An exploratory study of auditors’ responsibility for fraud detection

An exploratory study of auditors’ responsibility for fraud detection

An exploratory study of auditors’ responsibility for fraud detection

An exploratory study of auditors’ responsibility for fraud detection
An exploratory study of auditors’ responsibility for fraud detection

An exploratory study of auditors’ responsibility for fraud detection in Barbados

Philmore Alleyne
Department of Management Studies, Faculty of Social Sciences, University of the West Indies, Barbados, West Indies, and

Michael Howard
Department of Economics, Faculty of Social Sciences, University of the West Indies, Barbados, West Indies

Purpose – Recently, fraud has been brought to the forefront with the scandals of Enron and Worldcom. Fraudulent financial reporting and misappropriation of assets served to undermine investors’ confidence in audited financial statements. This study investigates how auditors and users perceive the auditors’ responsibility for uncovering fraud, the nature and extent of fraud in Barbados, and audit procedures utilised in Barbados since Enron.
Design/methodology/approach – A total of 43 respondents (19 auditors and 24 users) were surveyed regarding their perceptions and experiences on fraud, using qualitative and quantitative approaches.
Findings – Indicates that the expectation gap is wide, as auditors felt that the detection of fraud is management’s responsibility, while users and management disagreed. Also finds that fraud is not a major issue in Barbados and that companies who have internal auditors, sound internal controls and effective audit committees are better equipped to deal with fraud prevention and detection.
Research limitations/implications – The sample size is relatively small and it is not intended nor claimed that those interviewed comprise a representative sample.
Practical implications – This research fills a void in research in this area in a small country like Barbados. These findings have important implications for users of Barbadian accounts, especially investors, auditors and regulators.
Originality/value – This paper fulfils a resource need for academics and practitioners, and makes an interesting contribution to our understanding of fraud in Barbados.
Keywords Fraud, Auditors, Barbados
Paper type Research paper

For a long time, there has been controversy over the role of the auditor with respect to the detection of fraud. It has been argued that an audit should be done by a competent, independent, individual and involves the collection and assessment of evidence about information to decide and report on the degree of correspondence between the information and certain established criteria (Arens et al., 2003, p. 11).

The Association of Certified Fraud Examiners (ACFE, 2004) in its study entitled The Report to the Nation on Occupational Fraud and Abuse has reported that annual fraud costs to US companies exceed 6 per cent of their revenues, which is approximately US$660 billion annually. However, this figure does not include the impact that fraudulent financial reporting has on the capital markets (Cox and Weirich, 2002). The ACFE (2004, p. 1) defined occupational fraud as:

the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organisations’ resources or assets.

Some common types of fraud include creating fictitious creditors, “ghosts” on the payroll, falsifying cash sales, undeclared stock, making unauthorised “write-offs”, and claiming excessive or never incurred expenses.
In today’s technological age, fraud has become very complicated, and increasingly difficult to detect, especially when it is collusive in nature and committed by top management who are capable of concealing it. Consequently, auditors have argued that the detection of fraud should not be their responsibility.
This exploratory study attempts to focus on the auditors’ and users’ perceptions in detecting fraud and related audit procedures, the nature and extent of fraud in Barbados, possible influences of professional experience and educational background of auditors, and the organisation’s previous experience in detecting fraud (Moyes and Hasan, 1996, p. 41). The paper also looks at the way auditors respond to the increased likelihood of material misstatements caused by fraud, especially since Enron (Makkawi and Schick, 2003). International literature contributes much on the debate of the auditor’s role and the public’s perception of his role, but none has been researched on this issue in Barbados. However, KPMG in Barbados (KPMG, 2000a, b) has carried out a study on fraud in Barbados which provides a foundation for the conduct of the present study.
The paper is structured as follows: The second section looks at a brief historical background. The third section deals with a review of previous research and is followed by the fourth section on key characteristics of Barbados. The next section looks at the research methodology and the findings and discussion are then presented and analysed in the sixth section. The final section concludes the study.

Brief historical background

The role of the auditor has not been well defined from inception. In the nineteenth century, auditors claimed fraud detection as an audit objective. In re London and General Bank (No. 2) [1895] 2 Ch. 673, Lindley LJ stated that it was the auditor’s duty to report to shareholders all dishonest acts which had occurred and which affected the propriety of the contents of the financial statements (Porter, 1997). However, the learned judge also argued that the auditor could not be expected to uncover all fraud committed within the company, since the auditor was not an insurer or guarantor, but was expected to conduct the audit with reasonable skill and care in the circumstances.
By the 1930s, it became generally recognised that the principal audit objective was the verification of accounts (Vanasco, 1998). The profession took the position that fraud detection was management’s responsibility since management had a responsibility to implement appropriate internal control systems to prevent fraud in their organisations. This was as a result of the increase in size and volume of companies’ transactions that made it virtually impossible for the auditor to examine all transactions (Porter, 1997). Auditors used sampling and testing procedures, which offered only reasonable assurance of the contents of financial statements. In addition, auditors were unable to detect fraud that involved unrecorded transactions, theft and other irregularities (Vanasco, 1998, p. 4).
By the 1960s, there was widespread criticism from the press and the general public of the profession’s denial of responsibility for detecting fraud (Morrison, 1970, cited in Porter, 1997). The author also argued that the press and general public considered an audit useless if it was not designed to uncover major frauds (Morrison, 1970, cited in Porter, 1997). Despite the criticism, auditors continued to minimise the importance of their role in detecting fraud and continued to stress that it was the role of management. By publicly disclaiming responsibility for detection of fraud, external auditors wished to avoid or minimise legal liability in order to protect them from legal claims holding them responsible for fraud (Humphrey et al., 1993; Vanasco, 1998).
From the 1980s, as a result of technology, the complexity and volume of fraud have posed severe problems for the corporate world. However, Porter (1997) argued that, although case law has determined that in some circumstances auditors have a duty to detect fraud, the courts have attempted to maintain that duty within reasonable limits.

Selective review of the literature
Fraud may be defined as intentional deception, cheating or stealing and can be committed against users such as investors, creditors, customers or government entities (Weirich and Reinstein, 2000). Statement on Auditing Standards (SAS) No. 82 identified two categories of fraud as fraudulent financial reporting and misappropriation of assets. Fraudulent financial reporting (management fraud) is where management seeks to inflate reported profits or other assets by overstating assets and revenues or understating expenses and liabilities in order to embellish the financial statements. Misappropriation of assets (employee fraud) is where employees steal money or other property from their employers. Various fraud schemes could include embezzlement, theft of company property and kickbacks.
Albrecht et al. (1995) classified fraud into employee embezzlement, management fraud, investment scams, vendor fraud, customer fraud, and miscellaneous fraud. Albrecht et al. (1994) identified the causes associated with individuals committing fraud. They concluded that there are factors (also known as the fraud triangle) such as situational pressures, perceived opportunities and rationalisation. Situational pressures originate from underpaid and overworked staff, excessive debt and lifestyle. Perceived opportunities allow fraud to be committed because of poor internal controls or negligence. Rationalisation is where the individual justifies the behaviour as being acceptable with seemingly plausible, but false reasons (Moyes and Hasan, 1996).
In the international arena, there are examples of corporate failures such as Bank of Credit and Commerce International (BCCI), Barings Bank, Enron and Worldcom. In July 1991, there was the “wind up” of BCCI as a result of fraudulent activity which included collusion with top management and third parties in fictitious loan schemes, and the falsification of accounting records (Vanasco, 1998, p. 38). As a result of this fraudulent activity, there were lawsuits worldwide as investors attempted to recoup some of their monies, and guilty parties were even incarcerated (Truell and Gurwin, 1992). In February 1995, there was also the collapse of Barings Bank in England as a result of the speculative and unauthorised activities of a trader named Nick Leeson in Singapore. Leeson misled the bank by seemingly earning phenomenal profits while incurring substantial losses (Drummond, 2002, p. 232) and “left debts of over £850 million that brought down one of England’s most prestigious banks” (Strategic Direction, 2002, p. 4). In 2001, Enron, a US company, was a perfect example to illustrate the awareness by both management and the auditor of fraudulent financial reporting. The collapse of Enron took down the accounting firm of Arthur Anderson (Vinten, 2003). The Treadway Commission has defined fraudulent financial reporting as intentional or reckless conduct, either by act or omission, which results in materially misleading financial statements (COSO, 1999).
Beasley (1996) concluded that there was a significant negative relationship between the proportion of outside directors on the board and the likelihood of financial statement fraud. He also concluded that the presence of an audit committee did not significantly affect the likelihood of financial statement fraud. However, it may be argued that mere presence alone could well not have an impact on fraudulent financial reporting, but rather it depends on the way the audit committee operates. Abbott et al. (2000) found that companies with audit committees, which comprised independent directors and met at least twice per year, were less likely to be sanctioned for fraudulent or misleading reporting. In many cases, since members of audit committees may not have the type of information to make independent judgements on fraud, they depend heavily on information provided by the internal auditors.
Cox and Weirich (2002, p. 374) argued that the pressure to meet or exceed analysts’ expectations has resulted in various entities turning to fraudulent financial reporting activities. Vinten (2003) pointed out that it is often the chief executive officer (CEO) who is involved in the efforts by the corporation to inflate profits or hide certain liabilities off the financial statements as was done by Enron.
Moyes and Hasan (1996, p. 46) concluded that the degree of fraud detection was not dependent on the type of auditor, since both internal and external auditors have equal abilities to detect fraud. Moyes and Hasan (1996, p. 46) also found that organisational success in detecting fraud was significantly enhanced in auditing firms with previous experience in fraud detection than auditing firms with no such history. It was also found that auditors who were certified as certified public accountants (CPAs) were more likely to detect fraud than auditors who were non-CPAs. Moyes and Hasan (1996) argued that this certification may imply a greater level of professional competence in fraud detection. The authors further argued that the peer review process puts pressure on auditors to be more diligent in incorporating relevant audit procedures to detect fraud.
Bonner et al. (1998) concluded that there existed some support for higher incidence of litigation against auditors, when a company’s financial statements contain fraud that most commonly occurs, or when fraud arises from fictitious transactions and events. Summers and Sweeney (1998) found that insiders reduced their equity stake during the occurrence of fraud.
There is still no modern consensus about the role of the external auditor, so far as the detection of fraud is concerned. Users of financial statements and accountants have a divergent perception of the auditor’s role. The literature refers to this difference as the “Audit Expectation Gap”, a phrase which was introduced by Liggio (1974). The audit expectations gap may be defined as the difference between the levels of expected performance as perceived by the external auditor and the user of financial statements (Pierce and Kilcommins, 1996). Farrell and Franco (1999) found that more than 61 per cent of the CPA respondents disagreed that they should be responsible for searching for fraud.
Auditors claim that they are not responsible for detecting fraud, but that the detection of fraud is management’s responsibility and that audits are not designed, and cannot be relied on, for this purpose (Porter, 1997). The SAS 1 (AU110) Codification of Auditing Standards and Procedures stated that:

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