Forensics, skeptics and politics.

The need for professional skepticism in auditing is increasingly in vogue, including the use of forensic audit procedures. What is sometimes less touted is the need for professional skepticism by auditors and preparers in reviewing and responding to proposed and existing standards, with an eye toward practical application and meeting the standards' intent.

Forensics 

The Public Company Accounting Oversight Board (PCAOB) convened a panel on Forensic Audit Procedures at its Standing Advisory Group (SAG) meeting held in February. The SAG heard from such experts as Toby Bishop, a partner with Deloitte and former CEO of the Association of Certified Fraud Examiners (ACFE), and other auditors and academics.

Can forensic audits detect fraud? The answer from the SAG panel of experts seemed to be a resounding yes, particularly with respect to "garden variety" fraud--such as employees creating fictitious vendors or purchase orders, or processing payments to a fictitious alter ego.

Bishop was asked by a PCAOB board member if forensic or other audit procedures could eliminate management override through such things as "top-line" journal entries. He replied that forensics is not rocket science--but neither is it a surefire way to detect fraud conducted through management override.

The PCAOB's discussion of forensics was part of its ongoing consideration of how auditors, and audit standards, can help prevent and detect fraud. There is still an "expectation gap" related to the auditors' role in detecting fraud, even under existing standards.

A report issued last November by the CEOs of the six largest global audit firms recommended consideration of forensic audits on an annual, rotational or "choice" basis (i.e., at the option of companies' directors). Performing forensic audits on an annual basis would not necessarily be practical, Bishop noted.

Skeptics

Some SAG members lamented the difficulty in moving auditors from "trusting" their clients (who pay auditors' fees) to having the requisite amount of professional skepticism to consider the possibility that their client--particularly top management--committed fraud.

Others suggested it may be useful to interview psychologists to understand how to get auditors to be able to suspend belief in their clients' honesty long enough to ask themselves (and their client) questions like: If I was going to commit a fraud here, how would I do it? Where are there loopholes or gaps that a fraudster could slip through?

SAG member Lynn Turner of Glass Lewis, former chief accountant at the Securities and Exchange Commission (SEC), suggested that this kind of information is readily available by talking to people who were "really good at [fraud]." One of the best ex-cons--Frank Abagnale, subject of the "Catch Me If You Can" movie and a consultant to the FBI--will speak at FEI's Summit conference in Boston May 20-22.

Politics

Although the need to question the veracity of management and auditors is in vogue, there is another side to such skepticism that is often considered "politically incorrect." That is the need to maintain a balanced view of proposed standards, with an eye toward cost benefits, and in reviewing the effectiveness and efficiency resulting from implementation of existing standards.

Financial professionals are sometimes placed on the defensive when pointing out concerns about proposed or existing standards--such as the PCAOB's definition of "material weaknesses" as being "more than remote" in Auditing Standard No. 2 (AS2), or FASB's "marketplace participants" model requirements for devising "fair values" under "Level 3" or non-market-traded (or illiquid market-traded) instruments.

The views expressed by FEI and other organizations representing management are sometimes positioned by the press under headlines like "Business Wins Its Battle to Ease a Costly Sarbanes-Oxley Rule" (The Wall Street Journal, Nov. 10, 2006). Drawing artificial battle lines may stir the pot, but it clouds the role of FEI, which is more in harmony than might otherwise be apparent with that of the regulators' goal of strong capital markets.

In fact, the views expressed by organizations like FEI are sometimes the "canary in the mineshaft," noting important concerns with likely or actual effectiveness and reliability of reporting under proposed and existing standards.

"Professional skepticism" should be an active, embedded part of implementing and auditing financial reporting standards. Similarly, constructive criticism of proposed and existing standards, such as that conducted by FEI's technical committees, is an important part of the standard-setting process.

Edith Orenstein ([e-mail]) is FEI's Director of Technical Policy Analysis.