How to Lessen the Risk of Financial Reporting Fraud

Apr 4th 2017
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A new report published by the Center for Audit Quality (CAQ) essentially is a primer on how to prevent financial reporting fraud and stay out of trouble when handling the most complicated accounting issues. Except that the target audience should certainly know how to stay out of trouble, right? But knowing and doing are two different things.

Addressing Challenges for Highly Subjective and Complex Accounting Areas offers findings and recommendations gleaned from workshops hosted by the Anti-Fraud Collaboration, whose members include the CAQ, Financial Executives International, National Association of Corporate Directors, and the Institute of Internal Auditors.

The main objectives of the workshops were to facilitate discussions on the effectiveness of accounting policies centering on highly subjective, complex accounting areas, as well as on internal controls over financial reporting (ICFR) design and effectiveness.

At every step of the way, it was made clear to workshop attendees that they – the gatekeepers – are integral to preventing fraud.

Margaret McGuire, chief of the US Securities and Exchange Commission (SEC) Enforcement Division’s Financial Reporting and Audit (FRAud) Group, made that abundantly clear in this statement: “In every investigation we embark on related to financial reporting, issuer disclosure, and audit failure, we always look at the gatekeepers – board of directors, audit committees, external auditors, even external consultants – and what they did, what they knew, and how they documented it. The role of the gatekeeper should be in all capital letters because it’s a hugely important role. Ideally, that gatekeeper is coming out on the side of assisting the SEC staff in its investigation, as opposed to being a focus of it.”

Representatives of the SEC FRAud Group, SEC Office of the Chief Accountant, and the Public Company Accounting Oversight Board (PCAOB) Division of Enforcement and Investigations described how they work and emphasized that they work together.

Accounting areas that SEC enforcement actions target are revenue recognition, expense recognition, valuation issues, asset impairments, and earnings management. Revenue recognition and valuation issues were common among enforcement actions that identified ICFR.

Here’s a snapshot of recommendations:

  • Accounting policies must adhere to technical accounting guidance. Nonaccountants “who may not be conversant in the nuances of technical accounting” must understand those policies.
  • Processes and policies must be married.
  • Test policies first, and then monitor them.
  • Revenue recognition policy should be “granular because even slight differences in interpretation can have a major impact,” the report states.
  • Standardize contract terms and ensure that they reflect how transactions relate to revenue recognition requirements under US GAAP.
  • Deviations from typical contract terms that can affect revenue recognition should be documented and approved by senior managers.
  • Regulators give “substantial credit” to self-reporters who provide “extraordinary cooperation” to SEC investigators. The PCAOB views external auditors the same way.
  • The SEC is paying close attention to the reporting of non-GAAP measures. “Companies should be aware of the exposure they have from reporting non-GAAP financial measures that do not comply with SEC regulations,” the report states.

Naturally, no fraud-prevention discussion could leave out warning signs. Here are three to ponder that the report indicates are frequently connected to fraudulent journal entries:

1. The characteristics of entries or adjustments made to unrelated, unusual, or seldom-used accounts by people who typically don’t make them, recorded at the end of the period or as post-closing entries with little or no explanation or description, and containing round numbers or a consistent ending number.

2. The nature and complexity of the accounts, meaning that inappropriate journal entries may be made to accounts that involve complex or unusual transactions, contain significant estimates and period-end adjustments, have had past errors, contain unreconciled differences or haven’t been timely reconciled in the past, include intercompany transactions, or are “otherwise associated with an identified risk of material misstatement due to fraud,” the report states.

3. Entries or other adjustments processed outside the normal course of business.

The report adds this advisory: “Auditing standards require the auditor to use professional judgment in determining the nature, timing, and extent of the testing of journal entries and other adjustments. For purposes of identifying and selecting specific entries and other adjustments for testing, and determining the appropriate method of examining the underlying support for the items selected, the auditor should consider guidance at AS 2401.61 (previously AU 316.61).”