Auditor Liability in Management Fraud: Human Factors

Auditors will continue to be blamed for the costs of management fraud, notes accounting expert Dr. Barry Jay Epstein, CPA, CFF, in comments prepared for a panel presentation titled “The Human Side of Financial Fraud,” scheduled for the American Accounting Association’s annual meeting in Chicago on August 8-12, 2015.

The session is on the need to revise the conduct of audits to take into account new insights into how personality differences–including the presence of so-called “dark triad” personality types that are estimated to be present in as many as 20% of management ranks (Narcissistic, Machiavellian, and psychopathic types)–should be taken into account in planning and conducting audits.

Large lawsuit settlements and insurance premiums are among the significant direct costs imposed on the public accounting (auditing) profession due to claims of accountant malpractice that arise from management fraud.

Listed below are the key points that Dr. Epstein will be making in his presentation on auditor liability in management fraud.

Management fraud (inclusive of asset theft and fraudulent financial reporting) is and will remain endemic. Absent the development of a “new honest economic man” as a universally embraced model for human behavior, the multitudinous and diverse behavioral motivations for engaging in management fraud will continue, resulting in, inter alia, large economic losses affecting owners, creditors, customers and various other stakeholders in the economy. Loss estimates, such as the 5%+ of GNP per ACFE’s biennial Report to the Nations, provide a rough gauge of the cost of fraud and, complementarily, of the potential value to be created by addressing, reducing, and ultimately eliminating these losses.

Auditors, particularly external, independent financial statement auditors, will continue to be blamed in large measure for the costs imposed on society by management fraud, notwithstanding the profession’s periodic efforts to “educate” financial statement users (as with the so-called expectation gap standards of the late 1980s) regarding the practical limitations on auditing efficacy, and this will continue to impose significant direct (lawsuit settlements, insurance premiums) and indirect (reputational harm, occasional demises of public accounting firms, opportunity costs associated with expanded societal roles that might have otherwise redounded to the profession’s benefit) costs on the public accounting (auditing) profession.

Fraud detection can be described as the “once and future focus” of independent audits. For various reasons, the former (early 20th century) expectation that outside audits had fraud detection as a major objective gave way, over the past 75 years, to the growing belief that fraud detection (forensic examination, et al.) was a “higher level” service, making use of tools that ordinary audits would not (and perhaps could not, economically speaking) employ, and that users had to be disabused of the notion that routine audits would be effective at fraud detection. This effort at “educating” the users failed, has never been successful as a defense argument in malpractice litigation, and was ill-conceived from a public relations perspective. Dropping long-employed, effective tools, such as the “proof of cash” (four-column bank reconciliation), no longer even taught in many programs, was mistaken, and attempting to define “fraud auditing” as a premium service tended to devalue and commoditize the ordinary audit.

The effectiveness of auditing can and should be enhanced, both by the development and deployment of better traditional auditing tools, such as analytical procedures, and by improved understanding of the human side of financial fraud (including, e.g., the Cressey fraud triangle model or its variants, and personality-based research such as that dealing with the “dark triad”), and the incorporation of this understanding into improved routine auditing procedures. This will require teaching students more about communication skills (written, spoken, and body language), more about human behavior in general (psychology and social psychology), and more practical guidance regarding internal control design, evaluation, and monitoring procedures.

Fraud education must address state-of-the-art tools used by fraud perpetrators – such as “desktop publishing” of bogus bank statements, customer orders, and shipping documents – and must provide updated guidance on the means of detecting these schemes, which have played central roles in many of the major, widely-reported financial reporting frauds of the past few decades. Although even experienced auditors will not become experts on, e.g., document authenticity, the risks attendant to these technology-driven or –assisted fraud techniques must be understood and their implications for scoping decisions (nature, timing and extent of substantive auditing procedures) be more effectively mapped into the audit planning process.

Auditors must be held to very high knowledge standards regarding GAAP, so that nonsensical, but seemingly well supported (often with fraudulently produced documentation), accounting procedures used by reporting entities cannot escape audit scrutiny. This may mean that consultations with technical experts have to be made mandatory, and that more effort be put on “understanding the client’s business” and other basic, planning-stage undertakings for even seemingly simplistic audit engagements.

Professional skepticism, a requirement under GAAS, has to be more effectively taught and enforced; some portion of this intersects with behavioral concepts and this may mean, e.g., that some would-be auditors lack the behavioral characteristics (e.g., self-esteem that would enable challenging management’s assertions) to be successful in the field of auditing, or need remedial or expanded training to overcome their personality-based weaknesses.

Full details on the panel presentation are listed below.

The Human Side of Financial Fraud, Session 6.09
American Accounting Association Annual Meeting
August 8-12, 2015, Chicago

Moderator:

Vasant Raval, Creighton University, (NASBA Field of Study: Accounting)

Panelists:

Barry Jay Epstein, Epstein + Nach LLC, Chicago-based accounting expert
William (Bill) Foale, EY
Pamela R. Murphy, Associate Professor and E. Marie Shantz Fellow in Accounting and Director, Corporate Governance Center, Queens University, Canada.
Sridhar Ramamoorti, Kennesaw State University

A complete agenda is available at:
https://www2.aaahq.org/AM/concurrent06.cfm