A new academic study funded by the Center for Audit Quality scrutinizes the role of the external auditor in fraudulent financial reporting and found that the top areas cited by the Securities and Exchange Commission were failure to gather sufficient competent audit evidence, failure to exercise due professional care, and an insufficient level of professional skepticism.

During the 13-year period from 1998-2010, there were 87 sanctions against external auditors in SEC fraud investigations involving publicly traded companies, according to the study, by professors Mark S. Beasley of North Carolina State University, Joseph V. Carcello of the University of Tennessee, Dana R. Hermanson of Kennesaw State University, and Terry L. Neal of University of Tennessee.. Approximately 9,500 entities file financial statements with the SEC on an annual basis.

The study, An Analysis of Alleged Auditor Deficiencies in SEC Fraud Investigations: 1998 – 2010, found that only 11 of the 87 instances of alleged auditor deficiencies involving fraudulent financial reporting  occurred after 2003, the years following the passage of the Sarbanes-Oxley Act in July 2002. However, the researchers noted that there is a time lag between when an infraction occurred and when the SEC releases an enforcement action, so the number of deficiencies could be subject to change.

Among the 87 instances examined, the size of the public companies involved was small, with median assets and revenues under $40 million, and the companies span a number of industries. The public company auditing profession commissioned the study in an effort to provide a critical look for auditors and others concerned with improving audit quality and the detection of financial statement misstatements due to fraud.

“The auditing profession, the CAQ and our member firms have been, and continue to be, actively engaged in efforts to mitigate the threat of fraud, which is why we commissioned this study,” said CAQ executive director Cindy Fornelli in a statement. “I believe the fact that SEC allegations of financial reporting frauds are rare, albeit serious, events and that the large majority do not involve sanctions against public company auditors is noteworthy. Our first concern is investor confidence in the credibility of the capital markets. It is important that public company auditors and other members of the financial reporting supply chain take their responsibilities in this regard seriously and commit to seizing opportunities for improvement.”

The study identifies the root cause issues related to audit deficiencies involving fraudulent financial reporting cases citing the auditor and contains a number of insights to enhance understanding of the audit process and strengthen the execution of procedures performed to lower the incidence of undetected fraudulent financial reporting. In recent years, the CAQ and the profession have pursued efforts that address a number of the opportunities for improvement identified in the study. The primary deficiencies cited by the SEC relate to audit evidence, due professional care, skepticism, management representations, and the audit opinion.

Among these 81 cases, the SEC issued sanctions against individual auditors in 80 cases and sanctions against the audit firm in 27 instances (26 cases involved sanctions against both individual auditors and the audit firm, with the SEC sanctioning only the audit firm in one case).

The top five areas cited by the SEC in these 81 cases involved the following:

1. Failure to gather sufficient competent audit evidence (73 percent of the cases)
2. Failure to exercise due professional care (67 percent)
3. Insufficient level of professional skepticism (60 percent)
4. Failure to obtain adequate evidence related to management representations (54 percent)
5. Failure to express an appropriate audit opinion (47 percent)

Most of the 81 cases involved multiple alleged deficiencies. For example, 58 of the cases cited more than one of the top three deficiencies, and 42 cases cited the top three deficiencies.

The most common deficiencies were quite similar for national firms and non-national firms. The top four issues are consistent across these two groups (with a slightly different ranking), and 11 of the top 14 deficiencies appear in both the national firm and non-national firm lists.

Of the 35 national firm cases, nine involved audits performed by Arthur Andersen. There were six instances where the auditor prepared the financial statements or did not perform any meaningful level of audit procedures. The researchers refer to these six instances as “bogus audits.”

The CAQ commissioned the research from the professors because they had previously authored the foundational research report Fraudulent Financial Reporting: 1998 – 2007, An Analysis of U.S. Public Companies, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in May 2010.

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