I am sure you’ve been familiar with the term of financial auditors—those who perform financial auditing task and issue opinion, at the end of the audit process, whether the audited financial statement does or does not contains any material misstatements. How about fraud auditors? What is the different between financial and fraud auditors?
Financial auditing is a wholly different term that needs to be distinguished from fraud auditing—and forensic accounting in general. Therefore financial auditors and fraud auditors are two different specialized-skills and disciplines, in the auditing fields.
As it might very well known, financial auditing typically refers to the process of evaluating compliance of financial information with regulatory standards, usually for public companies, by an external, independent entity. But, in the lexicon of accounting, terms such as fraud auditing, forensic accounting, fraud examination, fraud investigation, and investigative accounting are not clearly defined. Some distinctions apply between fraud auditing and forensic accounting. Fraud auditing involves a specialized approach and methodology to discern fraud; that is, the auditor is looking for evidence of fraud—with a single purpose; to prove or disprove a fraud exists.
Fraud investigation usually encompasses about the same thing as a fraud audit except investigation typically involves a lot more non-financial evidence, such as testimony from interviews, than a fraud audit. So fraud investigation includes fraud audit but goes beyond it in gathering non-financial forensic evidence.
Historically, forensic accountants, however, have been called in after evidence or suspicion of fraud has surfaced through an allegation, complaint, or discovery. Forensic accountants are experienced, trained, and knowledgeable in all the different processes of fraud investigation including. The Association of Certified Fraud Examiners (ACFE) refers to this definition of forensic accounting as fraud examination.
In recent years, the broadest of these terms in the antifraud profession is forensic accounting, which typically refers to the incorporation of all the terms involved with investigation, including fraud auditing; that is, fraud auditing is a subset of forensic accounting.
Before going to overview each of the financial auditors, fraud auditors and forensic accountants, let’s have a look the distinction of financial vs fraud audit.
Financial Versus Fraud Audit
The published Sarbanes Oxley incorporates concepts and procedures to deter and to catch fraud in audits of internal controls over financial reporting. However, the focus of financial audits and financial reporting ultimately is concerned with providing reasonable assurance that a material misstatement to financial statements has not occurred, regardless of the reason.
Many in the public have questioned why financial auditors do not detect more fraud. The general public believes that a financial auditor would detect a fraud if one were being perpetrated during the financial auditor’s audit. The truth, however, is that the procedures for financial audits are designed to detect material misstatements, not immaterial frauds.
While it is true that many of the financial statements and frauds could have, perhaps should have, been detected by financial auditors, the vast majority of frauds could not be detected with the GAAS of financial audits. Reasons include the dependence of financial auditors on a sample and the auditors’ reliance on examining the audit trail versus examining the events and activities behind the documents. The latter is simply resource prohibitive in terms of costs and time.
There are some basic differences today between the procedures of fraud auditors and those of financial auditors.
Fraud auditors look behind and beyond the transactions and audit trail to focus on the substance of the transactions instead. The fraud auditor doesn’t question if there is a prudent internal control in place. It does not question if the accounting process comply with the accounting standard, either. But it rather question about:
- Where are the weakest links in this system’s chain of controls?
- What deviations from conventional good accounting practices are possible in this system?
- How are off-line transactions handled, and who can authorize such transactions?
- What would be the simplest way to compromise this system?
- What control features in this system can be bypassed by higher authorities?
- What is the nature of the work environment?
Another difference is the current status of technical guidance combined with research on frauds. Frauds can be divided into three main categories: (1) financial frauds, (2) asset misappropriations, and (3) corruption (ACFE fraud tree). Financial frauds are typically perpetrated by executive management and average millions of dollars in losses.
According to a recent KPMG Fraud Survey, that average is about $258 million. Generally speaking, therefore, financial frauds are likely to be material, and thus financial audit procedures have the potential to detect them—because they would be a material misstatement, due to a material fraud.
However, those who might be responsible for fraud audits internal to the firm could be constrained or thwarted in detecting the fraud because executives are in a position to hide the fraud or misdirect fraud auditors’ efforts. Cynthia Cooper argues that at WorldCom she was thwarted from doing her job as internal auditor, but she eventually did uncover the financial fraud being perpetrated there.
Next, let’s have a look at financial auditors, fraud auditors and forensic accountants.
The term financial auditor broadly applies to any auditor of financial information or the financial reporting process. The largest classification of financial auditors is those who work for public accounting firms and perform audits of financial statements for public companies. This classification is the most commonly used in this book when referring to financial auditors.
Financial auditors have expertise in their knowledge of accounting and financial reporting (such as in generally accepted accounting principles or GAAP, PCAOB standards, or International Financial Reporting Standards or IFRS), auditing (generally accepted audit standards or GAAS), and how those standards apply to business transactions.
As expressed in the GAAS literature, the most important financial auditing attributes are independence, objectivity, and professional skepticism.
Financial auditors traditionally have been seen as, and to an extent have been, numbers oriented, and their processes have been driven by the audit trail. The financial audit procedures are designed to detect material misstatements, and thus financial auditors focus on misstatements that singularly or in the aggregate are large enough to be material. Fraud auditors and forensic accountants are not constrained by materiality.
The discipline of financial auditing has been thought to be almost a checklist of items to complete. In reality, judgment is crucial in financial auditing and has progressively increased in the direction of more dependence on auditor judgment. SOX requirements involve auditor judgment to a large degree; auditors are to understand processes significant to financial reporting and to evaluate management’s controls over those processes. Additionally, auditors are to consider environmental, including soft, intangible, factors in that evaluation.
Fraud auditors are generally accountants or auditors who—by virtue of their attitudes, attributes, skills, knowledge, and experience—are experts at detecting and documenting frauds in books of records of accounting and financial transactions and events.
The skills fraud auditors require include all of those that are required of financial auditors, plus the knowledge of how to gather evidence of and document fraud losses for criminal, civil, contractual, and insurance purposes; how to interview third-party witnesses; and how to testify as an expert witness.
Fraud auditors must know what a fraud is from a legal and audit perspective, an environmental perspective, a perpetrator’s perspective, and a cultural perspective. They also need both general and specific kinds of experience. They should have a fair amount of experience in general auditing and fraud auditing, but should have industry-specific experience as well (e.g., banking; insurance; construction; and manufacturing, distribution, and retailing).
Fraud auditing is creating an environment that encourages the detection and prevention of frauds in commercial transactions. In the broadest sense, it is an awareness of many components of fraud, such as the human element, organizational behavior, knowledge of fraud, evidence and standards of proof, an awareness of the potentiality for fraud, and an appreciation of the red flags.
In short, fraud auditing is the process of detecting, preventing, and correcting fraudulent activities. While completely eliminating fraud is the goal, it is simply not feasible. The concept of reasonableness is applicable here, and this concept is often associated with the fraud-related fields of financial accounting and auditing. Fraud auditors should be able to thwart a reasonably preventable fraud.
Accounting-type frauds are usually accompanied by the modification, alteration, destruction, or counterfeiting of accounting evidence. But accounting records can be either intentionally or accidentally modified, altered, or destroyed, by human error or omission.
The first objective for the fraud auditor, then, is to determine whether a discrepancy in accounting records is attributable to human error. If it is, there may be no actual fraud. If the discrepancy (missing records, destroyed records, modified records, counterfeit records, errors, omissions) cannot be attributed to accidental or human error, further investigation should follow at an appropriate level.
Forensic accountants may appear on the crime scene a little later than fraud auditors, but their major contribution is in translating complex financial transactions and numerical data into terms that ordinary laypersons can understand. That is necessary because if the fraud comes to trial, the jury will be made up of ordinary laypersons.
Areas of expertise of forensic accountants are not only in accounting and auditing but in criminal investigation, interviewing, report writing, and testifying as expert witnesses. They must be excellent communicators and professional in demeanor.
The involvement of the forensic accountant is almost always reactive; this distinguishes forensic accountants from fraud auditors, who tend to be actively involved in prevention and detection in a corporate or regulatory environment.
Forensic accountants are trained to react to complaints arising in criminal matters, statements of claim arising in civil litigation, and rumors and inquiries arising in corporate investigations. The investigative findings of the forensic accountant will impact an individual and/or a company in terms of their freedom or a financial award or loss. The ACFE refers to this person as a fraud examiner.
The forensic accountant draws on various resources to obtain relevant financial evidence and to interpret and present this evidence in a manner that will assist both parties. Ideally, forensic accounting should allow two parties to more quickly and efficiently resolve the complaint, statement of claim, rumor, or inquiry, or at least reduce the financial element as an area of ongoing debate. Objectivity and independence of the forensic auditor are paramount for these purposes.
Financial auditors are those who perform financial auditing. Fraud auditors are part of the forensic accountants—in broader manner—who have skills, abilities, and knowledge related to the fraud cycle (experts at detecting and documenting frauds in books of records of accounting and financial transactions and events). And, forensic accountants are those who not only expert in accounting and auditing process but in criminal investigation, interviewing, report writing, and testifying as expert witnesses.