Understanding Fraud in Audits: Risks and Consequences

Fraud in audits is when an entity is found to have illegally altered financial statements to manipulate its financial health or to hide profit or losses. It is severely punished since fraud undermines the trust that is the bedrock of the global financial system.

Auditing Explained

Auditing is a process of checking the financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are and financial records of a company to ensure accuracy and fair representation. Transactions that are recorded in financial records and compiled in financial statements must provide a fair representation of a company’s actual economic state and its operations.

Financial records are created internally, and therefore, are subject to a high risk of manipulation or fraud from insiders. There are many personal incentives to manipulate these records, and auditing is important to ensure that these records and statements are not misstated.

Under existing auditing standards, auditors are responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether it is caused simply by error or by fraud.

Auditors must obtain reasonable assurance that financial statements are free from material error, and will issue a qualified or clean opinion.

Accounting Fraud Explained

Accounting fraud occurs when an entity, such as a company or government, deliberately falsifies its financial records. Fraudulent behavior is sometimes hard to define within accounting since many components in the financials are based on estimates.

For example, a corporationCorporationA corporation is a legal entity created by individuals, stockholders, or shareholders, with the purpose of operating for profit. Corporations are allowed to enter into contracts, sue and be sued, own assets, remit federal and state taxes, and borrow money from financial institutions. may decide to make an estimate that ends up being revised later. It is not considered fraudulent behavior, as long as the company produced the estimate in good faith by using relevant information at the time of the estimation.

Accounting fraud occurs when deliberate misstatements are made, i.e., a company overstating its assets to make itself appear more financially healthy. Another example is if a company overstates its revenues to make itself appear more profitable than it actually is.

Punishment of Fraud in Audits

In the United States, the Securities and Exchange Commission (SEC) is an independent agency that is tasked with protecting investors and maintaining fair, orderly, and efficient markets. Its role is to ensure public trust within the financial system for publicly listed companies.

Fraud undermines the trust that is required for a well-functioning market economy. If you cannot trust a company’s financial statements, you are unlikely to invest and entrust your hard-earned money to that company.

However, if there is a protective system in place, even if you do not personally know anyone from that company, the fact that you can trust their financial reporting will facilitate your decisions to invest and provide capital.

Auditors are held to the same level of trust as well. If investors cannot trust the auditors who are supposed to be providing unbiased opinions, it will undermine the financial system. Therefore, to have an efficient and transparent market economy, there must be three elements:

1. Rules (accounting standards)
2. Verifiers (auditors)
3. Enforcers (laws and government agencies – SEC)

Example – Enron Scandal

One of the most publicized and famous accounting scandals in the 21^st century involved Enron CorporationEnron ScandalThe Enron scandal is likely the largest, most complicated, and most notorious accounting scandal of all time. Through deceiving accounting tricks, Enron, an American energy company, and Arthur Andersen, formerly one of the Big Five accounting firms.

Enron used accounting loopholes to hide billions of dollars’ worth of debt. Their auditors from Arthur Andersen issued unqualified opinions on Enron’s financial statements even though they were aware of the misstatement. This led to the bankruptcy of Enron and the dissolution of Arthur Andersen.

More strict accounting standards were instituted, and harsher punishments, including the Sarbanes-Oxley ActSarbanes Oxley ActThe Sarbanes-Oxley Act is a U.S. federal law that aimed to protect investors by making corporate disclosures more reliable and accurate., were put in place. The act increased penalties for destroying, altering, or fabricating financial records in federal investigations or deceiving shareholders.

Related Readings

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