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The new fraud detection standard: substance or cosmetics.

The New Fraud Detection Standard: Substance or Cosmetics

In order to set the stage for some critical observations about SAS No. 53, our new fraud detection standard, it is appropriate to briefly revisit the origin of SAS No. 16.

SAS-16 and Its Predecessor


SAS-16 states that it "supersedes Statement on Auditing Standards No. 1, Section 110.05-.08." Two points may be clearly discerned from this section of SAS No. 1. 1. The discovery of fraud was

not an objective of the independent

auditor's examination. 2. An ordinary examination

"cannot be relied upon to

assure its discovery."

SAS No. 1 essentially disclaimed a responsibility for the-detection of fraud in the course of an ordinary examination. However, several significant cases of client fraud, such as Equity Funding and National Student Marketing, plus congressional activities, including the passage of the Foreign Corrupt Practices Act (1977), along with threatening SEC intervention, forced the AICP to behave in the customary reactive mode. They responded with the formation of the Public Oversight Board, the creation of Peer Review and started the SEC Practice Section. The Auditing Standards Executive Committee reacted by issuing several new auditing pronouncements. One of these, SAS No. 16, was apparently intended to expand the accountant's responsibility for the detection of fraud.

The language of SAS-16 was ambiguous. It did not provide adequate guidance and therefore did not meet the needs of the accounting profession or the business community.

Financial fraud was purported to exceed $55 billion in 1982. Congress, through the actions of Congressman John Dingell and Senator Wyden, was preparing to take drastic actions to ensure the safety and integrity of financial reporting in the United States. In fact, in 1987, the New York Times quoted Congressman Dingell as saying that the accounting profession had one year to improve its performance before the government would formally intervene.

"Expectation Gap"


The response by the AICPA was reactive instead of proactive. In simple terms, accountants lived with some inadequate standards until revisions were forced when congressional muggings became imminent. In April 1988, the AICPA issued nine "expectation gap" SASs. Two of these pronouncements, SAS No. 53 and No. 54, dealt specifically with congressional concerns about the detection of financial fraud and the potential illegal activities of audit clients. As noted above, the business community and congressional critics were simply not going to continue to tolerate the perceived passive role of the accounting profession in these areas.

Fraud Detection: Will SAS-53

Make A Difference?

Table 1 presents one view of the perceived changes from the old standards (primarily under SAS 16) to the new standards recently established by the Auditing Standards Board in SAS No. 53.

In superseding SAS No. 16, paragraph 5 of SAS No. 53 formally adds the following:

"The auditor should assess the risk that errors and irregularities may cause the financial statements to contain a material misstatement. Based on that assessment, the auditor should design in the audit to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements."

This is very sound advice. However, based upon previously issued authoritative pronouncements (e.g., SAS-47, Audit Risk and Materiality in Conducting an Audit, SAS-31, Evidential Matter, and SAS-39, Audit Sampling), does anyone who is familiar with the audit planning and development procedures of the larger accounting firms really think this requirement represents a substantive change from existing practice?

The response we received from three firm partners in charge of practice unit audit operations was that their firm's reactions were largely in the semantics of the audit programs and planning meeting agenda to indicate compliance with SAS-53. It was their opinion that no substantive changes would occur in the actual audit procedures or applications. One would logically presume this would generally be the reaction in most of the larger accounting firms.

Audit Planning

The Auditing Standards Board provided some guidance when-they identified and discussed five environmental characteristics which may signal the existence of fraud. These five environmental items were paraphrased by Reinstein and Hansen (1988) as follows: 1. Management characteristics

(e.g., an overly aggressive or

unethical management). 2. Operating and industry characteristics

(e.g., an entity that

operates in a volatile industry). 3. Engagement characteristics

(e.g., a new client with many

significant, unresolved accounting

issues). 4. Account balance characteristics

(e.g., a complex series of

transactions involving cumbersome

calculations that are

subject to judgment). 5. Audit procedure characteristics

(e.g., significant differences

in confirmation replies).

Granted the preceding is sound guidance, however, we must suggest that most SEC Practice Section members and many Private Company Practice Section members will already have these items as part of their annual audit planning materials and as part of their "new client" checklist.

Therefore, these "changes" are largely for cosmetic appearances for many firms with perhaps one exception. It is possible that some of the smaller firms may not have these "new" guidelines formally incorporated into their audit practice materials. Accordingly, there may be some benefit to these guidelines, but on balance it is not likely that a multi-million dollar fraud will be prevented or detected through the application of SAS No. 53 requirements by smaller practice units. To amplify that potential non-effectiveness of SAS No. 53 on smaller firms, one national firm partner suggested that the smaller firms, who often deal with aggressive middle market venture capitalists, may be even more sensitive than national firms to situations where fraud may occur. Thus, the practical utility of the "much more extensive guidelines" provided by SAS-53 is quite debatable.

The Effect of Irregularities

on the Audit Report

SAS-53 requires the auditor to consider the effects any errors or irregularities may have on the audit report and identifies the actions that would be necessary for the auditor to take in a variety of circumstances.

From an operational perspective, it is difficult to expect any practitioner to believe the preceding requirements will impact the nature of the deliberations made by their accounting firm prior to rendering an audit opinion.

Again we have a purported change in our standards which, upon closer scrutiny and logical consideration, is largely cosmetic in nature.

SAS No. 53: Some Positive


There is one facet of SAS-53 that has truly changed the old SAS-16 audit standard and should have a substantive impact on audit practice. This is the area of required communications by auditors upon the discovery of errors and irregularities.

To quote from the standard: "The auditor should assure himself that the audit committee is adequately informed about any irregularities of which the auditor becomes aware during the audit unless those irregularities are clearly inconsequential." (SAS-53, para. 28)

This action will permit the audit committee (or their equivalent) "to make the informed judgments necessary to fulfill its responsibility for the oversight of financial reporting." (para. 28) This definitely expands the auditor's responsibility to communicate significant errors and irregularities relative to the more limited requirements under SAS-16. This difference may be noted as Item 3 in Table 1.


SAS-53 is truly a "perception gap" pronouncement. This statement, along with its eight Valentine's Day relatives issued last year, may bridge some gaps of perception regarding the auditor's responsibility as the attest function is performed.

It is unlikely, however, that SAS-53 will have a material effect upon either the prevention or the detection of fraud by the larger accounting firms. SAS-53 suffers from two of the same ills possessed by its predecessor, while it gives the illusive appearance of expanding the auditor's role in the area of fraud detection. To make these shortcomings apparent, we must ask two provocative questions. 1 Are the required guidelines

and procedures proposed in

SAS-53 newly developed? 2 If these guidelines and procedures

are not new, were they

not being applied prior to

the issuance of SAS - 53?

The latter question suggests one of the real problems faced by accountants. Why were these guidelines and procedures not clearly spelled out a decade ago as a part of SAS-16 when the accountants could have demonstrated innovation? Why did the profession require a decade to recognize a deficient auditing standard? Do we always have to be threatened by external intervention before taking an active role in the progressive development of standards? Must we so often be on the defensive and function in a reactionary mode?

On a more generous note, the new SAS does have some merits. The expanded duty to communicate the discovery of errors and irregularities to the audit committee is a positive step. Also, there will probably be a benefit to some of our smaller firms in terms of quality improvements in audit practice materials. Unfortunately, the economic benefits that should accrue to society and business in terms of material fraud detection and prevention are unlikely to occur as a result of the changes that may be made in the audit practices of smaller practice units.

In closing, one would have to expect the overall benefits to be derived from the issuance of SAS-53 to be minimal to the accountants and to society.
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Author:Madison, Roland L.; Ross, Wayne A.
Publication:The National Public Accountant
Date:Aug 1, 1990
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