Why Auditors Fail to Detect Fraud Presented by: Dennis F. Dycus, CPA, CFE, CGFM AGA – Baltimore Chapter Baltimore, MD May 9, 2012

2 Why Auditors Fail to Detect Fraud Willful Ignorance: If you keep your eyes shut, you won’t see anything! Go in with your eyes wide shut!

3 Why Auditors Fail to Detect Fraud A little history A little history February, 1997 February, 1997 Barry Melancon, President of the AICPA at the ACFE’s Annual Conference in Vegas Barry Melancon, President of the AICPA at the ACFE’s Annual Conference in Vegas FRAUD is a four letter word FRAUD is a four letter word SAS No. 53, Errors and …. SAS No. 53, Errors and ….

4 Why Auditors Fail to Detect Fraud Per SAS No. 82, Consideration of Fraud in a Financial Statement Audit, in the past auditors failed to detect fraud because they did not know what it looked like Per SAS No. 82, Consideration of Fraud in a Financial Statement Audit, in the past auditors failed to detect fraud because they did not know what it looked like And they had not been trained to look for it And they had not been trained to look for it Although introduced with much fan fare, SAS No. 82 did not increase the auditor’s responsibility for the detection of fraud Although introduced with much fan fare, SAS No. 82 did not increase the auditor’s responsibility for the detection of fraud

5 Why Auditors Fail to Detect Fraud For financial statement reporting purposes, it does not matter whether a misstatement is due to an error or fraud For financial statement reporting purposes, it does not matter whether a misstatement is due to an error or fraud But for audit purposes, it’s a huge difference But for audit purposes, it’s a huge difference SAS No. 99 did not increase the auditor’s responsibility for the detection of fraud SAS No. 99 did not increase the auditor’s responsibility for the detection of fraud It did require a significant amount of additional documentation as to how the auditor considered the possibility of fraud in an audit It did require a significant amount of additional documentation as to how the auditor considered the possibility of fraud in an audit

6 Why Auditors Fail to Detect Fraud Fraud takes on the characteristics of its surroundings Fraud takes on the characteristics of its surroundings So what does fraud look like So what does fraud look like Once the AICPA said the F Word (FRAUD), they could talk about it Once the AICPA said the F Word (FRAUD), they could talk about it Prior to SAS No. 82, the only voice in the wilderness was the Association of Certified Fraud Examiners (ACFE) Prior to SAS No. 82, the only voice in the wilderness was the Association of Certified Fraud Examiners (ACFE)

7 Why Auditors Fail to Detect Fraud For the first time, SAS No. 82 required the auditor to inquire of management about the possibility of fraud For the first time, SAS No. 82 required the auditor to inquire of management about the possibility of fraud Also required brainstorming with staff Also required brainstorming with staff Also referred to SAS No. 78, Consideration of Internal Control in a Financial Statement Audit, and the Tone at the Top Also referred to SAS No. 78, Consideration of Internal Control in a Financial Statement Audit, and the Tone at the Top

8 Why Auditors Fail to Detect Fraud In defining internal control, SAS No. 78, breaks it down into five elements In defining internal control, SAS No. 78, breaks it down into five elements The first element is the TONE AT THE TOP The first element is the TONE AT THE TOP All other controls are a function of the TONE AT THE TOP All other controls are a function of the TONE AT THE TOP SAS No. 78, states that …… SAS No. 78, states that …… THE TONE AT THE TOP IS EVERYTHING

9 Why Auditors Fail to Detect Fraud How do you think most frauds are detected? It’s not by the external auditor!

10 Why Auditors Fail to Detect Fraud ACFE’s 2010 Report to the Nations on Occupational Fraud and Abuse Frauds are detected by: 37.8% - Tips (Somebody Knows) 37.8% - Tips (Somebody Knows) 23.0% - Internal Controls 23.0% - Internal Controls 17.1% - Management Review 17.1% - Management Review 9.3% - By accident (Dumb Luck) 9.3% - By accident (Dumb Luck) 4.2% - External Audit (9% in 2008) 4.2% - External Audit (9% in 2008)

11 Why Auditors Fail to Detect Fraud The auditor often fails to consciously decide whether to retain an entity as a continuing client or take a new entity on as a client The auditor often fails to consciously decide whether to retain an entity as a continuing client or take a new entity on as a client Auditors should be very careful about initial impressions Auditors should be very careful about initial impressions Failure to develop and maintain Professional Skepticism Failure to develop and maintain Professional Skepticism

12 Why Auditors Fail to Detect Fraud Professional Skepticism It’s An Attitude

13 Why Auditors Fail to Detect Fraud REMEMBER FRAUD AND STUPID OFTEN LOOK EXACTLY THE SAME

14 Why Auditors Fail to Detect Fraud Failure to know your client Failure to know your client Do you know what a normal/usual transaction is Do you know what a normal/usual transaction is What’s there that should not be there What’s there that should not be there What’s not there that should be there What’s not there that should be there Do you understand the environment your client works in Do you understand the environment your client works in Little things can mean a lot Little things can mean a lot Do you see what you see Do you see what you see Often fraud is right in front of you, just looking at you…. And you don’t see it Often fraud is right in front of you, just looking at you…. And you don’t see it

15 Why Auditors Fail to Detect Fraud Failure to know your client Failure to know your client Do you know what a normal transaction is Do you know what a normal transaction is What’s there that should not be there What’s there that should not be there What’s not there that should be there What’s not there that should be there Little things can mean a lot Little things can mean a lot Do you see what you see Do you see what you see Often fraud is right in front of you, just looking at you and you don’t see it Often fraud is right in front of you, just looking at you and you don’t see it You never know when you may see indications of fraud You never know when you may see indications of fraud

Why Auditors Fail to Detect Fraud Look for things that should be there but are not Look for things that are there but should not 16

Why Auditors Fail to Detect Fraud It’s not what you look at that matters; it’s what you see. Henry David Thoreau 17

18 Why Auditors Fail to Detect Fraud The auditor’s failure to take into consideration who steals ….. The auditor’s failure to take into consideration who steals ….. BASICALLY HONEST PEOPLE The Fraud Triangle

19 Fraud Triangle Need Rationale Opportunity Control Environment

20 Why Auditors Fail to Detect Fraud Failure to take an individual’s lifestyle into consideration Failure to take an individual’s lifestyle into consideration 43% 43% Over reliance on ….. Over reliance on …..DOCUMENTATION The workprogram and the Xerox machine The workprogram and the Xerox machine

21 Why Auditors Fail to Detect Fraud Failure to empower staff ….. Failure to empower staff ….. You won’t find most fraud sitting behind a desk You won’t find most fraud sitting behind a desk Walkn’, Talkn’, Lookn’ and Listenn’ Walkn’, Talkn’, Lookn’ and Listenn’ Someone knows Someone knows Can we talk Can we talk

22 Why Auditors Fail to Detect Fraud Not knowing how to ask a question ….. Not knowing how to ask a question ….. Without asking a question Without asking a question What message are you sending with your question What message are you sending with your question Failure to make yourself available Failure to make yourself available They have something you want They have something you want You don’t have anything they want You don’t have anything they want You may only have one chance You may only have one chance Don’t blow it Don’t blow it Remember the 85/15 rule Remember the 85/15 rule

Why Auditors Fail to Detect Fraud Use caution in asking questions Use caution in asking questions As a rule, you should never ask a question that you don’t have a pretty good idea what the answer will be ……. As a rule, you should never ask a question that you don’t have a pretty good idea what the answer will be ……. Especially in court Especially in court 23

24 Why Auditors Fail to Detect Fraud Failure to know when someone is lying or telling the truth Failure to know when someone is lying or telling the truth People use words to lie, but the body always tells the truth People use words to lie, but the body always tells the truth Do you really understand the answer …. does it make sense Do you really understand the answer …. does it make sense

25 Why Auditors Fail to Detect Fraud Failure to know when someone is lying or telling the truth Failure to know when someone is lying or telling the truth People use words to lie, but the body always tells the truth People use words to lie, but the body always tells the truth Do you really understand the answer …. does it make sense Do you really understand the answer …. does it make sense But you got your DOCUMENTATION But you got your DOCUMENTATION

26 Why Auditors Fail to Detect Fraud At the beginning of this presentation, I asked what did fraud look like. I don’t know, but I’ll know it when I see it. Look for things that are out of place; unusual transactions; things that surprise you; things that should not be there; things that should be there but aren’t; explanations that don’t make sense …..

27 Detecting fraud is like going hunting …. The woods are full of animals …. You just have to know what they look like and where they hide Good Hunting Let me leave you with one last thought