Detection of fraudulent financial reporting.

Are internal auditors not spotting red flags?

Internal auditors are responsible for pursuing perpetrators of fraud every day. They always, according to the Institute of Internal Auditors' Standards for the Professional Practice of Internal Auditing, should be alert to the possibility of wrongdoing and have sufficient knowledge to recognize potential fraud. Researchers found company managers sometimes have concerns that may tempt them to pad earnings--for example, improving their bonuses, appeasing shareholders or lienholders or both and attracting potential investors. Our research examined whether internal auditors, as part of their duties, were sensitive to what might signal numbers fudging, especially when they performed analytical procedures.

We asked 127 internal auditors from 38 companies to explain a hypothetical unexpected fluctuation in operating income under various conditions and to assess the chances of fraud. We found internal auditors were more likely to consider fraud when income surpassed, than when it fell short of, expectations. They also bore fraud in mind when debt covenants were restrictive in a situation where income was better than expected. In this circumstance, managers might beef up earnings to maintain a particular ratio of assets to liabilities required by a lienholder. We also discovered internal auditors considered fraud to be even more probable if income surpassed expectations and managers had an earnings-based bonus plan. This was also true in cases when income was more than expected and managers had an earnings-based bonus plan and debt covenants were restrictive.

The practical implication of our findings was that in accordance with standards, internal auditors actually did raise their antennae when presented with specific clues pointing to potential fraud. Internal auditors, therefore, are an asset to those who may need to evaluate and assess the risk of financial-statement tampering.

For the full text of the research paper, see "Factors Affecting Internal Auditors' Consideration of Fraudulent Financial Reporting During Analytical Procedures," Auditing: A Journal of Practice & Theory, March 2001, vol. 20, no 1.

BRYAN K. CHURCH, CPA, PhD, is associate professor, Georgia Institute of Technology, Atlanta. His e-mail address is [e-mail]. JEFFREY J. McMILLAN, PhD, is associate professor, Clemson University, Clemson, North Carolina. ARNOLD SCHNEIDER, CPA, PhD, is professor, Georgia Institute of Technology.