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Fraudulent financial reporting: the role of auditors

13 March 2020: a new ICAEW report argues that auditors play a significant role in detecting and preventing fraud and sets out recommendations for how to do this.

The collapse of several high-profile companies last year not only eroded trust in the audit profession, it also led to increased scrutiny. ICAEW’s Audit and Assurance Faculty’s latest publication 'Fraudulent financial reporting: fresh thinking' provides some recommendations and encourages further debate to tackle fraud.

While fraud by its very nature is hidden and harder to detect than other irregularities affecting the financial statements, auditors are well placed to use their skills and insights to identify fraudulent financial reporting. Auditors are experts in financial reporting, but their work also involves interacting with many different and sometimes difficult personalities. They observe how people respond to challenge and gain first-hand experience of the culture of a company.

Therefore, auditors are able to routinely look beyond the numbers and use these behavioural and cultural insights to help the company identify areas that may be vulnerable to fraud. This ultimately helps the company to prevent it or detect it if it has already occurred.

The report identifies four key areas to which auditors should pay particular attention:

  1. Organisational culture: auditors can observe the organisational culture to get a detailed understanding of how employees behave and communicate in the business.
  2. Management style: a lot can be deduced from observing the management style in terms of what tone is set at the top by senior managers and directors.
  3. Motivations and pressures: auditors are advised to pay attention to what motivations and pressures can be observed. It will help them to gain insight into what factors might drive relevant individuals to manipulate the numbers.
  4. Behavioural controls: it’s important to get a better understanding of the behavioural controls that may be in place – how does a company promote a culture of honesty and openness?

The full report is part of the faculty’s 'Thought Leadership series on the future of audit'. This series aims to contribute to the next stage of audit reform, which is likely to see intense discussion about the challenges of achieving clear and decisive progress in an area that has arguably little positive to show for many years of debate.

In his recent report on audit quality and effectiveness in the UK, Sir Donald Brydon described the question of fraud as “the most complex and most misunderstood in relation to auditor’s duties”. He set out a number of recommendations in this area including his proposal for a new audit profession. This would introduce auditor training in fraud awareness and forensic accounting so auditors “learn to be able to apply the same mindset as do forensic accountants in relevant circumstances”.

As Nigel Sleigh-Johnson, Head of ICAEW’s Audit and Assurance Faculty, adds: “improving the effectiveness of audit in relation to fraudulent financial reporting will do much to restore trust in the profession. Sir Donald Brydon identified fraud as one of the most complex areas of audit, and our report suggests ways in which auditors can rise to the challenge. We welcome further insights from members and, in particular, examples of ways the challenges are being addressed in practice by firms of all sizes”.

ICAEW will contribute in due course to the expected BEIS consultation on how best to take forward these and other ideas set out in the report.