People often believe that audits can help root out fraud in cases and that an audit is a magic wand bestowing financial stability upon a company. But an audit is simply an independent examination of a company’s financial statements to ensure that its financial records are a fair and accurate assessment of its transactions. An audit is ultimately only as good as the information given to the auditors.
Of course, an auditor’s responsibilities do include providing reasonable assurance that a company’s financial statements are free from material misrepresentations due to error or fraud. Auditors aren’t infallible and can miss problems without outside information. But an audit is a good first step toward identifying red flags in a company’s financial statements.
Identifying Accounting Fraud
Before beginning an audit, the audit team will frequently have a fraud brainstorming session. The auditors will use this session to set a tone of professional skepticism for the audit and encourage the team to think about how the company could commit fraud. A fraud specialist may also participate, advising the group on how similar companies may have committed fraud in the past.
Journal Entry Testing
Financial statement or accounting fraud requires manipulating a company’s financial records. So, as part of the audit, the team will examine the company’s entry journals for signs of adjustments. The entries most likely to face scrutiny are larger, posted late in the accounting period, or made by senior management. The company will need to provide supporting data for any journal entry selected by the auditors to review.
Estimates are often one of the most likely places for financial fraud because they are subjective. As a result, the auditing team will pay close attention to accounting estimates, examining the methodology used to obtain the estimates. If the company’s estimating methodology changes from year to year, this can be a sign of fraud. Auditors will also examine the direction of estimates as a whole and from year to year. For example, if one year’s estimates showed only decreasing income and the next year’s estimates showed only increasing income, this may be a red flag.
Reporting Audit Fraud To The SEC
Auditors will also look closely at unusual transactions that vary from a company’s typical business transactions. Auditors may ask the company to explain the purpose and business rationale for any of these unusual transactions if they are significant.
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