“There’s an underlying requirement of an auditor to understand the client’s business, which is the foundation of the obligation to get evidence to justify the numbers, all of which encompasses a duty to discover fraud,” she says. In some cases, the lapses go beyond a lack of professional skepticism, she says, “It goes to becoming the audit client’s advocate, whether it’s against regulators or coming up with better numbers for the market.”
Even when auditors are well-intentioned, there are certain types of sophisticated fraud that may be difficult to detect without employing specialized forensic audit expertise. For example, collusion between the company and its banks, major customers, or government agencies can result in an auditor “confirming” fictional revenue or cash balances. This is a particular risk in developing markets, where counter parties may lack robust internal controls of their own. In other cases, computer forensics and expertise in document authentication required to catch fraud are outside the scope of a normal audit.
If an auditor has evidence that fraud may exist, they are required to report it — to senior management for localized fraud and directly to the audit committee if senior management is involved in illegal acts that impact the accuracy of the financial statements. If after raising the issue with the audit committee, no action is taken to address the issues, then the auditor is required to withdraw their opinion, terminate the engagement, and make a filing using form 10A(b) to the Securities and Exchange Commission.
However, as a matter of practice such filings are very rare, with only 29 10A(b) reports filed between 1996 and 2003, according to the GAO. “This gets talked about a lot, but the auditors don’t do it,” according to McKenna, who sought updated information on the frequency of these filings from the SEC, only to be told that the data was not being tracked and not available. Often, it seems, auditors prefer to quietly withdraw from troubled clients.
When Fraud Prevention Systems Fail
When the internal and external systems designed to prevent fraud function as designed, investors will normally never learn about it — accounting issues will be rectified, and internal controls strengthened before there is any material impact on the financial results.
“It seems a little counterintuitive to tell your employees to find problems and present them to you. But every company has problems,” said Caryn Schechtman. “So, the real key to preventing it from becoming a fraud that can bring down a company is being able to identify the issue at an early stage and properly resolve it.”
But when these systems fail, then other actors may come forward with allegations of fraud, including whistleblowers, short sellers, and investigative journalists. This can create a chain reaction in which the company faces investigations by the SEC, Department of Justice, their stock market, PCAOB and others. In many cases, such allegations also result in shareholder plaintiffs filing class-action lawsuits against the company.
Michelle Johnson feels that there is an imbalanced playing field when financially incentivized players come to the table with claims of wrongdoing that may be unfounded or overblown and are able to reap quick profits.
“Short sellers views can be wrong, and when they are, their allegations impose significant cost to shareholders and harm to companies,”she said. For example, if a short seller publishes a report or blog post that causes the stock to drop based on misleading information, they may cover their position within minutes as the stock collapses in a speculative panic. “The company is left to defend shareholder lawsuits, government investigations, and market speculation long after the blogger’s claims are shown to be inaccurate.”
Emily Alexander feels that class-action lawsuits are often ineffective as a means to make investors whole. While there has been an explosion of class-action securities litigation over the past three decades, most of these suits are treated as nuisance litigation that settle out of court and have little proven effect on fraud deterrence. These suits “are not effective in getting restitution to the ones who actually lost money or in deterring fraud. They are actually a complete fail,” Alexander said.
In summary, a blizzard of new regulations, including the Dodd-Frank (849 pages) and Sarbanes-Oxley legislation (200 pages, with amendments), do not appear to have eliminated public company financial shenanigans. Shareholder lawsuits alleging fraud continue to escalate each year, while the “vigilante justice” of short seller reports imposes exorbitant costs on shareholders without prior knowledge of the publication and can cause lasting damage to companies when the allegations are unfounded.
Given these circumstances, are there any changes that could significantly reduce the incidence of public company fraud?
Fraud-Proofing the Stock Market
Until the day that greed and mendacity are eliminated from human behavior, it is unlikely that investing in the equity markets will ever be entirely “safe” from the risk of financial fraud.
“There’s no red pill for frauds and scams, nor for fraudsters and scam artists,” notes Roddy Boyd.
He believes that more aggressive enforcement actions by the SEC and DOJ criminal prosecutions are required to focus the minds of executives and board members on the downside of corporate malfeasance. This would include naming and docking the compensation of managers who were in the chain of command when frauds occurred, doing away with financial settlements in which corporations are permitted to “neither acknowledge nor deny” guilt, and holding boards civilly and criminally liable. “Directors who have been notified about the existence of a possible fraud and who don’t make good faith efforts to at least determine the truth need to be held culpable,” Boyd said.
Enforcement efforts in the financial markets tend to run in cycles, with urgent calls for accountability following major market downturns, often followed by a laxer approach during bull markets. But there are some structural changes that could be effective in reducing the incidence of fraud across the market cycle through improved education and more transparent disclosure.
Here are a few suggestions:
Send Auditors to Fraud School – Earning a CPA entails studying for and passing a rigorous test that covers audit procedures, accounting rules, economics, IT, operations and ethics. Conspicuously absent is any specific training on how to detect fraud. Fraud detection should be part of the basic education of every public company audit professional, with requirements for continuing education. Topics should include the conditions that allow fraud to occur, how to perform risk assessments for fraud, how to perform supplemental testing, and when to call in additional resources to authenticate documents or perform forensic testing on computer systems. Once audit staff has the knowledge and mindset to look for fraud, then they should be empowered with the means to escalate any concerns without fear of retribution if they believe they are not being addressed by the audit partner. Senior partners who have been found to be complicit in fraud should be shown the door and stripped of retirement benefits.
Make Inspections Consumer Friendly – The Public Company Accounting Board (PCAOB) currently conducts regular inspections of auditors to assess the quality of the audits. In 2018, the PCAOB inspected 160 different auditors and looked at over 700 different company audits. The PCAOB issues reports following these inspections that identifies the types of audit deficiencies it found, but it withholds much of the detail as long as the firm corrects the issues within 12 months of the report. In 2017, the PCAOB found that certain firms had deficiencies in 50% to 73% of the audits inspected, to the point that the firms did not have sufficient evidence to support their audit opinion. While the PCAOB makes it clear that these reports are not designed to provide a “balanced scorecard,” the board should consider presenting the information in a format that is more useful to investors and audit committees. For example, presenting the trend in the percentage of deficient audits by firm might create strong commercial incentives to reward firms that make the extra investment in audit quality and fraud prevention.
Make Audit Committees Accountable – Given the central role that the audit committee has in hiring and overseeing the independent auditor, overseeing the internal audit function, and discussing significant accounting decisions with management, greater transparency about how they execute these roles would be valuable to investors. An annual letter from the audit committee to the shareholders on how they defined and discharged these duties would provide helpful insights as to what level of independence and insight is in place. All board members should be provided training on techniques for building a fraud-resistant company including setting the “tone at the top,” effective internal controls, addressing whistleblower concerns, and identifying high-risk behaviors and transactions. (“The Fraud-Resistant Organization,” available at the Center for Audit Quality website, is a great resource for management and boards.) Audit committees who are deeply knowledgeable about all the areas in which risk of fraud exists, will also be much more effective in advising management to deal with spurious short reports, having probed the issues in advance.
While financial fraud remains the exception among public companies, its consequences to investors’ net worth and to confidence in the fairness of the markets can be devastating. A greater focus on training, transparency, and proper alignment of incentives can help make major public company fraud a rare event.
The opinions is in this article reflect those of the author and not those of Marcum Bernstein and Pinchuk or Marcum LLP.
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