"Why Ask?" You Ask
Because it's part of your job--and it may uncover fraud. Financial statement frauds, the bane of the auditing profession, come in different forms. But, from studying hundreds of fraud cases, we can learn a great deal that can help CPAs in detecting these illegal acts. A vital part of discovering fraud concerns the auditor's ability to ask questions and the implications of not asking them. Since most auditors have had no formal interview training, this article focuses on the basics: how to approach the fraud issue with your client and the types of questions to ask. Consider the two common elements in the following cases of material fraud described in previous issues of the JofA. "Crazy" Eddie Antar and his immediate family members owned a chain of electronics stores in the New York area and committed a $120 million financial statement fraud. The crime was discovered when some family members had a falling out and one of them revealed the scheme to authorities (see "So That's Why It's Called a Pyramid Scheme" Oct.00, page 91). The $500 million Phar-Mor fraud, engineered by CEO Mickey Monus, was carried out by his CFO, Pat Finn. The crime was discovered when one of the members of Phar-Mor's board of directors received a tip from an acquaintance. The board member confronted the CFO, who immediately confessed (see "Ghost Goods: How to Spot Phantom Inventory," Jun.01, page 33). Edward Thomas, a bank president, accepted silent interests in businesses in exchange for lending the bank's money. The bank was small and his activities were well known to the employees, who eventually informed the board of directors of Thomas's crimes (see "... And Nothing But the Truth: Uncovering Fraudulent Disclosures," Jul.01, page 47). One common element in all three examples was that none of the employees shared important knowledge of fraud with their independent auditors. In these situations and many more, the reason was simple: The auditors hadn't been trained to ask the right questions. Another common element was that all those who committed these financial statement frauds were top executives. According to a 1999 COSO study, that's a predictable pattern: The CEO orchestrates the fraud three-quarters of the time. Out of necessity, the CEO almost invariably involves the CFO too. To detect and deter financial statement fraud, therefore, a good auditor must be prepared to ask company executives some very penetrating, although nonaccusatory, questions about the subject--a concept called "diligent inquiry." THE MOST POWERFUL AUDIT TECHNIQUE Asking questions is the most effective audit technique of all. Although there are no exact figures, experts claim that about 80% of all frauds are discovered through tips and complaints compared to 20% for other methods, including management oversight and audits. If that surprises you, it shouldn't. Fraud, by its nature, is easy to conceal and difficult to detect. The methods for covering up such crimes are many and varied. But that doesn't mean there aren't clues when someone in an organization commits fraud. The best clues usually don't come from the books but from the people who work with them. In cases involving management fraud, the CEO typically directs underlings to do the dirty work. That means the CEO's closest aides normally know if a financial statement fraud scheme is afoot. At the other end of the spectrum, an employee who embezzles from the company normally carries out the crime alone. But the embezzler then conspicuously spends money he or she doesn't earn, and other people in the company usually are aware of it. Although the benefits of diligent inquiry should be obvious, some CPAs are reluctant to ask questions about fraud for one of three reasons: They think it will offend people to ask them about such sensitive issues, they believe it could lead to legal trouble or they don't think people will answer such questions truthfully. …