The warning signs of fraudulent financial reporting.

What do auditors believe are the best ways to spot fraud?

One frequently cited cause of audit failure is audit teams' lack of awareness of the warning signs of fraud. If auditors better understood these signs and applied professional skepticism, their risk of not detecting fraud would decrease. To improve their understanding of the signs, auditors may find it helpful to know what other auditors thought was important in alerting them to possible fraud.

This article reports the results of a survey that identifies the perceptions of a group of practicing auditors concerning the relative importance of some commonly cited fraud warnings. The 130 auditors who participated were from several offices of one of the six largest accounting firms. We asked them to rank 30 commonly cited potential warning signs as to their relative importance in spotting fraudulent financial reporting. The exhibit on page 77 lists them in descending order of importance to the auditors.

RED FLAGS

The auditors perceived client dishonesty to be the most important red flag. They also viewed as particularly risky clients that placed undue emphasis on meeting quantitative targets, engaged in opinion shopping and were very aggressive in their financial reporting. In addition, auditors thought a weak control environment to be another very important warning sign.

Overall, the survey's findings are consistent with the results of other research. For example, a study of large and midsize U.S. companies by KPMG Peat Marwick (see "Combating Fraud: Know the Facts," JofA, Sept.95, page 20) revealed the number-one action companies took to reduce fraud was reviewing and improving their internal controls. Thus, corporate America seems to agree that a weak control environment is an important indicator of fraud.

FOLLOWING A PATTERN?

Our survey revealed an interesting pattern: Auditors generally perceived "attitude" factors to be more important warning signs than "situational" factors. For example, dishonest, hostile, aggressive and unreasonable management attitudes were considered more significant than economic conditions and adverse environmental or industry conditions. These auditor perceptions are consistent with several academic studies that found closer links between attitude factors and the occurrence of fraud than between situational factors and fraud.

IMPLICATIONS FOR AUDITORS

Auditors are justifiably concerned about their potential legal liability for failing to detect fraudulent financial reporting in audit engagements. The auditing standards issued in the late 1980s to reduce the "expectation gap" between the services CPAs perform and those clients believe CPAs provide increased auditors' responsibilities and the risks they face. While Statement on Auditing Standards no. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, directed auditors to do more work to uncover potential fraud, it did not provide as much specific guidance as auditors might like. For example, while SAS no. 53 lists a number of warning signs auditors might consider in assessing the risk the financial statements are materially misstated, it does not provide operational guidance on how to use these signs.

Our survey provides evidence about risk factors that a sample of auditors considered to be key signs of fraudulent financial reporting. While auditors should not use this evidence exclusively or apply it in a mechanical way, they can use the results as a starting point in their initial assessment of the risk of fraud in a particular audit situation. For example, auditors might construct a checklist of the most highly ranked warning signs to guide their preliminary review' of a potential client or in their engagement planning. Use of such a checklist could help increase consistency in implementing auditing standards by ensuring auditors do not overlook the fraud risk factors generally considered to be most important. If many of the most significant signs are present in a specific setting, auditors should be more vigilant. Auditors also should use professional judgment in considering the possibility of combining important risk factors rather than just considering them individually.

The American Institute of CPAs auditing standards board has acknowledged the need for increased operational guidance on financial statement audits and fraud. The May 1996 exposure draft, Consideration of Fraud in a Financial Statement Audit, reaffirms and clarifies the auditor's responsibilities. It also provides guidance on how to document the risk assessment process and how to respond appropriately to the assessed level of risk. The ED lists 38 examples of factors auditors might wish to consider ill assessing fraud risk. However, as in SAS no. 53, the ED does not give any indication of the relative importance of the factors. Given the current state of knowledge about such matters, it is logical not to include such guidance. However, the ASB does call for additional research, communication, training and education about fraud risk factors. The evidence from our survey is a first step in this process.

WHAT'S REALLY IMPORTANT

Knowing the most important warning signs should help auditors do a better job of assessing fraud risk. While current and proposed auditing standards require auditors to make this assessment, they do not provide guidance on the relative importance of particular signs. By seeing which factors other auditors considered to be the most important, practicing auditors can assess the risk of fraud in their own audit engagements more efficiently and consistently. EXECUTIVE SUMMARY

* WHILE EXISTING AUDITING STANDARDS require auditors to do more work to uncover potential frauds, they do not provide as much specific guidance as auditors would like. Statement on Auditing Standards no. 53 and the recent exposure draft on fraud list warning signs auditors might consider, but do not indicate their relative importance.

* THE LACK OF AWARENESS OF THE WARNING signs of fraud is a frequently cited cause of audit failure. If auditors better understood the signs and applied professional skepticism, they would decrease their risk of not detecting fraud.

* A SURVEY OF 130 AUDITORS ASKED THEM to rank 30 commonly cited warning signals of fraud according to their relative importance. The auditors ranked client dishonesty, as the most important factor.

* THE SURVEY REVEALED AN INTERESTING pattern. Auditors generally perceived "attitude" factors to be more important warning signs of fraud than "situational" factors.

VICKY B. HEIMAN-HOFFMAN, CPA, PhD, is associate professor of business administration at the Katz Graduate School of Business, University of Pittsburgh. KIMBERLY E MORGAN, CPA, is a PhD candidate at the University of Pittsburgh. JAMES M. PATTON, CPA, PhD, is professor of business administration at the Katz Graduate School of Business.

Auditors' Rankings of the Relative Importance of Fraud Warning Signs Auditors' rankings' Fraud warning signs

1 Managers have lied to the auditors or have been overly evasive in response to audit inquiries.

2 The auditor's experience with management indicates a degree of dishonesty.

3 Management places undue emphasis on meeting earnings projections or other quantitative targets,

4 Management has engaged in frequent disputes with auditors, particularly about aggressive application of accounting principles that increase earnings.

5 The client has engaged in opinion shopping.

6 Management's attitude toward financial reporting is unduly aggressive.

7 The client has a weak control environment.

8 A substantial portion of management compensation depends on meeting quantified targets.

9 Management displays significant disrespect for regulatory bodies.

10 Management operating and financial decisions are dominated by a single person or a few persons acting in concert.

11 Client managers display a hostile attitude toward the auditors.

12 Management displays a propensity to take undue risks.

13.5 There are frequent and significant difficult-to-audit transactions.

13.5 Key managers are considered highly unreasonable.

15 The client's organization is decentralized without adequate monitoring,

16 Management and/or key accounting personnel turnover is high.

17 Client personnel display significant resentment of authority.

18 Management places undue pressure on the auditors, particularly through the fee structure or the imposition of unreasonable deadlines.

19 The client's profitability is inadequate or inconsistent relative to its industry.

20 The client is confronted with adverse legal circumstances.

21 Management exhibits undue concern with the need to maintain or improve the image/reputation of the entity.

22 There are adverse conditions in the client's industry or external environment.

23 Accounting personnel exhibit inexperience or laxity in performing their duties.

24 The client entered into one or a few specific transactions that have a material effect on the financial statements.

25 Client management is inexperienced.

26.5 The client is in a period of rapid growth.

26.5 This is a new client with no prior audit history or insufficient information from the predecessor auditor.

28 The client is subject to significant contractual commitments.

29 The client's operating results are highly sensitive to economic factors (inflation, interest rates, unemployment, etc.).

30 The client recently entered into a significant number of acquisition transactions.

' Auditors' Rankings are based on the average of the ranks assigned by the participants in our study, Rank 1 is most diagnostic; 30 is least diagnostic.