Don't expect too much from auditors - they're watchdogs, not bloodhounds
Alarm bells tend to ring when a company is given a clean bill of health by auditors and then suddenly becomes accused of accounting fraud. Those who follow and use financial statements - such as investors, analysts, credit agencies and creditors - rely on auditors to keep tabs on the accuracy of companies' accounts.
Contrary to what many investors may believe, however, detecting fraud is not the key responsibility of auditors. It is the management's responsibility to ensure that financial statements are prepared properly and any fraud is detected. This is of little use if management itself is committing fraud.
Misstatements may be a result of error or fraud. Errors are not so hard to spot. Fraud, on the other hand, exploits weaknesses in accounting and internal control systems. It is usually well concealed and, therefore, difficult to detect. In addition, as management makes many judgments and estimates (such as determining the value of illiquid assets and provision of bad debts) in preparing the accounts, there are opportunities to window-dress financial statements.
The auditors' job is merely to provide a check on management by expressing an opinion as to whether the financial statements present a 'true and fair' view of a company's affairs. Simply put, they have to ensure that the financial statements are prepared in accordance with the relevant accounting standards and do not contain material misstatements (those large enough to make a difference to decision making by an investor).
However, in arriving at their opinions, auditors are required to perform their work in such a way that they will have a reasonable, not absolute, chance of detecting fraud. So, an auditor will not be legally liable for failing to spot material misstatements resulting from fraud, as long as he can prove that he has undertaken reasonable procedures in trying to detect it.
You may think auditors are let off lightly. But businesses generate large numbers of transactions and documents, and it is not possible for auditors to go through every transaction. It would be too costly for the company if they did. So auditors usually check by sampling and focus on the largest items.
Businesses have grown more complex, too, spanning different jurisdictions and regulations, and are involved in an ever-increasing array of business, transaction and financing structures (off balance sheet financing, derivatives, and so on).
Management and employees are intimately involved in the day-to-day affairs of their business, while auditors are on a client's premises for only a few weeks or months a year. It is unrealistic and unreasonable to expect auditors to be as knowledgeable as their clients.
As such, in doing their job, auditors are heavily reliant on management, who could potentially mislead them. To cover themselves, auditors obtain a letter from management testifying that the financial statements are fairly stated.
Fraud, by its nature, is difficult to detect. Balance sheet items are confirmed with independent third parties such as banks, suppliers and customers. However, collusion could have taken place with such third parties to forge bank statements or confirmations.
Sales could be fabricated by invoicing seemingly unrelated companies, who would then duly confirm the balances. An employee could also go under the radar screen to siphon off immaterial amounts of cash from a large number of accounts.
Given such uncertainties, it is difficult for auditors to provide an absolute assurance that financial statements are free of material misstatements.
Good auditors are in short supply and highly sought after, resulting in rising salaries and greater staff turnover. Many junior staff performing the critical fieldwork often lack the experience to uncover fraud and are unfamiliar with the companies they are auditing.
So what is the value of an audit? Auditors would argue that the fees they receive are barely commensurate with the scope of their responsibilities. If a higher standard or larger scope of work was required of them, audit fees would have to increase accordingly.
Many companies view auditing as a necessary regulatory evil and an unnecessary cost to be minimised.
Auditors like to say their role is that of a watchdog (who barks when they see something suspicious) rather than a bloodhound (who actually searches for something suspicious).
So beware next time you pick up a set of financial statements with a spotless audit opinion. It does not guarantee a clean bill of health.
Khor Un Hun is a former investment banker with extensive experience in advising on mergers and acquisitions and fund-raising in Asia