Auditing is the process of obtaining and evaluating evidence that supports (or refutes) the material financial statement assertions made by management of the entity under examination.  Auditors must examine sufficient appropriate evidence to support their opinions (per U.S. Auditing Standards, AU-C Section 500, and PCAOB Auditing Standard No. 15), but have always been inclined to focus on documentary evidence, whether internal (books of account, purchase orders, etc.) or external (confirmation responses, etc.) in origin.  This bias is probably a normal consequence of auditors’ education and training and, in the author’s experience, has been exacerbated by the rise in so-called “computer-based auditing,” which tends to keep auditors firmly planted behind computer screens and disinclined to engage in what some fail to appreciate as key activities, such as touring the physical facilities.

Article Highlights

  • Developing physical analogues to use in the audit setting should not be difficult if the auditors understand the client’s business operations, as required in U.S. Auditing Standards AU-C Section 315 and PCAOB Auditing Standard No. 9.
  • Physical measurements are intended to serve as identifiers of “red flags,” and should never be expected to alone prove the existence of fraud.
  • The IRS uses physical analogues for the purpose of reconstructing income when underreporting has been suspected, as it is for many cash businesses.

The auditors’ utilization of physical existence has been rather limited by comparison with use of documentary evidence.  It has primarily pertained to the observation of the client’s inventory-taking procedures and, less often, to the inspection of physical assets, usually limited to major additions during the period.  Rarely have creative approaches to make use of physical evidence for corroborative purposes or as indicia of the occurrence of financial reporting improprieties been observed.

Audit Testing Procedures to Uncover Fraud Perpetrators

In the relatively unlikely event that members of management are engaged in fraudulent financial reporting, they will be familiar with the typical audit testing procedures employed during these annual examinations, and will take what they assume to be appropriate steps to keep the fraud from being revealed by those tests.  Because auditors’ biases for documentary evidence are known, fraud perpetrators will also direct their attention at creating – or concealing, as warranted – documents such as bogus sales invoices, bills of lading, customer confirmation responses, and so forth.

Much less likely to be addressed by perpetrators are the relatively minor physical indicia that will correlate well with financial data, if and when those financial data are accurately portrayed by management, and which well might reveal marked disparities when the financials have been fraudulently manipulated or have been distorted by errors.  In the author’s experience, auditors have paid too little attention to these analogues, in part because they tend to be only suggestive, rather than definitive or probative, and in part because they assume that these are forensic procedures not suited to routine audits.  Both of these factors have served to make even ordinary audits less effective than they might otherwise be.

Physical Analogues as Red Flags for Financial Reporting Frauds

Physical analogues are intended to serve as identifiers of “red flags,” and should never be expected to alone prove the existence of fraud.  However, a review of major financial reporting frauds demonstrates that auditors have too often failed to even take note of the red flags, so anything that more effectively brings these to the auditors’ attention should be given careful consideration.  Once red flags are identified, auditors can and should make use of expanded testing procedures – e.g., examining larger samples and/or employing different tools, such as the powerful but rarely employed “four column” bank reconciliation (a/k/a reconciliation of receipts, disbursements and bank accounts, or a “proof of cash”), which might then confirm that the irregularity hinted at by the “red flags” does in fact exist.

Given its somewhat different objectives vis-à-vis independent auditors, the IRS has been much more energetic in making use of physical analogues.  It has done so primarily for the purpose of reconstructing income when underreporting has been suspected, as it is for many cash businesses.  Financial statement auditors, on the other hand, have generally eschewed use of these tools, in part because addressing income understatement by clients has proven awkward.  However, creative use of physical analogues is more widely apropos than has been appreciated, and greater utilization of this tactic could prove of great value in even routine audit situations.

Techniques to Uncover Under-Reported Income in Bars and Taverns

A classic example of income underreporting pertains to taverns and lounges, where receipts can be easily skimmed by a crooked bartender (or owner) by, for example, ringing up the sale of a beer instead of a more-expensive cocktail and pocketing the difference.  The obvious way to investigate this possibility is by correlating the number of bottles of whisky purchased to revenues reported, using the standard ratio of numbers of cocktails that are produced by each fifth or quart of whisky, gin, vodka, etc. This would identify the extent of “breakage,” which might ultimately lead to identification of theft by one or more employees.  A simple fraud scheme such as this would probably be detected fairly quickly, however.

If the dishonest server is somewhat cleverer, he/she might be quite willing to absorb the cost of goods sold in order to conceal the theft of revenues, making detection more difficult and prolonging the period over which the thefts might continue unnoticed.  The crooked employer has to shoulder this cost of doing business, but will still derive an excellent profit from the scheme, and be less likely to be detected.  In this variant, the worker buys his own whisky or other spirits, brings it to the tavern, and uses it to make drinks, which are then not rung up at all.  With both the cost of the raw materials and the revenues missing from the books, rudimentary analytical procedures will not identify an anomalous situation – or so the corrupt employee might presume.  But here is where the use of physical analogues can prove effective at identifying fraudulent revenue-skimming schemes.

Physical analogues are indicia of revenue producing transactions and, to be useful for auditors should be both closely correlated to revenues and sufficiently insignificant themselves that perpetrators will fail to manipulate them to conceal the fraud.  The minor (and thus typically overlooked) physical analogues in the tavern situation could be items such as cocktail napkins, stirrers, toothpicks, olives, pearl onions, cherries, and so forth, as well as mixers such as 7-Up and tonic water.  For a given establishment, with its particular demographics (the drink preferences of its customer base, etc.), there will be a relatively constant ratio among the various drinks (dry vermouth-using Martinis, sweet vermouth-using Manhattans, et al.) over time, and the usage of these minor ingredients and accouterments, which are individually insignificant, can be closely correlated with the amounts of spirits of various kinds consumed, and thus with projected revenues.  For example, for a given establishment it may be that 5% of mixed drinks are Martinis, so that total drinks revenues can be reasonably projected from the quantity of olives consumed.  A more than random series of variations from these expectations should be red flags to auditors.

Industry Variations of Physical Indicators for Financial Reporting Fraud

Simplistic physical analogues can work in a wide range of settings.  In another situation from the author’s actual experience (as was the preceding example), a retail brokerage business’ gross commissions were suspected of being understated.  In those pre-Internet days, salesmen operated from desks with telephones, and split commissions with the house.  The number of desks and telephones essentially dictated the amount of customer contacts that could be handled each day, and a review of order tickets allowed construction of a range of commissions per trade, within a reasonable margin of accuracy.  Thus, the physical plant proved to be a subtle, but meaningful, physical analogue for sales revenues.  Similarly, warehouse square footage, tanker truck capacities, and a host of other mundane-appearing physical capacities can be used to corroborate key financial statement assertions, such as revenues, cost of goods sold, compensation expense, and rent and utilities.  (Many of these can be further corroborated using analytical procedures that relate different financial statement line items – for example brokerage salesmen’s commissions as a percentage of gross revenues, based on employment contract terms, et al.)

Auditing Standards Relating to Uncovering Under-Reported Income

Developing physical analogues to use in the audit setting should not prove to be a difficult task, if the auditors understand the client’s business operations, as auditing standards (specifically, U.S. Auditing Standards AU-C Section 315 and PCAOB Auditing Standard No. 9) demand.  In fact, the assignment of identifying candidate indicia and developing such analogues might be a vehicle that would more fully engage the audit staff in the planning and fraud risk assessment stages of the audits, removing these from the realm of abstractions or a checklist-limited exercise, as they are often treated as being.

Harnessing staff creativity can pay dividends both in terms of the successful completion of the audit – the paramount objective – and also in developing staff audit skills.  Here, then, is yet another reason why the “brainstorming” session required among audit team members (by U.S. Auditing Standards AU-C Section 240 and PCAOB Auditing Standard No. 12) can be a remarkably productive use of budgeted audit time.

January, 2015

ABOUT THE AUTHOR: Accounting expert Barry Jay Epstein, Ph.D., CPA, CFF, is a Chicago-based forensic accountant, author and frequent expert witness who works with securities attorneys and U.S. regulatory agencies in the areas of white-collar defense, financial reporting, fraud, securities litigation, and auditor liability. He can be reached at barry.epstein@epsteinnach.com.

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