Magazine. No. 1, p. 27.

Weaver, L. (2008). Forensic Auditing. Student Accountant. September 2008, p. 58-60.

Week-end: Audit Commercials

My favourite TV/video commercial in audit area was made by Ernst & Young. Yes, I know it is old :) But I can't give up the idea to display it in my blog.

If you know any other TV ads on YouTube related with audit and as cute as the one above, then please share with me information in comments. Have a nice week-end!

Group Audit: Practice Considerations

During preparation for Advanced Audit exam I have decided to update my knowledge about group audits (GA). I read two rather technical and a bit of boring articles in Student Accountant magazine by Lisa Weaver and Graham Fairclough. In real life the topic is very interesting and might require some imagination from people who have never been working in auditing, nevertheless participating in group (also referred as ‘multi-location audit’) audit to understand group auditing process.

In this article I would like to share my experience about several elements of multi-location audit.

Planning stage of group audit

In my subjective opinion planning stage plays more important role for GA than for audit of standalone financial statements. The reason is complexity of 2 elements of system:

·       Business relations within the audited company, inter-company relations, related party issues;

·        Accounting process accompanying these relations.

As a result of planning stage we will be able to identify the scope of audit, nature of procedures on final audit stage and resources needed accomplish our goal.

If the whole audit of group is undertaken by one audit firm, then all audit work would be split between consolidation audit team (i.e. ‘group auditor’ as referred in Fairclough’s article) and location audit team (component auditor if the auditor is other audit firm).

Participation in planning process of group audit gives strategic view on audit process. Understanding business is really essential at planning stage and the function of each company within the group need to be identified. For example, common type of gold mining holdings in Russia is as follows:

·        Mining entities themselves - the companies which extract gold;

·        Factories, gold processing plants (sometimes included within mining company);

·        Servicing catering companies: extraction of natural resources is often carried out in ‘hard-to-get’ places. The workers live there temporarily in camps and services like canteen, hotels, utilities need to be provided by mining company or outsourced;

·        Finance/holding companies. Their function in the group is to establish control and governance over the group, provide finance, management services.

·        Offshore companies, these companies often used to minimize taxes paid by company in country of operation. They are established in jurisdictions with soft tax regimes in countries like British Virginia Islands. It might be not legal so some companies play quite risky games with their tax authorities. Be aware about this auditing tax section.

Materiality

The planning materiality (PM) of group and each location is often discussed on focus audit team meetings and the decision of partners is communicated by consolidation team to local teams.  PM calculation has some specifics here, because it has to be allocated for each subsidiary depending on size of subsidiary/location. The size is usually measured based on subsidiary’s contribution to group assets, revenues or net incomes. I have presented below the table with possible size of subsidiary and assigned percentage of allocation:

Communication and interaction

The communications between consolidation and local audit team is critical during whole audit process. On the one hand, the consolidation team is able to emphasize only critical problems which help to concentrate local audit teams on risky areas, on the other hand, consolidation team can solve issues related with client, e.g. raise issue that one of subsidiary the local management is reluctant to give necessary information to local audit team.

Work in consolidation audit team is a bit of everything:

·       Administrative work: coordination of local audit teams, communications with client on corporate level, allocation of tasks and consolidation all essential information;

·        Audit work itself: consolidation team has to audit consolidation process and accounting issues related with consolidation/group accounting such as goodwill, inter-company eliminations, fair values allocations, non-controlling interests and etc.

·        Review of local audit team’s working papers and establish additional procedures to ensure that audit risk decreased;

·        Checking accuracy of final financial statements and reporting forms which have to be submitted to SEC (e.g.  10-K in US) in case client-company is listed.

In military language the consolidation audit team is army headquarters.

Participation in group audit

I was lucky that in the beginning of my audit career that I was able in to participate in big audit project of NYSE listed company. It was great experience to be part of the well elaborated and strategically well-considered audit process. The focus on planning stage gives very good understanding of both audit process itself and client as business and strict requirements to documentation might give you an idea how to formalize your understandings of complicated issues.

In summary, I would like to advise to anyone who is working in audit firm to try to take part in group audit, both as a member of consolidation and local audit team.  

References

Fairclough, G. (2011). Group Auditing. Student Accountant. April 2011, p. 1-6

Weaver, L. (2008). Objectives and Responsibilities. Student Accountant. March 2008, p. 72-75.

Event Study: Audit Report Announcements

Event study methodology is widely used in researches dedicated to the impact of audit opinion on investors’ decisions. This methodology requires specification of date of audit opinion announcement, date when the information about type of audit opinion becomes available to public. This date is event and days (allowed to capture pre- and post- effects) around the date are ‘event window’ (Campbell et al. 1997). See illustration of Time Line:

Source: Campbell, J.Y., Lo, A.W. and MacKinlay, A.C. (1997). The Econometrics of Financial Markets. Princeton, NJ: Princeton University Press, p. 157.

I wrote about this kind of studies in audit area in one of my posts (click link) on February. The issue here is difficulty to identify correct date of event as this would influence the whole research. There are number of researchers who emphasized this issue, e.g. Craswell (1985), Martinez et al. (2004), Soltani (2000). Especially this problem arises when it is necessary to compare studies in different countries, i.e. jurisdictions.

In following paragraphs I want to discuss briefly the features on event identification process in different countries.

Anglo-Saxon system

The countries with a case law system are suggested here: USA, UK, Canada, Australia. I would consider two key relevant characteristics:

·        Work of stock exchange commissions (let us name ‘SEC’ all similar authorities) with financial/annual reports, e.g. US companies are obliged to file 10-K (which contains audited FS) within 90 days after fiscal year end and after filing 10-Ks almost immediately become available to public via US SEC site (see sec.gov)

·        Transparency, e.g. it is more common for US companies to announce audit opinions before the annual general meeting or 10-K filing date.

Reasonable methodic in date selection was used by Menon and Williams (2010). They chose earlier of:

(1)   10-K filing date;

(2)   Date of press release of financial statement and audit opinion.

Continental European (Roman) Legal tradition

Following could be outlined as features in relation to opinion announcements (based on example of France and Spain):

·        SEC do not make audited financial statement available to public as soon as possible (see below some peculiarities in Spain) with deadline of 90 days after fiscal year end;

·        Audited financial statement must be provided (France and Spain) to shareholders at least 15 days (or any other number of days prescribed by law to notify shareholders about AGM) before annual general meeting (AGM). At the same time reports are to be send to SEC and only after this they are to be published by SEC ;

·        Listed companies are reluctant to announce publicly audit opinions (Soltani 2000).

To solve this issue for French market Soltani (2000) defined and calculated results for following three event dates:

(1)   Date of audit opinion signature;

(2)   15 days before the AGM date (most precise as was mentioned by Soltani);

(3)   Average date between the (1) and (2)

Martinez et al. (2004) identified that law requires listed companies to file audited financial statements (FS) within Spanish SEC (which has to publish them aftermath) before the date of AGM announcement. So Martinez used the earlier of:

(1)   Date when Spanish SEC makes FS and audit reports available to public;

(2)   15 days before the AGM date.

Russian jurisdiction

Russian modern corporate laws also belong to continental legislation system with specifics of emerging market economy and socialistic overregulated past.

Following matters to be considered:

·        All open joint stock companies have to file their audited FS to Tax authorities within 90 days after year end, but Tax authorities must not release them to public (Accounting Law, ФЗ 129);

·        Audited FS must be distributed to shareholders at least 20 days before AGM (Open Joint Stock Companies Law, ФЗ 208);

·        Audited FS must be also included in the quarterly report of issuer (ежеквартальный отчет эмитента) for the first quarter, which must be issued not later than 45 days after 1^st Quarter end, i.e. 15^th of May,

·        Announcement about the issue of quarterly reports and AGM must be placed by companies on the state authorized news wire available to public via internet (State Provision about Disclosure Information by Issuers, Приказ ФСФР N 06-117/пз-н).

 So in selection correct event date it would be reasonable to consider the earlier of:

(1)   Announcement of 1^st Quarter report issue on statutory news wire;

(2)   20 days before the AGM date.

Conclusion

I hope above summary and considerations about Russia would help researchers involved in accounting/reporting area to do event studies. I am going to use these ideas in my coming dissertation and I would like my readers to share with me information about report release legislation in their countries.

References

Campbell, J.Y., Lo, A.W. and MacKinlay, A.C. (1997). The Econometrics of Financial Markets. Princeton, NJ: Princeton University Press.

Craswell, A. T. (1985) Studies of the information content of qualified audit reports, Journal of Business Finance and Accounting. No 12(1), pp. 93–115

Martinez, M., Martinez, A. and Benau, M. (2004). Reactions of the Spanish capital market to qualified audit reports. European Accounting Review. Vol. 13, No. 4, pp. 689-711.

Menon, K. and Williams D.D. (2010). Investor Reaction to Going Concern Audit Reports. The Accounting Review. Vol. 85, No. 6, pp. 2075-2105.

Soltani, B. (2000) Some empirical evidence to support the relationship between audit reports and stock prices – the French case. International Journal of Auditing. No 4, pp. 269–291.

Week-end: Comrade's Blog - Audit is Fun!

I would like to try new type of week-end column/rubric in my blog. I want it to be more relaxed and casual than other week-day posts. So this one you read, would be the first week-end column.

I have found in internet one more enthusiast-auditor, s.wardrop. At least, there are not  to many people out there writing and popularizing audit and accounting with love and passion ;) That is why it always pleasure to meet comrades :)е, приятно встретить товарищей. 
Link to his blog, pls click.
I liked his post: Audit is fun:

   I can hear the cries of derision from here - how sad, must be nuts. But listen up folks, audit is not what it used to be - just columns of endless figures, ticking and bashing, checking invoices; I am sure many out there have already twigged to this, but how often do we say it?

    And maybe I am letting the best kept secret of the profession out of the bag - but as I see it, audit is about business, which is about people - customers, suppliers, staff, managers, directors, shareholders, stakeholders, charitable beneficiaries. For those who have a smidgeon of latin, you only have to think about the term "audit" and you know that talking to people and listening to them is as important as sticking your head in a room full of invoices and never coming out.

   In what other profession do you have total access to ask whatever questions you like, to learn about how business operates, fails or suceeds, to learn about management, about people.... and about life. And I dont know about you, but I enjoy it!

   And since I am here - I am tired of listening to the media and others, including some fairly close to home, bashing auditors and saying how little value we add, and how we are to blame for.... well, just about anything. We are not all "big" firms, we dont all audit BT or Shell or (heaven forbid) banks (not that I am decrying what they do, I wouldn't want the job), but a lot of us work year in and year out auditing smaller clients, charities, family companies and adding value to what they do. Over the past 4 years, we have helped our clients to over £100,000 in actual cash in bank savings - now tell me that audit doesnt add value!

Photo is taken from here: http://www.goodbyecobber.com/?page_id=38
Text from blog: http://www.accountingweb.co.uk/blogs/swardrop/audit-fun-and-it-works-no-really/audit-fun

Ethical Auditor: Being Holier than the Pope

     Ethics issues in business have been always matter of discussions. Audit profession is especially subject of this arguments. Probably only medical workers have as sound ethical principles as auditors do.

     In the beginning

     IFAC code of ethics explains this phenomena in following way: ‘A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest. Therefore, a professional accountant’s responsibility is not exclusively to satisfy the needs of an individual client or employer’. European Commission acknowledges this fact by emphasizing that auditor has to fulfill societal mandate.

     Unfortunately these statements do not stick in the mind of young beginning auditors. It is very rare if anyone from accounting firm’s HR or management would ask candidates during interview: “Do you really aware that you are going to hold societal mandate and act in public interest?” It a fantasy, isn’t? Especially for accounting firms operating in emerging markets with low level of law enforcement and legal awareness of society.

     Men and women of principles

     At this point I think I must list fundamental principals auditor’s ethics:

• Integrity
• Objectivity
• Professional Competence and Due Care
• Confidentiality
• Professional Behavior

     The principles are really very bright and constitute best moral qualities of humanity. For example, integrity means that auditor being honest should never allow his/her name to be associated with something dishonest. Professional behavior means that auditor must comply with relevant laws and regulations and avoid any action that may bring discredit to the profession. As my honorable lecturer, John Stead, says that ‘it is not just a coat you put on when you go to the work in the morning and leave the office in the evening, it is an attitude of mind’. May be it is not the newest thought in the world, but I like the reasonableness and fairness of these words.

     Of course! When students hear such things from their lecturers there are ironic smiles on their faces. They know that human beings tend to lie and act irresponsibly in their own interest, because human beings are not perfect from birth.

     Some illustrations. For example, I am shareholder and I do not want financials of my company to be audited by the guys who illegally download some software/music from internet. They commit crime and if this information becomes public this would negatively impact audit profession. Or, for example, audit partner is in cahoots with criminal authoritarian government members. Is it just a friendship or something related with corruption? We do not know, but reputation of audit partner willingly or not would be damaged at this case. There are no immaterial things here – even if you are stowaway in a bus, it still matters!

    Another good point is that ethics is not only, auditor knows if he is guilty (ethical) or not guilty (non-ethical). It is also about public perception of auditors’ actions.  If society believes that private relationships of audit partner and CFO matter even if auditor sure that it is 100% does not matter, the society is right.

     On the other hand, we are not saint. There is always compromise. The relevant rule here is: “Do not do silly things”. In my opinion, for different people different ethical issues matter. Moreover, I think that the most ethical values are grounded in childhood and youth. If future auditor failed to recognize an ethical issue at the age of 18 it most likely that he/she would struggle to recognize it in adult ages even after completing ethics courses.

     Ethics models

    David Campbell, the examiner of P1 in ACCA qualification, have several useful tips in his article in Student Accountant magazine. He briefly described features of two ethics models: American Accounting Association model with seven steps and Tucker’s 5-question model. I will place here just major points of model, the article is freely available and you can read details there.

       I think they are very clear and useful, even in daily live.

      

       

References:

Campbell, D. (2008). Work ethics. Student Accountant. March 2008, p. 56-59

IFAC (2006). Code of Ethics for Professional Accountants. IFAC, New York

New Audit Order: Take 2. Remodeling audit services

The audit profession is very conservative by its nature but to survive any organism must be flexible, open for changes and new trends.

How can we modify meaning of “audit services” terminology? How could it influence audit firms market and multinational companies (MNC)?

New services – more analysis

Let’s be clear about it. Society demands from auditor to give the opinion about financial soundness and performance of listed companies, given that auditors have extensive access to information. Green Paper of  European Commission suggests that ‘forward looking analysis’ of ‘large listed companies’ might be ‘real value added to the stakeholders’.

So auditors are going to move to the business of credit rating agencies and financial/equity analysts. And I would suggest this is very good news! Auditors are extremely fit for this job: auditors have enough expertise, knowledge and analytical skills to provide sound analysis of companies, moreover they know degree of reliability and relevance of each line of financial statements.

Format of product: three-fold report

We have already had reports with two types of opinions: financial statements opinion and effectiveness of internal control (over financial reporting) opinion. Under SEC requirement Companies listed in US need to be audited in accordance with Public Company Accounting Oversight Board (PCAOB) standards (after enacted SOX legislation). See, for instance, extracts from Hershey’s financial statements audit report:

Source: http://www.thehersheycompany.com/investors.aspx?ICID=HCOMP1005        

Obviously, the third part could be added to this report. Brief paragraph about financial viability of company (going concern analysis) which must be accompanied by detailed analysis of company’s previous financial year performance and financial perspectives based on evidences  gathered as at  audit report date. The brief paragraph in the body of report together with detailed analysis should give unambiguous understanding of auditor’s opinion about the company financial and business perspectives.  

How to do – technique

Some words about audit team management. In my opinion, in the above case scenario the audit team should split at least in 2 parts: financial statements audit team and business audit team. The first one would be concerned with internal controls and financial statements. The business audit team would have to spend time on analysis. These split in two roles is necessary to avoid any eye-soaping of members of audit team and would encourage fresh look on business activity and company’s reports by business team.  Definitely, both team must work together and question each other on their findings, inconsistencies and misunderstanding. For example, such procedures like overall analytical review supposed to be carried out in cooperation.

Responsibility of auditor: less regulated more active and open?

Responsibility of auditors is very complicated issue to discuss. There are similar kind of services provided by other companies, but their responsibility is not as much auditors’. What does hold our profession from development? How does responsibility influence on competition?

I suggest responsibility should be limited to quality of services provided. In any case, dissatisfaction by work of auditors whether they failed to predict bankruptcy of Lehman brothers or failed to reveal fraud in Enron is caused by bad quality of audit work; non-compliance with audit standards or weak audit standards itself. If society is not satisfied by quality audit standards then it is time to change them, but there is no use to blame auditors, because they complied with wrong standards.

On the hand we have market, which is supposed to regulate audit business. If shareholders are not satisfied with quality of audit services they hire another auditor and bad reputation would not let providers’ of bad services to succeed.

Some considerations about other industries…

Let us look on credit rating agencies. There are no much regulations about them. They do not have such comprehensive quality standards as accountants do. But it is also quite oligopoly market (Big three:  Standard & Poor's, Moody's Investor Service and Fitch Ratings). The agencies also has faced severe criticism after financial crunch for not being accurate in their assessment of companies’ rating. This reminds me something…

There is another interesting industry which is worth mentioning: the higher education institutions. Suppose, I hired MBA graduated from Yale University with GPA = A+. After we signed one year labour contract it have been appeared that my new hire has had idea neither  about efficient market hypothesis nor net present value analysis. What should I do? Should I sue Yale University for that? Does it mean that there is unsatisfactory education quality control and attesting system at University? Or is there anything wrong with my  recruitment system?

Anyway I think it is time to make Porter’s five force analysis and PESTEL for regulators and audit professionals to assess:

1)      if legal, social and political barriers have been already rather high and suppress competition in industry;

2)      if lowering of those barriers might increase competition level;

3)      if increased completion level might positively impact quality of audit services and provide additional value for society.

There are lots of work to be done and long journey to be made.