Why Don't Auditors Find Fraud?

In a recent Financial Times opinion piece, journalist Stephen Foley addressed the perennial debate regarding external auditors' responsibility in detecting and reporting corporate fraud. 

Despite investors' long-standing frustrations, audits have historically only caught 3-4% of fraud cases, according to the Association of Certified Fraud Examiners. While internal controls like whistleblower hotlines may aid in detecting malfeasance, detection becomes more challenging when management is involved. A survey by the Center for Audit Quality found that 57% of investors believe the current system often fails to detect illegal acts, raising concerns among regulators about auditors' effectiveness as a safeguard for investors.

The US Public Company Accounting Oversight Board has sought to broaden auditors' scrutiny of clients' non-compliance with laws and regulations. However, audit firms argue against this, citing the impracticality of making legal judgments and the limited effectiveness of additional procedures. An even narrower UK proposal — which does not require auditors to investigate every minor regulation and allows them to rely on existing compliance programs as a starting point — received a similarly feverish backlash. 

Meanwhile, the International Auditing and Assurance Standards Board proposed stricter standards on fraud detection, emphasizing the need to identify even qualitatively material misstatements. Foley noted a convergence of proposals worldwide, reflecting a growing acknowledgment within audit firms of the need for improvement. Some firms, like PwC, pledged reforms to enhance fraud detection and whistleblower program scrutiny, though achieving industry-wide consensus on these issues remains a challenge.

Foley suggested that these proposals could empower auditors to more assertively examine clients' operations and challenge executives when necessary, aligning with the professional skepticism inherent in auditing. He underscored investor willingness to pay extra for a more robust service. "A high-quality audit is sometimes called a 'credence good', because its value is difficult to calculate," he concluded. "But, as the shareholders of Enron, Wirecard and countless others will tell you, the cost of a bad audit can be so much more."