Monday, January 22, 2007

PCAOB Details Auditor Duties Regarding Fraud Detection

By James Hamilton, J.D., LL.M.

A PCAOB report based on inspection results found that a number of outside auditors use a check-the-box approach to fraud detection. While checklists can be useful tools for identifying fraud, noted the Board, mechanical implementation of the relevant auditing standard is unlikely to be very effective in detecting fraud. According to Chairman Olson, the report is a constructive way to remind all auditors of what the Board's standards require of them in these areas. He urged careful attention to these requirements as crucial to best positioning auditors to detect material misstatements caused by fraud.

The interim auditing standard with respect to the consideration of fraud in a financial statement audit is AU §316, which was a pre-existing standard adopted by the Board on a transitional basis. The report is extensively based on Board inspection observations and does not reflect any determinations by the Board as to whether any firms or persons have engaged in any conduct for which the Board could sanction them.

The report contains solid Board advice on fraud detection. For example, the auditor's planning should include consideration of how the financial statements might be susceptible to fraudulent misstatement and how management could conceal fraudulent financial reporting. The Board also advised the audit team to hold brainstorming sessions to discuss those issues in order to be aware how fraud might be perpetrated and concealed.

The Board is fully aware that fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively. To address the risk of management override, the Board urged auditors to examine journal entries for evidence of possible fraudulent misstatements and review accounting estimates for biases that similarly could result in such misstatements.