How Forensic Accountants Can Aid Auditors in Risk Assessment
Should an assessment of corporate culture be a factor auditors should consider as part of a risk assessment process? These authors think so. Find out why.
Lattiman (2011) reported Richard Fuld, former Chief Executive Officer of Lehman Brothers, along with 12 other Lehman executives and directors, agreed to pay $98 million to settle shareholders’ suits accusing them of lying about Lehman’s financial condition. With assets of $639 billion at the date of its bankruptcy filing, Lehman’s bankruptcy filing was the largest in history.
Among the findings, Lehman was found to have a corporate culture that prevented employees and whistle blowers who called out problems and concerns from being heard and heeded. The examiner also found implications for culture and business practice where the risk management framework was superseded by executives’ practical experience (Lattiman, 2011).
Lehman Brothers is only one example of a financial reporting crisis in which the tone at the top was a major contributing factor. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) detailed an internal control framework (COSO, 1992), which was eventually embedded in U.S. generally accepted auditing standards with the issuance of Statement on Auditing Standards No. 78 (AICPA, 1995). The COSO framework states that the control environment is the foundation for all the other components of internal control (COSO, 1992). In 1987, COSO issued a report identifying the tone set by top management as a causal factor of fraudulent and misleading financial reporting (COSO, 1987).
Castellano and Lightle (2005) discussed the financial statement fraud of Health South, and they posited the idea of the cultural audit. They proposed the use of a cultural audit every three years to help ensure the proper tone at the top for the organization. As can be seen by the events that have taken place at Lehman Brothers in the last several years, it does not appear that the use of cultural audits has found its way into the mainstream of the profession.
It is interesting to note that the recently formed London-based Parliamentary Commission on Banking Standards is studying the possibility of performing behavioral monitoring audits on British banks in the hope of finding a solution to a seemingly endless series of banking scandals (Enrich & Thompson, 2012).
Managers face various internal and external pressures that may influence financial reporting practices. Managers in publicly held companies may feel pressure to meet analysts’ earnings expectations or they may be motivated to achieve certain earnings goals to maximize their performance bonuses. Krantz and Hansen (2012) conducted a study of CEO compensation at 138 of Standard & Poor’s 500 companies for 2011 and found total CEO compensation averaged $9.6 million, of which $6.3 million was in the form of stock and stock options. The average cash bonus for each member of this group was $2.1 million, perhaps providing motivation to report the highest possible earnings. Managers in privately held companies may also be motivated by various factors including minimizing the company’s corporate income tax liability or meeting certain financial ratios to comply with loan covenants.
A good understanding of an organization’s corporate culture can help auditors evaluate the risk of aggressive or fraudulent financial reporting practices by better understanding the true tone at the top. The risk assessment process helps auditors develop audit procedures designed to minimize the risk of a material misstatement due to error or fraud. To clearly understand the organizational culture, auditors should consider conducting a cultural assessment during the client acceptance or planning stages of an audit engagement. A cultural assessment would provide auditors with means to more accurately assess the tone at the top including managers’ attitudes as understood by the rank and file toward internal controls and ethical decision making. The objective assessment might include questions that attempt to measure the degree to which:
Those conducting the cultural assessment should survey employees from all levels within the organization to identify key issues affecting the tone at top. The assessment questions should be designed to help auditors assess the organizational culture regarding achieving earnings goals, complying with loan covenants, minimizing income taxes and the fear of disappointing management. The survey should be conducted in person and should include all corporate officers, and at least a minimum random sample of both administrative and non-administrative personnel that would provide statistical validity.
Based on a cultural assessment, auditors should develop audit procedures designed to minimize risks associated with the organization’s corporate culture. This should include random variations in audit procedures and thresholds (Terrell, Terrell & Herron, 2011) and some fraud testing procedures not performed in prior audits. With the trend being to hold auditors increasingly more responsible for finding fraud, they should use every cost effective tool available to minimize the risk of failing to uncover fraudulent financial reporting practices, including the use of a cultural assessment.
1. American Institute of Certified Public Accounts. (1995). Statement on Auditing Standards No. 78,– Consideration of internal control in financial statement audits. An amendment to SAS No. 55, New York, NY. American Institute of Certified Public Accountants. (SAS No. 78): AICPA
2. Committee of Sponsoring Organizations of the Treadway Commission . (1987). Report to the national commission on fraudulent financial reporting, New York, NY. Committee of Sponsoring Organizations of the Treadway Commission. Retrieved from http://www.coso.org: COSO
3. Committee of Sponsoring Organizations of the Treadway Commission. (1992). Internal control integrated framework, New York, NY. Committee of Sponsoring Organizations of the Treadway Commission. Retrieved from http://www.coso.org: COSO
4. Castellano, J. & Lightle, S. (2005, February). “Using cultural audits to assess tone at the top,” The CPA Journal, 6-11. Retrieved from http://www.cpajournal.com
5. Enrich, D. & Thompson, A. (2012, September, 24). “Plenty of ideas on how to fix U.K. banks,” The Wall Street Journal, p C3, New York, NY. Article in possession of author
6. Lattiman, P. (2011, August 25). “Ex-Lehman officials to pay $90 million to settle suit,” New York Times. Retrieved from http://www.nytimes.com
7.Krantz, M. & Hansen, B. (2012, March 20). “CEO pay rises again in 2011 while workers struggle to find work,” USA Today. Retrieved from http://www.usatoday.com
8. O’Brien, G. (2010, March 18). “Lehman Brothers perfect storm: Where ethical lapses meet bad judgment,” Worldpress.com. Retrieved from http://www.worldpress.com
9. Terrell, R., Terrell, K., Herron, E. (2011, November/December). “Using Random Variation of Audit Procedures and Soft Cues to Better Detect Fraud,” CPA Focus, 16-17.
Charles Gray, CPA; Dr. Robert L. Terrell, CPA, CIA, CFE; and Dr. Katherene P. Terrell, CPA
Charles A. Gray, CPA, is an accounting instructor at the University of Central Oklahoma in Edmond, Okla., where he teaches auditing and accounting principles courses. He has 39 years of public accounting experience in auditing having served as an audit partner in local and regional accounting firms. An Oklahoma Society of Certfied Public Accountants (OSCPA) member for more than 40 years, Gray has served on the OSCPA Insurance Committee and as a chapter officer and president for the OSCPA Oklahoma City Chapter.
Dr. Robert L. Terrell, CPA, CIA, CFE, has served as professor of accounting at the University of Central Oklahoma in Edmond since 1986. An OSCPA member for 41 years, he practiced public accounting for more than 20 years. Terrell teaches auditing and financial accounting courses. He is also the recipient of the 1995 Outstanding Accounting Educator Award.
Dr. Katherene P. Terrell, CPA, has served as professor of accounting at the University of Central Oklahoma in Edmond since 1988. She is currently the chairperson of the UCO Accounting Department. She also practiced public accounting more than 20 years. She also teaches financial accounting courses. Terrell has been an OSCPA member for 40 years and has served on the OSCPA’s Liaison with Educational Institutions Committee. She is also the recipient of the 2005 Outstanding Accounting Educator Award.