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Section 1. Accounting
Ms C., Ikbale Tota, "Aleksander Moisiu" University, Dunes, Albania E-mail: i.tota@yahoo.com
THE HISTORICAL RELATIONSHIP BETWEEN AUDIT PROFESSION AND FINANCIAL FRAUD DETECTION
Abstract: This paper is a historical review of the changes that have taken place in audit objectives and techniques, shifting the audit profession toward Forensic Accounting Investigator. We focus mainly on the relationship concerning the ability of these professions to detect and disclose financial fraud. Keywords: Audit; Fraud; Financial Information; Forensic Accounting.
1. History of audit profession related to fraud
Auditing, like all professions, exists to satisfy a need of society. It is, therefore, to be expected that auditing change as the needs and demands of society change [1]. Many of the standards and significant events in the history of the audit profession and public accounting, in particular, are related to a fraud. The opportunities to engage in financial statement fraud are higher during economic downturns, as many companies seek to reduce costs and compromise investment efforts in internal controls, governance mechanisms, and risk management. During financial crises and economic meltdowns, the focus on financial statement fraud prevention and detection is more important than ever, as investors, regulators, and companies seek a better understanding of corporate malfeasance and misconduct [2].
1.1 Period pre -1920
Fraud in one form or another has been a fact of business life for thousands ofyears. In Hammurabi's Babylonian Code of Laws, dating to approximately 1800 B.C.E., the problem of fraud is squarely faced: "If a herdsman, to whose care cattle or sheep have been entrusted, be guilty of fraud and make false returns of the natural increase, or sell them for money,
then shall he be convicted and pay the owner ten times the loss. "Hammurabi's Code of Laws (1780 BCE), L. W. King, trans. The earliest lawmakers were also the earliest to recognize and combat fraud [3].
The greatest financial debacle in history was perpetrated in the 1700s. "The South Sea Bubble" scandal in 1720 caused the loss of over $500 billion translated to today's dollars. It took over 300 years to beat that record but is quite obvious that the 21st century has made its mark with fraud and the collapse of major companies that have for decades graced the pages of business magazines [4].
During the pre-1844 period, the main audit objective was the detection of fraud [1]. In the early years of the auditing profession, from 1850 through the early 1900s, the primary purpose of the audit was to detect fraud errors, and international misstatements [2]. The share market was unregulated and highly speculative, and the rate of financial failure was high. At this time, liability was not limited and the treatment of debtors, including innocent investors who became debtors when 'their' business venture failed, was very harsh. Given this environment, it was clear that the growing number of small investors needed some protection [1]. The Industrial Revolution and the substantial
growth in public companies and their transactions caused a shift away from verifying all business transactions in order to discover fraud to determining the fair presentation of financial statements [2].
The main audit objectives were: the detection of fraud and error and the proper portrayal of the company's solvency (or insolvency) in the balance sheet. Corresponding with the primary audit objective of detecting fraud and error, auditing procedures from 1844 to the 1920s involved close examination of the accounting entries and related internal documentary evidence, and detailed checking of the arithmetical accuracy of the accounting records. However, towards the end of the period, judgments by the courts made it clear that auditors were required to do more than merely check the company's books and records. The balance sheet was regarded as a private communication between the company's management and its shareholders. Indeed, there was much debate in accounting circles about the auditor's report on the balance sheet. The Act only required that the report be read at the shareholders' annual general meeting and many professional accountants apparently thought it was wrong to also attach it to the published balance sheet. They feared that the auditor might have something to say in the report which, should it become public knowledge, might be injurious to the company [1]. 1.2 Period 1920-1990
During 1920s-1990 periods the Centre of economic and auditing development shifted from the UK to the USA. Auditing changed in four main ways. These are as follows:
a) Development of sampling techniques: As companies grew in size, the volume of transactions in which they engaged made it progressively less feasible for auditors to check in details all of the entries in the accounting records;
b) Increased emphasis on external audit evidence: new emphasis was given to the physical observation of assets such as cash and stock and to the use of external evidence (for example, confirmation of debtors);
c) Auditing the profit and loss statement: As return on investment became the factor of prime importance for investors, and as companies' stakeholders focused their attention on receiving adequate compensation for their contribution to joint performance, so the emphasis of financial statement users shifted away from the balance sheet and ideas of solvency, towards the profit and loss statement and ideas of earning power.
Change in audit objectives: The focus of auditing shifted away from preventing and detecting fraud and error towards assessing the truth and fairness of the information presented in companies' financial statements [1]. Auditors sought to immunize themselves from professional liability by issuing professional pronouncements that minimized or denied professional responsibility for fraud discovery. By the mid-point of the century, authoritative professional pronouncements avoided even using the word "fraud," preferring discreet euphemisms like "irregularities" [5].
1.3 Period 1990 - present
Users of audited financial statements, particularly investors and creditors, traditionally have held independent auditors responsible for detecting financial statements fraud [2]. Financial statement users believe auditors are responsible for detecting and preventing fraud, however, in fact, the responsibility of fraud detection lies upon management and not external auditors. External auditors have a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud The auditing profession has moved from acceptance of fraud detection as the primary purpose to the expression of an opinion on the fair presentation of financial statements during the twentieth century. Recently, the accounting profession has directly addressed the external auditor's responsibility for financial statement fraud detection in its Statement on Auditing Standards (SAS) No. 99 entitled Consideration of Fraud in a Financial Statement Audit [6]. Thus, auditors are not directly responsible for
detecting every fraud in an organization, but only the material misstatements arising from them [7].
In recent years, it has been nearly impossible to open any business newspaper or magazine without seeing headlines relating to various types of corruption. One type of corruption - fraudulent financial statements - has been especially prevalent. Although Europe has experienced several financial statement frauds, by companies such as Parmalat (Italy), Royal Ahold (Netherlands), and Vivendi (France), these frauds have not been nearly as devastating as frauds in the United States, by companies such as Enron, WorldCom, Fannie Mae, Waste Management, Sunbeam, Qwest, Xerox, Adelphia, and Tyco [8]. The appearance of certain business irregularities after the auditor has issued his favorable audit report has led many users to question the validity of the account audit process [9]. "Where were the auditors?" The answer, strangely enough, is that the auditors were too busy auditing to find fraud. But don't blame them, for they were doing only what they were taught. Or, more correctly, not taught [2].
Independent auditors, however, in compliance with their professional standards, provide only reasonable assurance that financial statements are free of material misstatements, whether caused by error or fraud [2]. External auditors play a crucial but a secondary role in fraud detection. They are not guarantors of the accuracy or the reliability of financial statements but they are only responsible for giving a reasonable assurance that the financial statements are free from material misstatements whether caused by errors or fraud [10]. The primary role in fraud detection lies in the company's management. This does not mean, however, that external auditors should exert less effort in fraud detection [7]. The financial statements are management's responsibility. The auditor's responsibility is to express an opinion on the financial statements [3]. External auditors are not required to uncover all instances of fraud that might be occurring, as this would be an onerous and nearly impossible task [11].
1.2 The expectation gap in auditing
As we noticed from the history of audit related to fraud, the auditing profession has responded to the expectations all the parties had by expanding their responsibility in performing an audit. Business failures are interpreted to be an audit failure.
Current auditing standards require that independent auditors provide reasonable assurance that the financial statements are free from material misstatements, whether caused by error or fraud, in order to render an unqualified (clean) opinion on the financial statements. This reasonable assurance is regarded as a high level of assurance but not absolute assurance. Reasonable assurance may mean different levels of assurance for different groups [2]. The expectation gap exists when auditors and the public hold different beliefs about the auditors' duties and responsibilities and the messages conveyed by audit reports. Apparently, there is a gap between what the public expects and what it actually gets [12]. The user of the financial information of a going concern expect that the entity's financial information is correct, true and sufficient, and therefore financial information users have a series of very specific expectations regarding the account audit task [9]. An auditor conducting an audit in accordance with ISAs is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by error or fraud [11].
Today auditor's responsibilities are to provide reasonable assurance about fairness in financial reporting rather than detecting fraud. This notion of reasonable assurance has widened the gap between society's expectations of auditors and auditors' responsibilities and performance. In the auditing profession, the so-called expectation gap is the difference between (a) what the investing public and other users of audited financial statements believe auditors' responsibilities are and (b) what auditors are willing to assume as responsibilities according to their professional standards. For example, the public desires to hold auditors responsible for all fraudulent activities involved
in public companies' financial reports; auditors, however, only provide a reasonable assurance that financial statements are free from material misstatements, whether caused by error or fraud [2].
The appearance of certain company irregularities after the auditor has issued a favorable audit report has called the audit activity into question and has led to doubts about whether audit tasks are carried out adequately [9]. The auditing profession has asserted that the expectation gap, and its related effects on auditor legal liability, has been caused by diverging perceptions by the auditing profession and third-party litigants regarding the profession's role, responsibilities and related performance [13].
Given the current situation, it is likely that the audit expectation gap will continue to be a major concern for many more years to come [12]. Even though additional research has been performed related to the problems of financial statement fraud since the late 1980s, there still remains a paucity of empirical evidence about the problem of financial statement fraud. Much of that limitation is due to the lack of available relevant data related to actual instances of financial statement fraud. Much of the needed data are not available in public documents, and access to confidential information is generally restricted due to the sensitive nature of fraud investigations and related litigation [14].
References:
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5. Gray O. R., & Moussalli S. D. Forensic Accounting and Auditing united again: A Historical Perspective. Journal of Business Issues, I. 2006.
6. AICPA. Statement on Auditing Standards No. 99: Consideration of Fraud in Financial Statement Audit. American Institute of Certified Public Accountants. 2002. Available at URL: http: www.aicpa.org/ donload/auditstd/summarysas99.doc
7. Kassem R., & Higson A. Financial Reporting Fraud: Are Standards' Setters and External Auditors doing enough? International Journal of Business and Social Science, 3. 2012.
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9. Saladrigues R., & Grano M. Audit expectation gap: Fraud detection and other factors. European Accounting and Management Review. 2014.
10. AICPA in SAS No.1. American Institute of Certified Public Accountants. Available 1997.
11. ACFE. Fraud Examiners Manual 2014 International Edition. Association ofCertified Fraud Examiners. 2014.
12. Koh H. C., & Woo E. S. The expectation gap in auditing. Managerial Auditing Journal. 1998.
13. Lowe J. The expectation gap in the legal system: Perception differences between auditors and judges. Journal of Applied Business Research. 2011.
14. Beasley M. S., Carcello J. V., & Hermanson D. R. (1999). Fraudulent Financial Reporting: 1987-1997 An Analysis of U. S. Public Companies. Research Report, Committee of Sponsoring Organizations of the Tread way Commission (COSO).
