Examination continues to be the most widely investigative tool to detecting fraud. The process of examination begins with predication; a conclusion made by a qualified individual in the belief that fraud has occurred or is likely to occur (Albrecht, 12-19). Auditing involves the examination of the books of account to ensure that they represent a true and fair value and that the right accounting standards have been used (Drake, 14). Any inconsistency identified during the audit is further investigated to determine any evidence of foul play.
The Internal Revenue Service is also likely to ask for an examination in case they suspect tax avoidance or where they suspect instances of unreported income in the tax returns (Drake, 96). At the beginning of the examination the proposition is that the case may end up in a legal action. The examination process takes place in the format of research. The process of examination begins by making an assumption on the possibility of fraud occurring. This is done through analysis of the available data which is followed by creation of a hypothesis (Albrecht, 77-98).
In this case, a hypothesis refers to an idea that has not yet been proven or justified and which would need research in order to come up with a conclusion. The next step is to test the hypotheses. This is the most important part and it involves going through the company’s documents, financial records and may at certain times involve the interviewing the parties involved in preparation of the financial accounts. Thorough scrutinizing of the records, comparison and re-calculation are highly involved in this process.
Certain clues to misappropriation and fraud can be shown by differences in the usual signature used to authorize payment which may mean someone forged to obtain money illegally; questionable dates where such transactions do not match any activity in the firm; different ink used in the same document which could represent manipulation of information; in case of typed material, the use of different fonts and styles could suggest foul play; the paper used does not seem to be similar to what the company uses or is there are missing counterfoil numbers or pages in documents such as checks, invoices and receipts (Drake 45-52).
The idea is to determine whether the hypotheses set are true or not and thus come up with a conclusion on whether fraud was actually committed. Once the relevant information has been established, the auditor can now accept or reject a hypothesis based on the information and any amounts of evidence obtained during the study to either victimize the reports or declare them free of fraud. The advantage with examination is that it lays out a systematic guide on how the investigation will be conducted (Albrecht, 9-16).
The auditor is therefore less likely to divert from his goal or waste time in reviewing information that is not of significance to his investigation. A disadvantage however is that the hypotheses listed may fail to capture certain features that could lead to identification of fraud. II. Probing The principles of auditing give an auditor the authority to question financial statements and to seek any clarification from the management and the accountants in a firm where he believes there could be possibility of fraud.
He may also involve other members of staff to question on the various financial activities that take place at the workplace such as the salary packages, petty cash flow and number of employees in the organization to help in detecting ghost workers (Drake, 34). Fraud situations are suggested by inconsistencies in the financial systems for example where original entries do not match balance sheet entries, figures are highly rounded, calculation mistakes show significant variation between the actual and the given figure among other irregularities.
The auditor need not ask for permission to conduct a probing exercise and the affected parties have an obligation to answer the auditor’s questions failure to which he may refuse to give his opinion on the reports. The concept of ‘whistle blowing’ comes in at this point and the auditor should report such misdeeds to the shareholders or the rightful authorities who will then determine the plight of the management (Drake, 39). Probing is said to be advantageous because it combines the auditor’s findings with testimonies from those involved in the use of a company’s cash and other assets and the preparers of the financial reports.
This way, genuine mistakes can be corrected and in genuine ones probed further (Drake, 41). Auditors are trained to use of their accounting knowledge during the probing session making sure to ask questions from different angles while observing the body language of the interviewee, paying attention to the manner in which they answer the questions and making relevant notes (Drake, 39). It has been evidenced that in the process, people who have been involved in fraudulent activities are likely to contradict their statements or act in a manner to betray their guilt.
Examples of actions that may arouse suspicion of the person having committed include fidgeting on the chair; trying to avoid certain questions; giving contradictory reasons, statements and explanations usually in long exaggerated stories which do not support his claims; being overly aggressive to the auditor among others. The method however does not come without its disadvantages because suspected persons could withhold vital information required to make effective conclusions. There are those people who have perfected the art of lying and the auditor may be deceived into believing them thus ending up with the wrong information.
Further, this method could pose a risk to the auditor and many have reportedly been hurt by aggressive suspects in the process and in extreme circumstances murdered (Drake 42). The person suspected of fraud may decide to get the auditor out of the way to save his head rather than risk a fraudulent charge being put against him. To do this, many turn to threatening the auditor so as to prevent him from probing them or disclosing any irregularities directly related to them. III. Risk based approach Identifying risks forms an important component of auditing.
The risk based approach has been there for ages being used both as a preventive and as an investigative tool in fraud. Also known as the ‘red flag’ approach, the risk based approach uses selective investigation (Drake, 20). In their efforts to detect corporate fraud, auditors cannot practically go through all the company’s books of accounts and accounting procedures and hence the need to sample out the most vulnerable areas where investigation should concentrate on. This method is used during the normal audits and in cases where fraud is detected but the company is not sure where it could be in the financial statements.
An example is whereby a company’s profits have dropped significantly yet business has been as good as during previous periods. Risk assessment is best done by determining the areas which are likely to be affected or where the magnitude of potential occurrence of fraud weighs more heavily (Drake, 24). In essence, the auditor comes up with hypotheses which he must prove right or wrong at the end of the assessment. Risk assessment as the name suggests explores the areas where risk is most likely to occur.
Drake (21) lists a several risk areas including the cash at hand and cash at bank, payroll, accounts receivable, accounts payable and inventory. The use of risk assessment saves the company’s finances as to when all the company’s books are analyzed (Drake, 34). Another advantage is that this method helps to prevent future occurrence of fraud as continuous assessment is done in the various selected areas. However, once the employees learn of this method as a way of assessing the company’s accounts, they may seek alternative ways of stealing from the company and by time the management realizes a lot of money could have been lost.
In other words, this method is not exhaustive (Drake, 36). IV. Data Mining Data mining encompasses the extraction of data, analysis and manipulation to support a certain review or allegation. Auditors use this tool when there are huge data sources and the data needs to be further scrutinized through more traditional audit processes (Winn, 4). This investigative method uses information given about suspected fraud to decide the area in which the auditors will commit their efforts. The next step involves retrieval of primary sources of information pertaining to the issue and previous records related to the problem in question.
Using these sources, the interaction between the different transactions and the available documents can then be established. Descriptive statistics are used to bring out outliers in the data; trends including the fluctuation patterns in the data are established through the use of ratios; comparisons are done and exceptions are identified (Winn, 4). The conclusions can then be inferred to determine whether there is truly a case of fraud. If the reports show that the financial reports are consistent with the investigations then the possibility of fraud is out-ruled.
The techniques to be used by companies in data mining depend with the financial endowment but most companies use Microsoft Access, Excel and ACL for data analysis. More sophisticated software such as the SAS® Enterprise Miner™ form effective analytical tools (Winn, 2). There are several advantages associated with using this method. One is that the data inferred is likely to be highly correct given that the information is sourced from original documents. Since the analysis is thorough and includes numerous comparisons, the cause of fraud is not likely to pass unnoticed.
The difficulty in this method comes in where the data mining is done manually. This can be very tedious and unless the auditor seeks additional help, it could take days. Computerized systems have however made data mining easier. V. Auditing software Technology has come to liberate and in the field of auditing is quickly embracing the use of auditing software. The technology base approach is also referred to as the use of computer-aided tools and techniques (CATTs). Software such as the ACL software is used by auditors to detect instances of fraudulent activities conducted within the company.
A well established MIS (Management Information System) can serve as an investigative as well as a fraud prevention tool. This is done through redemption of data and performance of queries which in turn identifies unusual patterns in data. These unusual occurrences are then further investigated using more traditional methods to get the cause of fraud. The advantage of audit software is that statistical errors are avoided and the audit risk is avoided (Drake, 41). Auditing procedures cannot be said to be free of errors and statisticians sight type I and type II errors as highly likely.
Type I is where negative figures are erroneously listed as positive while type II errors leads to a misrepresentation of positives as negatives. Audit risk refers to the likelihood of an auditor to giving a wrong report due to misstatements and general human errors. The use of CATTs also saves time for the auditor since the program does most of the retrieval functions and analysis. The use of CATTs however still raises questions of their abilities to detect fraud. One nature of fraud schemes is that they are adaptive and extremely dynamic. Fraudsters can always conceal their activities by manipulating figures to ensure the statements balance.
VI. Forensic accounting as an investigative tool Use of forensic accountants Forensic accounting is a tool that has come to the limelight in the wake of the many scandals that have emerged in the recent past. Apart from detecting fraud, it has been identified as an effective tool in detecting other white collar crimes such as money laundering and bribery. Forensic audits combine the knowledge on business information, accounting standards, auditing and financial reporting processes to come up with reports which are said to be forensic or usable in court.
Forensic accounting recognizes an auditor as an expert who can actually act as a consultant in litigation matters, use his skills to investigate fraud and if required offer court testimony against an accused in the court of law (Houck, et al, 2). The duties performed under forensic auditing are very much similar to examination only that in forensic accounting investigation usually concerns litigation matters. The auditor collects evidence through inspection of the books of accounts, establishes the occurrence of fraud and makes a report on the findings which are used as evidence in court (Houck, et al, 2).
Forensic accounting has the advantage of being thorough since it incorporates many ways of arriving at the final report. The auditors have to use both financial statements analysis and interviews to obtain evidence that is enough to testify against a company or an individual. The work done is therefore completely refined. VII. Vouching and tracing These are special tools that auditors use to perform simpler roles especially where the source of fraud is almost definite.
Vouching and tracing are actually applied in most of the methods discussed above for more refined details. While vouching refers to the process of tracing back information from the final accounts to the original documents, tracing tracks information from the source to the final accounts. This method is mostly used where it is suspected that the final accounts have been manipulated to omit some transactions so as to hide misappropriation or other illegal actions. The Enron Case Study A well publicized case of unearthed fraud is the Enron scandal.
Enron, a giant multinational company mostly dealing with energy, electricity, natural gas and broadband services at the time had taken to manipulating its stock prices by presenting accounts that did not reflect the actual position of the company. According to Fusaro and Miller (16-26), the Houston, Texas based company was getting its revenues and profits from its special purpose entities (A special purpose entities or SPEs as they are normally referred to are offshore entities or partnerships that companies create to help them in improving the business profitability and in avoiding taxes).
These entities gave the management an opportunity to easily move currency and provided them full anonymity. The money was used to conceal Enron’s losses which were escalating by the day in order to protect the company’s image in the eyes of the shareholders. The accounts therefore created an illusion of profits that kept the stock prices rising and the management was able to attract investors and keep the reputation of the company high. Investigation into the fraud started in September shortly after the Chief Executive Officer; Jeffery Skilling quit citing personal reasons.
The company’s internal auditors headed by William Powers had conducted an internal investigation starting February which indicated that Enron executives had indeed doctored the reports. SEC and the Financial Accounting Standard Board were the major external investigator into the Enron case even though other organizations took part in the investigations. These included the U. S department of justice, the congress and the white house. The SEC investigated the company and its partnerships to establish how this complicated accounting malpractice had been operating.
The accounting standards board sought to establish the use of accounting standards and the company violations of GAAP (Generally Acceptable Accounting Principles). There can be no specific method that can be identified as having used to investigate the Enron case because in order to unravel the extent of the fraud, investigations had to be conducted from all angles. However most prevalent was examination and probing. Considering that this was a case of litigation more than just auditors participated in the investigation. Forensic auditing was highly incorporated as the executives had to appear in court as from December.
The SEC appointed auditors to go through the books of accounts and financial statements to establish their authenticity before questioning the executives and accountants. The Financial Accounting Standards Board was keen to do thorough comparison of the company’s methods of recording income to establish how the executives were using to conceal their losses. Results showed that after taking part in various complicated deals, the company was deep in debt but continued to conceal this through partnership profits (Fusaro and Miller, 69-74).
The company was out rightly deceiving the public into believing that it was doing quite well and the constant manipulations in the profits meant to push the stock prices up helped in justifying their cunning act. Apart from finding out that the company was using these partnerships to hide their losses, numerous instances of financial fraud by the executives of the company was evidenced including mail fraud, wire fraud, securities fraud and money laundering (Los Angeles Times, 11: Spiegel, 22).
The employees retirement benefit funds which had been invested in stocks left them destitute as more than $ 800 million in 401 (k) savings were lost when the company was declared bankrupt. In November 2002 the company admitted to having manipulated the financial statements since 1999 and issued the correct figures showing that the company’s loss since then had been $586 million and it had not been making huge profits as earlier reported. The company was also highly indebted and there was a debt of $690 million due by the end of November (BBC, 12).
Conclusion It can be deduced from the above discussion that all of these investigative methods aim at one objective: detecting fraud. Another similarity is that all of them rely on financial records maintained by the company in different forms to perform their investigation. What varies is the approach that they use to come up with their conclusions. While the each has its advantages and disadvantages, the auditor gets to choose the one that he feels is most suited for his investigation.
For example, where an irregularity is reported on one side of the financial statements lets say the purchases versus the sales, data mining could be used by checking original receipts and invoices then compare them to the reported sums. Where the data is consistent, audit software could come in handy. No organization is immune to fraud as indicated by Enron which in the eyes of the public was the most profitable and well organized company. As indicated by Enron’s case, a company and its shareholders stand to lose once fraud is discovered.
The company led to huge losses for the company’s shareholders as well as the employee’s retirement savings. The company eventually went bankrupt in the wake of the scandal. The cause of this kind of fraud may not have been possible to understand were it not for the involvement of auditors to investigate the case. Fraud in auditing remains an important process that should not be overlooked by any company if they are to avoid losses caused by fraudsters. (Word Count: 3947) Works Cited Albrecht Goss.
Fraud Examination and Prevention. New York: Phoenix Educational Publishing, 2008. BBC. (2002). Enron: The Rise and Fall. Retrieved on May 9, 2009 from http://news. bbc. co. uk/hi/english/static/in_depth/business/2002/enron/timeline/1. stm Drake, Williams. Investigating fraud: Best Practices and Audit procedures. London: SAGE, 2003. Fusaro Peter & Miller Rose, What Went Wrong at Enron: Everyone’s Guide to the Largest Bankruptcy in U. S. History . New York: Wiley, 2002 Houck Max, et al.
Forensic Accounting as an Investigative Tool. Retrieved on May 9, 2009 from http://findarticles. com/p/articles/mi_qa5346/is_200608/ai_n21396631/ Los Angeles Times. Enron Gets Zapped by its Own Greed. Los Angeles Times, November 30, 2001. Spiegel, P. Fastow Points Finger at Enron Officials. Financial Times, March 20, 2002. Winn Thomas Jr. Data Mining at the Texas State Auditor’s Office. Retrieved on May 9, 2009 from http://www. scsug. org/conferences/two-day/PDF/WinnTom_DataMining. pdf