The Warning Signs of Fraudulent Financial Reporting

Abstract

What do auditors believe are the best ways to spot fraud? One frequently cited cause of audit failure is audit teams' lack of awareness of the warning signs of fraud. If auditors better understood these signs and applied professional skepticism, their risk of not detecting fraud would decrease. To improve their understanding of the signs, auditors may find it helpful to know what other auditors thought was important in alerting them to possible fraud. This article reports the results of a survey that identifies the perceptions of a group of practicing auditors concerning the relative importance of some commonly cited fraud warnings. The 130 auditors who participated were from several offices of one of the six largest accounting firms. We asked them to rank 30 commonly cited potential warning signs as to their relative importance in spotting fraudulent financial reporting. The exhibit on page 77 lists them in descending order of importance to the auditors. RED FLAGS The auditors perceived client dishonesty to be the most important red flag. They also viewed as particularly risky clients that placed undue emphasis on meeting quantitative targets, engaged in opinion shopping and were very aggressive in their financial reporting. In addition, auditors thought a weak control environment to be another very important warning sign. Overall, the survey's findings are consistent with the results of other research. For example, a study of large and midsize U.S. companies by KPMG Peat Marwick (see Combating Fraud: Know the Facts, JofA, Sept.95, page 20) revealed the number-one action companies took to reduce fraud was reviewing and improving their internal controls. Thus, corporate America seems to agree that a weak control environment is an important indicator of fraud. FOLLOWING A PATTERN? Our survey revealed an interesting pattern: Auditors generally perceived factors to be more important warning signs than factors. For example, dishonest, hostile, aggressive and unreasonable management attitudes were considered more significant than economic conditions and adverse environmental or industry conditions. These auditor perceptions are consistent with several academic studies that found closer links between attitude factors and the occurrence of fraud than between situational factors and fraud. IMPLICATIONS FOR AUDITORS Auditors are justifiably concerned about their potential legal liability for failing to detect fraudulent financial reporting in audit engagements. The auditing standards issued in the late 1980s to reduce the expectation gap between the services CPAs perform and those clients believe CPAs provide increased auditors' responsibilities and the risks they face. While Statement on Auditing Standards no. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, directed auditors to do more work to uncover potential fraud, it did not provide as much specific guidance as auditors might like. For example, while SAS no. 53 lists a number of warning signs auditors might consider in assessing the risk the financial statements are materially misstated, it does not provide operational guidance on how to use these signs. Our survey provides evidence about risk factors that a sample of auditors considered to be key signs of fraudulent financial reporting. While auditors should not use this evidence exclusively or apply it in a mechanical way, they can use the results as a starting point in their initial assessment of the risk of fraud in a particular audit situation. For example, auditors might construct a checklist of the most highly ranked warning signs to guide their preliminary review' of a potential client or in their engagement planning. Use of such a checklist could help increase consistency in implementing auditing standards by ensuring auditors do not overlook the fraud risk factors generally considered to be most important. …

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