How is Audit Fraud Detected?

What is Audit Fraud?

• Audit fraud is a concerted attempt by the management of an entity to misstate the Financial Statements.
• It can also refer to instances where Directors/shareholders/employees make false statements to Auditors, which would impact the Audit opinion given by the Auditors or a reader of the accounts trying to understand the organization and its prospects.

How does Audit Fraud happen?

It’s the management’s responsibility to prepare the Accounts for a particular period, usually a year. The Auditor then must make certain checks on the validity of the numbers and narrative within the Accounts.

However, the Auditors are by no means required to check every figure – it would not be practical to do so as the accounts are the sum of all transactions that the company has entered into over the course of a year – often thousands of expenses paid, sales invoices issued, monthly wages paid after-tax deductions, etc.

The Auditor carries out their statutory duties by sampling transactions recorded in the business’ records to see if they accurately reflect the underlying documentation. The Auditor will also rely on written and oral representation from the Directors, often when there is uncertainty regarding estimates included in the Financial Statements.

Characteristics of Audit Fraud and Types of Audit Fraud

Perhaps it’s worthwhile considering a few instances where Auditors have been caught out in the past.

• Bank Accounts opened that hide money in Audit Fraud.

  

  • It is often done to obstruct Auditors from finding out about certain transactions or so that those  hiding the funds can pass the money over to their own Bank account. This has happened once too often, and it’s not very easy to track once it has taken place. One way to try to protect the company against this is to have robust processes for opening new accounts – for example, including in the company’s governance documents (Articles and Memorandum of Association) that multiple signatories are required to open accounts.
  • Assets transferred to Directors/shareholders’ names/ownership – at values that compromise other shareholders. Auditors should challenge valuations where Assets are sold or purchased by the company. It should also be wary of any transactions benefiting related parties from the Companies funds or assets.
    

• Work in Progress (‘WIP’) overvalued in Audit Fraud

  

  • Many businesses work on contracts that are ongoing at the company’s accounting year-end. Accounting rules allow for activities to include in their turnover (sales) figure the amount of completed work. Therefore, it’s easy to see how companies might want to represent more work done than there is, hence inflating the sales figure for the year. Auditors can test that labour and materials charged to the work have been spent on that particular contract.

Conclusion in Audit Fraud

What can Investors/users of accounts do to protect themselves against the risk of Audit Fraud?

Ultimately readers of financial accounts should use their knowledge of business to back up what they are reading. Some of the warning signs are company is performing well in a sector where others are struggling or if the Director’s comments too bullish compared to other similar companies or if the company margins are unusually high, or if a company’s Accounting Policies seem to be more aggressive than others, etc. These can all be warning signs that something is amiss.