Securities and Exchange Commission Acting Chief Accountant Paul Munter issued an Oct. 11, 2022, public statement, urging auditors to do their part in detecting corporate fraud because it causes significant losses to investors each year. And his statement comes in part as the staff has observed some auditor shortcomings on fraud detection.
Among other frauds, companies might misappropriate assets or engage in financial reporting misconduct to make their financial performance look better than it is. He cited the Association of Certified Fraud Examiners, which estimates that organizations lose 5 percent of revenue to fraud each year, an estimated loss of $4.7 trillion globally.
Munter has been fairly active in issuing statements over the past year that emphasized high quality financial reporting and auditing in order to better protect people’s investments. Moreover, under the direction of SEC Chair Gary Gensler, the top accountant has been focusing on the critical importance of auditor independence.
“As we have emphasized on many occasions, independent auditors play an important gatekeeper role in supporting high-quality financial reporting and the protection of investors,” Munter said in the latest statement. “A critical aspect of this role is an independent auditor’s responsibilities with respect to fraud detection during the financial statement audit, or, in other words, the auditor’s use of the fraud lens.”
Today, public company auditors must consider fraud and get reasonable assurance whether the financial statements are free of material misstatement, whether caused by fraud or error under the auditing standards of the Public Company Accounting Oversight Board (PCAOB), which the SEC oversees.
“When considering materiality, auditors should not assume that even small intentional misstatements in the financial statements are immaterial,” Munter said.
Staff Observations of Shortcomings
However, he said that PCAOB inspections consistently found that some auditors did not properly apply due professional care and skepticism when considering fraud.
For example, some auditors did not perform substantive procedures designed to identify fraud risks, such as only performing inquiries or failing to identify revenue recognition as a potential fraud risk.
Munter said that recent SEC enforcement actions against audit firms continue to show instances of improper professional conduct with respect to fraud risks.
In addition, he said that the staff in the SEC’s Office of Chief Accountant (OCA), which he leads, has been hearing “particularly troubling feedback that auditors many times frame the discussion of their responsibilities related to fraud by describing what is beyond the auditor’s responsibilities and what auditors are not required to do.”
“We find this attitude of focusing on the limits of the auditor’s responsibilities at the outset as opposed to the affirmative requirements with respect to the responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement, whether caused by error or fraud, deeply concerning, as it could impact an auditor’s mindset or their degree of professional skepticism, and may thereby reduce the likelihood of fraud detection and potentially result in dereliction of professional responsibilities to the public trust,” Munter explained.
Munter said that being extra mindful on fraud risk is important given the current volatile economic and geopolitical environment in which companies operate. He is worried that such changes in the environment may result in new pressures, opportunities or rationalizations for fraud.
The tone at the top of a company and effective internal controls have historically been areas of focus for auditors. And these could go either way: exacerbate or mitigate pressures to commit fraud.
In Munter’s view, auditors have an opportunity to protect investors by helping to identify and address the precursors for financial reporting fraud so that more material misstatements arising from fraud are detected.
Is Company Management Inherently Dishonest?
To that end, he goes in-depth, explaining what is expected of auditors in fulfilling their responsibilities regarding fraud.
For example, Munter discusses a key point of distinction between a material misstatement that arises from fraud or error is whether the underlying action was intentional or not.
“As such, auditors should be aware of biases that may impede their ability to gather and objectively evaluate audit evidence,” Munter said. “For instance, the mindset of ‘trust but verify’ may represent potential bias if it is anchored in the belief that management is honest and has integrity. Such a mindset may interfere with an auditor’s ability to effectively evaluate signs of fraud when evaluating misstatements or to objectively challenge evidence provided by management.”
He said that due professional care requires the auditor to exercise professional skepticism. This means that auditors must have a questioning mind and must perform a critical assessment of audit evidence. Auditors must be skeptical of what management provides when the timing or manner in which such evidence is produced is questionable.
For example, he said a red flag should go up then auditors see invoices for large amounts with vague descriptions, invoices with related parties that have descriptions that are outside the normal course of business or when management provides “new” evidence in the late stages of the audit process that may be a difficult or contentious audit matter.
“Auditors should avoid any assumptions of honesty, be mindful of potential unconscious biases, and apply the appropriate level of professional skepticism,” Munter said.
Can Auditors Accept Any Engagement Strictly Following Guideline?
Some observers welcomed the statement. But others were more tepid in their endorsement, offering some advice to auditors when interpreting Munter ’s remarks in practice.
“The statement is a good reminder of long-standing auditing requirements along with several excellent specific suggestions that many auditors will find helpful,” said former FASB chairman Dennis Beresford, who was previously national director of accounting standards for Ernst & Young LLP and a former adviser to the PCAOB. “However, the overall tone could be read as somewhat of an overstatement of auditor’s responsibilities, particularly when stating, ‘Auditors should avoid any assumptions of honesty….’ If applied literally in performing client acceptance procedures, those words could preclude audit firms from accepting any audit clients.”
However, former SEC chief accountant Lynn Turner said that Munter’s remarks were “outstanding” without any reservation. Turner believes that auditors have been far too cozy with management given that they are paid by the company they audit, among other problems.
“An interesting question is can you name three instances where the ‘independent’ auditor was the first to detect a material error from fraud And the first to report it to the SEC or investors?” Turner asked. “Can you name one if you cannot name three? The remarks set forth findings from the PCAOB inspections that indicate an audit was not performed in accordance with PCAOB standards.”
This article originally appeared in the October 12, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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