How accountants combat fraud
June 3, 2021
Is fraud a serious issue?
When you think of accountants, you probably don’t usually think crime fighters, but that would not be an inaccurate description of many roles in the accounting profession. Accountants actually spend a great deal of time thinking about crime, particularly fraud – how to prevent it, how to detect it and how to make sure it doesn’t go unpunished.
According to the Association of Certified Fraud Examiners, the average organization loses about 5% of its revenue to fraud. That amounts to more than $4 trillion lost to fraud worldwide every year. Much of the responsibility for preventing and detecting that fraud falls on accountants, but the approach they take to stopping it varies from position to position. Here is a brief overview of 4 common accounting roles and how they fight fraud.
Financial statement auditor
Businesses create financial statements in a standardized form to show investors, creditors and other interested parties how well the business is doing. Investors know that the business has an interest in making the financial statements look as strong as possible, so they won’t necessarily take the company’s word for it. That’s where financial statement auditors come in.
The auditor typically works for an accounting firm that is hired by the business to verify the accuracy of their financial statements. Because the auditor does not work for not the company, investors are more likely to trust financial statements that have been audited.
Auditors gather and analyze evidence to determine whether financial statements are fairly stated and then issue a report with their opinion. The misstatements auditors find are usually caused by bookkeeping errors or misapplied accounting principles, but they are sometimes the result of fraud.
The auditor’s chief concern is not to see fraud punished but to understand its effect on the financial statements. If the fraud is so severe that the financial statements are not reliable, it is the auditor’s responsibility to make that information available to investors. There are 2 types of fraud an auditor is concerned with:
- misappropriation of assets
- financial statement fraud
Misappropriation of assets is another word for stealing, though it technically includes the misuse of company assets; for example, using the company’s delivery truck for personal use. Virtually all companies experience some level of misappropriation of assets, whether it is shoplifting by a customer or a cashier stealing from the cash register. Auditors are not really concerned with the theft itself. They are focused on the financial statements and only care about fraud that might affect their accuracy. If they find out that someone stole a few dollars from petty cash, they’ll let the company know about it. However, because such minor misappropriation is too small to meaningfully affect the reliability of the financial statements, it is not generally a concern for the auditor.
It sometimes happens, however, that misappropriation is a widespread problem throughout the company. In this case, the auditor will need to determine the effect that misappropriation has had on the financial statements. For instance, if auditors discover that half the inventory in the company’s warehouse consists of empty boxes because employees have been stealing and reselling the product, the company’s balance sheet will be misstated – a fact the auditors will include in their report.
Unlike the misappropriation of assets, which affects the financial statements only as a byproduct, financial statement fraud directly aims to misrepresent the company’s operating results or financial position. Because the compensation of high-level executives is often directly tied to the company’s performance, executives can be motivated to manipulate accounting records to make the company appear to be doing better than it is. The complexity of financial reporting at a large organization allows for financial statement fraud to take various forms. There are countless ways for executives to create fictitious sales and assets or hide expenses and liabilities. By doing so, they artificially boost the company’s bottom line and their bonuses with it.
The most famous example of financial statement fraud is Enron. Enron had a great deal of debt, but instead of reporting it on its own balance sheet, it created new companies and loaded them with the debt. This effectively hid the liabilities from investors, making the company appear much more financially viable than it was. When the scheme was uncovered, Enron quickly went from a darling of investors to bankruptcy. Enron is now a name synonymous with fraud.
While a financial statement auditor is independent of the organization he or she audits, an internal auditor is typically an employee of the company. Internal auditors review the processes and procedures companies use to make sure they accomplish their goals. One of their primary concerns is preventing and detecting fraud. The internal auditor will investigate suspected instances of fraud, look for suspicious transactions and ensure that internal controls intended to prevent fraud are operating effectively.
Suppose a single employee is responsible for authorizing a purchase, receiving the purchased goods on behalf of the company and recording the transaction in the accounting records. That employee could place an order with company funds, take the goods home and manipulate the accounting records to make it look like it never happened. This would make it nearly impossible for the theft to be discovered. For this reason, the internal auditor will ensure that company policy does not allow one single person to be assigned more than one of these duties.
Another essential internal control an internal auditor puts in place is a list of approved vendors. The purpose of such a list is to prevent billing fraud schemes. For example, someone assigned to make purchases might set up a fake company with a bank account they control. They could then make fake purchases from that company and pocket the funds. The simple step of ensuring that all purchases are checked against a list of pre-approved vendors makes this scheme much harder to pull off.
Unlike internal auditors who are responsible for preventing fraud, forensic accountants are tasked with documenting fraud and preparing financial evidence, usually for use in a lawsuit or criminal prosecution. They gather and analyze financial evidence, write a report and then serve as a witness at trial.
Forensic accountants may work in the public or private sector. In the public sector, they might help law enforcement trace money laundered by an international drug cartel or prove that a retirement home was billing Medicaid for services it never actually rendered. In the private sector, they could help an insurance provider identify fraudulent claims and sue the fraudster.
Forensic accountants also commonly help provide an accurate financial picture of an organization or individual. If one company is considering buying another, it will want to ensure that, for example, the company being purchased is not hiding substantial debt or overstating its assets. Similarly, in divorce proceedings, it is not uncommon for one spouse to hide money or assets. A forensic accountant might be retained in such a situation to find and document those assets.
A tax auditor reviews the financial records of individuals or organizations on behalf of a government agency, for example the Internal Revenue Service, to be sure they have correctly reported their tax liabilities. While a financial statement auditor is typically more concerned about a company reporting more income than it really earned, a tax auditor also looks for companies reporting less income as a strategy to lower their tax liability. When tax liability is intentionally underreported, the auditor might refer the case to law enforcement or gather evidence to be reviewed by an administrative panel to impose a penalty.
Tax auditors discover and report billions of dollars in tax fraud every year, and they likely prevent many billions simply by deterrence. Nonetheless, the IRS estimates that tax evasion costs the U.S. government alone around $400 billion per year.
The person hiding the ball always has the advantage over the person trying to find it. The expanding variety of fraud schemes and complexity of modern business make it impossible to put a stop to fraud, but accountants are working tirelessly to try to limit its scope.