It's Time to Go on the Offensive.

Like a punch-drunk fighter, America's audit industry is struggling to its feet amidst a barrage of criticism. The SEC, the press, and a horde of shareholders' attorneys have all taken a swing.

This summer we listened to a contrite former executive describe the "culture of fraud" that flourished for 12-plus years in what is now the Cendant Corp. We could list other cases, but the point is the same. Unless auditors do something decisive, the whole profession is going to the mat.

As chair of the Association of Certified Fraud Examiners, I've watched the latest round of financial bloodbaths with dread. For too long now, we've hung back, allowing our critics to set the pace. In looking at the development of auditing standards in this century, we find the most significant advances have been forced on us by criminal circumstances.

SWEDISH MATCH KING

In 1932, Congress debated what to do about a worsening economic depression. Many leaders argued that intervening in the capitalist system would plunge the country deeper into the abyss. They pointed out that Ivar Kreuger, a Swedish-born tycoon who built his worldwide empire selling matches, was supporting a number of European governments with loans from his private treasury. Time magazine ran Kreuger's picture on its cover Thursday, Oct. 28, 1929, the day before Black Friday. Inside, Time writers praised Kreuger, popularly known as "The Swedish Match King," for keeping his head in difficult days.

Then, in March 1932, Kreuger put a bullet through his brain in a Paris apartment. A post-mortem of his ledgers showed Kreuger had used accounting tricks, shell companies and psychological bully tactics to simulate the activities of a thriving multinational corporation. Losses to American investors exceeded $500 million.

The Kreuger debacle was taken up by critics of capitalism like Sen. Huey P. Long, who revealed that no one at the New Yorkbased audit firm handling Kreuger's business had ever personally examined the books of the Swedish Match Co. Instead, the auditors received an annual report on the Swedish operation, prepared by Kreuger himself, and accepted the numbers without question.

Kreuger's infamy as the dark prince of capitalism helped ensure the passage of the Securities Reform Act of 1934. With relatively minor revisions over the past 66 years, the SRA remains the industry's fundamental regulatory legislation.

The next significant revision to auditing standards was prompted by the suicide of another titan of American business, Philip Musica. Operating under the alias of Dr. Frank Donald Coster, the Brooklyn native used his profits from bootlegging to gain control of McKesson & Robbins Pharmaceuticals, still a thriving enterprise today.

Like Kreuger, Musica used fraud to counter the squeeze of the Depression. Wielding nothing but pen and ink, he created a booming business in crude drugs, the raw materials used to manufacture pharmaceuticals. After prospering for 10 years, Musica was undone when his company treasurer discovered that the crude drug operation--boasting nearly $20 million worth of assets--was entirely faked.

McKesson & Robbins Canada had been audited year after year, but no one ever questioned the operation's legitimacy. At that time, auditors were not required to examine the physical inventory of their clients. As long as the books balanced, auditors signed off with a smile.

Like Kreuger, Musica ended his life when his tricks were discovered, in December 1938, just a year after the Republican party had begged him to run for president. Following Musica's demise, the auditing standards-setters declared that an audit ought to include an inspection of a company's physical assets.

The Auditing Standards Board, feeling the pressure from disgruntled investors, took a jab at the problem of fraud in 1996, with their Statement on Audit Standards No. 82. But the measure did not go much further than recommending that fraud be considered in an auditor's risk assessment.

POB RECOMMENDATIONS

Now comes the Public Oversight Board's Panel on Audit Effectiveness. The POB's report, issued Sept. 7, finds that while most audits are conducted honorably, a spate of high-profile failures has given the profession a black eye.

In its primary recommendations, the POB suggests including a "forensic-type phase" in each audit and that auditors receive antifraud training. The forensic-type phase would involve testing high-risk areas of a company's financial statements for signs of fraud. It would also require certain members of management, their customers and their vendors to provide written statements about their knowledge of fraud in the company.

I'm pleased by the second of the POB's recommendations. I hope that the audit profession will lead the way to making the POB's recommendations into a standard. Every auditor ought to look for fraud. Every auditor ought to be required to learn about fraud. It's our best defense.

Joseph T. Wells, CPA, CFE, is founder and chair of the Association of Certified Fraud Examiners and the author of seven books. As a former FBI special agent, Wells investigated white-collar crime.