Financial Audits as a Fraud Prevention Mechanism in International Enterprises

In the last decade, international financial system has been hit several times by many different gigantic occurrences. The soonest was the subprime mortgage crisis, but the situation this dissertation will be concentrating is the failure of Enron. Mainly because the aim of this paper is to present financial audit as a fraud prevention mechanism, not the opposite. It will show relevant evidences that will try to figure out what was the main and real reason for the failure, as well as consequent failure of the company auditor - Arthur Andersen. Since the auditor was one of the Big Five (at that time, together with PwC, E&Y, Deloitte and KPMG), this scandal brought the attention of a potential loopholes and poor financial reporting regulations existing at that time. Baring in mind that the fraud was detected in gigantic energy services company, with the auditor involved in scandal, authorities have made an effort to increase the control and regulation levels in order to eliminate the chance of fraud. From that time, new accounting regulations were rapidly created and old regulations renewed in order to expand the accuracy of the financial statements and reporting, especially of the large public companies. The aim was to increase the transparency, since it has the biggest role in potential fraud situations elimination. One of the first legislations that were brought up was the Sarbanes - Oxley Act, which is actually a legislation for reforming accounting rules for public companies, protecting shareholders and potential investors. This act also increased the accountability of auditing firms to remain unbiased and independent of their clients.

Therefore, the purpose of the following dissertation is to fully present auditing in the modern financial environment. It will present why auditing is important in financial system and assessing performance of public companies. Finally, student will explore how the auditing has developed and expanded its operations during the years.

More in detail, this dissertation will have a role to closely connect auditors work with the fraud determination. Basically, auditing is meant to be a job for transparently assessing financial statements of companies and as a fraud prevention mechanism. On the other hand, based on the above mentioned example, we could draw some conclusions that auditing has failed to asses fraudulent actions in the particular example. Furthermore, the Enron scandal is a drastic example of company bankruptcy due to fraudulent management, therefore the dissertation will be mostly focused on that case study.

In addition, this paper will also be closely connected to the work of the Association of Certified Fraud Examiners. It is a very important fraud examining association that deals on day to day basis in numerous projects. Furthermore it determines the source of failure. The role of the association is how to prevent and spot the potential fraudulent activities. In cases in which the losses have been generated to fraudulent acts, the ACFA has a role of determining who is responsible for the failure. It assesses the problem deeply, and in many cases has determined that auditors have fallen into the trap of being presented a "clean" financial statement in which fraudulent actions have been committed, but without the auditors notice.

Finally, the dissertation has an aim to present auditing as an investment, and not a cost, in terms of transparently assessing and controlling management actions and company position throughout financial statements.

Background

From my point of view, a successful dissertation document should consist of parts which will bring closer the topic to different reader categories. What is meant by that is the fact that not everybody is finance major or has significant knowledge from this field, more precisely audit field. Therefore, a brief introduction to auditing history will be provided.

Auditing is the profession that has existed in the commercial life in the past, but many times in different forms. One of the simple synonym for auditing could be controlling. And controlling has always existed. It has existed, since the majority of the medium and large size businesses nowadays are driven by the experienced employees, managers who are not the actual owners of the entities they work for. That is the main reason for having the control over the management. This was the general assumption of how auditing looked like in the past, but it had completely different meaning and was not called that way either. During the years, auditing was developing, while the modern financial audit became to take place from 1850. The sudden growing number of firms which ownership and consequently control were separated, provided a need for financial auditing and the development of increasingly detailed disclosure requirements for financial statements. In earlier times, audits were mainly concentrated on exploring errors or omissions in balance sheet accounts and on stemming the growth of fraud associated with the increasing phenomenon of professional managers and absentee owners. Back at that time, the actual detection of fraud had a very important role in overall audit process. As already mentioned, the companies increasingly started to grow, the awareness of the potential fraudulent actions was also brought higher on the attention list. The only problem was if it could be controlled in the same way as before.

During the 20th century the focus of the audit has changed. Nowadays, we do have independent examination and expression of the opinion by something we call external auditing companies, or a qualified auditor (Power, 1997). There are two ways of determining the opinion, therefore the financial statement could provide a "fair" view, which is the US auditing practice, while on the other hand European auditing tends to be called "true and fair" view. On the other hand, fraud detection is not the primary objective of auditing process, although it is generally perceived by the wide range of professionals. The conflict between these two objectives is explained by as the "expectations gap". And this gap could be simply explained that public generally intends to think that all reports signed by the auditors and have the above mentioned notions as "fair" and "true and fair" are fraud risk free (Power, 1997). On the other hands, auditors tend to enclose themselves that the ones who should be responsible for fraud prevention are actually company managers and their systems.

When companies fail, like Enron did, for whatever reason (does not necessarily have to be fraud), the reaction of the public is always mainly focused on those who were controlling the statements of the company, auditors, not the ones who actually did fraudulent actions, the management.

To conclude with the introductory part, in the past decade, there has been very much lawsuits against auditors because public was suspected in their negligence in not detecting the financial statement fraud. As a result, auditors did not just risked the loss of money, which amounts to large sums, but other very important fact and that is reputation. One day you are on the top, and other day a bad news comes and completely fails your business, that took decades, sometimes centuries to build. After Enron situation, auditing companies started taking much more care about their operations. From the clients they accept to every single detail. Why? Because company reputation is always at stake. Especially for the large and well known companies. We are living in the world where bad news have an unbelievable traveling speed. Auditors know that their company's reputation is always at stake. Every single small detail can have a big impact on company reputation and future. Not only on auditing companies, but on audited companies as well. Auditors bear in mind the consequences their inadequacy could have on a complete financial system. It is a hard pressure on the auditors back. Hopefully, auditing companies have carefully adopted several risk management measures, as well as divided the responsibilities in order to have better quality services.

Finally, the main problem is to understand the reasons why auditors have not detected financial statement fraud and if there is any possibility, suggest several improvements in the complete auditing process. In order to do so, student has to fully research cases where these situations have occurred.

Literature review

Financial statement fraud

According to Association of Certified Fraud Examiners: "Financial statement fraud involves the intentional publishing of false information in any portion of a financial statement. It usually occurs when a company overstates assets or revenue, or when it understates liabilities and expenses." (Fraud 101, 2005 e-book, p.27)

This statement gives us a just a portion of what financial statement fraud actually looks like. Many times actual owners of the business, primarily shareholders or investors are actually blind to see the value of the corporate assets and the real value of liabilities when it happens to have such a fraud as Enron was. Most of the fraud related scandals have just given authorities a "must" to rapidly adopt new rules and acts, as Sarbanes-Oxley Act is, and all of them were financial statement fraud. Although mentioned Enron firstly seemed as a naive fraud situation, in the end resulted in the massive stockholder losses and liabilities to creditors, and the hardest situations to its employees who were left without anything, lost jobs and retirement funds.

According to 2008 Report to the Nation on Occupational Fraud and Abuse published by the Association of Certified Fraud Examiners, US companies have suffered a median loss of 2 million dollars to fraudulent schemes. They also note that this form of fraud is greatly different from other types of occupational fraud, since "the typical goal of a fraudulent statement scheme is not to directly enrich the perpetrator, but rather to mislead third parties, such as investors, owners, regulators and etc., as to only goal - profitability of an organization.

In other words, it is typically driven by the company managers who are seeking to enhance the economic appearance and brand respect by covering enormous debts or other lost assets. The question is, what is in stake for them? Well of course the stocks. They would sell stock, receiving performance bonuses or on the other hand selling stock to vanish their illegal or criminal acts. In the end, management benefits indirectly from financial statement fraud.

Overview of Methodology

Research is a very complex and time requiring process which consists of "data collection, coding, all other processes of preparing and analyzing data, including the presentation of the results." (Drucker-Godhard, 2001).

In this chapter, the student will present the methodology he will be using as a direction towards successfully concluding the paper. Methodology that student will follow consists of:

What research approach the student follows

Which data collection will be selected

Which case study method will be used

How to establish the reliability and validity of the researched material

Research approach

The research approach is basically dependent on the pillars of a normal research process. Elements of a research process mentioned by Brannick (1997), include:

Research question

Research category

Theoretical perspective

Methodology strategy

Data collection approach

Data analysis

Any practical research has to be in close relationship, or lets say dependent on theoretical framework or the existing concept. Having in mind that students research deals with the fraud prevention mechanisms used in auditing practices, student will start his work by taking a deeper look in the financial statements fraud and consequently the overall auditors role and their responsibilities in detecting such an occurrences

"The nature of the research question determines whether the study can be classified as an exploratory/casual type study" (Brannick, 1997, page 7). In conjunction with the research questions, "What", "When", "Where", "Who", "How" and "Why", the research approach will fall into the categories:

Exploratory

Descriptive

Exploratory/Casual

Since until now we have explained our research problem and researched the problem into the questions of "Who", "Why" and "How", student is of the opinion that the approach in this research should be descriptive and exploratory.

In order to bring closer the these two terms, find below the relevant explanations by Sekaran:

"Descriptive study is undertaken in order to ascertain and be able to describe the characteristics of the variables of interest in a situation" (Sekaran, 200, p.125). In his research, student will use the descriptive approach to describe the nature fraudulent financial statement cases, and to neglect the possibilities for how the management could have manipulated their financial figures, and very directly the auditors. In other words, how the auditors have fallen in to a trap for being presented a false figures without a notice.

Furthermore, "explanatory study is undertaken in order to establish correlations between a number of variables" (Sekaran, 2000, p. 129). In this dissertation, this explanatory part is being driven by the relationship between the misstatement of financial reporting and the responsibility of external (independent) financial auditors. Same relationship should also give a high value answer to an important question: "What was the problem with auditors not to discover the fraudulent actions in the timely manner?!"

Finally, when we sum up the methodology, and brought it down to descriptive and explanatory, we define it as case-based research, since our research is being followed by the real time occurrences and examples of which all of us have been witnesses.

Data collection

Since the most data available on the topics are from the books, articles and internet sources, secondary data will be mostly used. Furthermore, internet based video clip interviews as well as documentary films will be analyzed in order to fully research and understand the objective background of the analyzed cases.

Moreover, primary data will be used as well. Student has good relationship with Deloitte d.o.o, Serbia partners and employees, since he spent the placement year in that institution, the plan is to interview employees and management position members in order to gain comments on extensive audit experiences and fraud prevention mechanisms. Furthermore, questionnaires will be sent to several companies in Serbia to evaluate the work of auditors and how did they feel it has improved their business in the post auditing period.

Details of collecting primary and secondary data

As mentioned before, the primary data will be collected by the student. The plan is to prepare and send questionnaires to the several companies in Serbian market. The reason for choosing Serbian market as the one that should be questioned is the fact that the student is Serbian, has spent his placement there, has good relationships with many companies and could easily gather the needed information in prescribed time.

Semi structured interviews will be held with "Deloitte d.o.o." employees, as well as "Privredni Savetnik" management (leading Serbian periodical, whose employees are auditing and accounting experts with extensive experience in mentioned topics).

Secondary data will be collected from various sources. Many of the books are already collected, while others are ordered through the internet, some books are already downloaded in electronic format, while the rest of books will be used from various libraries. Concerning articles, those will be collected over the internet, which has shown a large number of search results concerning detailed topic.

Details of analyzing primary and secondary data

The quantitative questions that will be provided by sent questionnaires will be analyzed quantitatively. On the other hand, qualitative data, interviews with the experts and auditors will be analyzed qualitatively.

Major Sections To Be Covered

Introduction

Background

Purpose and Objectives of the paper

Defining research terms

Literature review

Introduction to audit and its role in changing financial environment

Presentation of fraud examiner, as an audit tool

Exploring future accounting rules and standards (concerning audit and fraud)

Research Methodology

Purpose of research

Primary and secondary data collection

Data sources

Data analysis

Validity and reliability

Data analysis

Financial audit fraud preventing tools and its implementation concerning different industry sectors

Association of Certified Fraud Examiners as the fundamental fraud prevention and detection association

Case study of Enron Scandal

Arthur Andersen and its role in the scandal

Dismissed fraud prevention steps

Responsibility determination

Recommendations

Executive interviews and findings

Deloitte d.o.o. Serbia

Privredni savetnik d.o.o., Serbia

Conclusion

Overall recommendations

References

Appendices

Preliminary conclusions

Since financial reporting frauds have attracted high attention from the public, and auditors were blamed to be responsible, student aim is to answer some of the most common questions: "Where were the auditors to explore the fraudulent activities?", "Are auditing services a bureaucratically imposed costs or a long term investment?" But those are the questions of the mass public that has not made an effort to go a bit deeper into the problem. Therefore, this document will have an aim to completely and widely research this phenomena in order to proportionally redistribute the responsibilities and failures of the each sides of the counter.

By beginning, the first dilemma is always why auditors have not detected fraud in the financial statements, and what is the solution of preventing these gigantic failures and happenings in the future.

To achieve such a goal, student has to study all the theories which are completely relevant to the researched topic. After the theory has been completely researched and relevant practical conclusions drawn, backed up with large list of evidences, student will be able to draw an objective conclusion. And it is very important to be objective, as this dissertation should be. Because we have a decade past from the Enron failure, massive research material and unbeatable evidences. Considering the time past between the failure and dissertation research period, student has more than enough confidence in order to believe his conclusion will be objectively drawn.

In the end, after the conclusion has been made, student would like to give some recommendations. Recommendations will be dedicated to auditors in order to help them in any way much faster identify the fraudulent actions, backed up with the upcoming accounting rules from this category adopted by IAS board.

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