Preventing and detecting fraud: how to strengthen the roles of companies, auditors and regulators

Fraud and forensics

Companies have never been as data-rich as they are today, providing new opportunities to detect material frauds through data mining, analysis and interpretation. Auditors are ideally placed to carry out this role and are increasingly using data analytics to identify unusual transactions and patterns of transactions that might indicate a material fraud. 

The use of forensic specialists in the audits of public interest entities (PIEs) may become mandatory in future. In the UK, Brydon’s review suggested that forensic skills and fraud awareness should be part of the formal qualifications and continuing professional development for all auditors. The EY organization supports that recommendation.

Technology is not a panacea, however, and the human element also comes into play. There is an opportunity for all involved – including management and boards, auditors and regulators – to focus more on corporate culture and behaviors to support fraud detection.  

Auditors’ professional skepticism and moral courage can be boosted through education and training in topics such as behavioral science, including the concepts of conscious and unconscious bias. These opportunities could have profound implications for auditor education and qualifications, as well as standards and audit regulation in the future. 

Collaborative change

When a fraud extends to a broad network across management and third parties, it can take more than a normal audit to find the evidence. So, what can be done to detect fraud as early as possible or even prevent it?

This issue goes far beyond the auditing profession. Large-scale fraud is mostly well thought through and difficult to detect. Auditing is an important check, but it is not the only one. In this context, adopting a “three lines of defense” approach against fraud is useful, comprising: corporate governance; the auditor; and capital markets supervision.

The three lines of defense are ripe for exploration to drive better prevention or detection of fraud.  In some cases, the suggestions below draw on best practices or requirements from different countries across the globe, but the public interest would be better served if they were applied more generally.

1. Corporate governance

• PIEs should have a system of strong internal controls over financial reporting that includes fraud risk specifically. This system would set out clear roles for management, board, audit committee and internal audit.
• Management and director certifications on the content of financial statements as well as the internal controls should be explored for PIEs. There should be meaningful consequences for inappropriate certifications. 
• Companies could do more to measure and oversee culture and incentives.  
• All actors in the corporate governance chain and reporting ecosystem, including auditors, should have strong whistleblower programs in place that both encourage and protect those who report issues.

2. The auditor

• Auditing standards should be reviewed to provide auditors with a stronger framework to detect fraud. Such a review should examine materiality, level of skepticism, use of forensic specialists, internal controls, access to and use of culture and incentives’ assessments, discussions with audit committees and public reporting.
• External auditors could be required to assess and report on a PIE’s internal controls and risk management processes (including how the company monitors and tests compliance) to boards, regulators and the public.  

3. Capital markets supervision

• Minimum corporate governance and reporting standards (including the proposals above) should be a precondition for a listing on a major stock market index.
• In many places, auditors already have red-flag obligations to escalate, or determine whether to escalate, any concerns they have over potential breaches of laws and regulations that may impact the financial statements, to an appropriate authority. Where these obligations exist, they must be clearly enshrined in law or regulation.