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.