The 'Cry Wolf' Problem in Current Fraud Auditing Standards

By McKee, Thomas A. | The CPA Journal, January 2010 | Go to article overview

The 'Cry Wolf' Problem in Current Fraud Auditing Standards


McKee, Thomas A., The CPA Journal


The CEOs of the six international audit firms do not feel that current fraud detection efforts are adequate. They state that there is an "expectations gap" when it comes to material fraud and the ability of auditors to uncover it at reasonable cost They believe "it is useful to consider additional ideas for enhancing fraud detection" ("Global Capital Markets and the Global Economy: A Vision from the CEOs of the International Audit Networks," November 2006, www.cybsoc. org/CEO_Vision.pdf).

The current fraud audit approach is predicated on the belief that specific identified fraud risks- red flags- help predict the overall risk of fraud. Both the 2007 U.S. auditing standard on fraud, the AICPA's SAS 1 13 (AU section 316, Consideration of Fraud in a Financial Statement Audit), and the international auditing standard on fraud, the International Auditing and Assurance Standards Board's ISA 240 (The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements), focus on auditors deterrnining if red flags are present.

The basic concept is that the presence of identified fraud risks should result in stronger audit procedures than if no identified fraud risks were present. In other words, there is a diagnostic value to identifying fraud risks, because they will help determine if the overall fraud risk is different from the default belief about it.

The audit approach of looking for red flags to help determine specific engagement fraud risk is analogous to medical doctors using a diagnostic test to screen for the presence or absence of a disease. If the test result is positive, then a physician might decide to treat the patient for the disease. The key word here is "might."

In making the decision, an informed physician would consider both the true-positive rate and the true-negative rate from the diagnostic test: The true-positive rate is the frequency with which patients with the disease test positive for it. The truenegative rate is the frequency with which healthy patients test negative for the disease. These test rates might convince a physician to start treatment for a disease or they might convince a physician to order additional tests.

An examination of the diagnostic value of fraud red flags based on current audit research shows that red flags are very limited in terms of assessing overall risk of financial fraud. Auditing standards setters may want to rethink the approach taken by current fraud standards. Auditors should not unnecessarily be crying wolf.

Bias in Current Red Rag Approach

The U.S. auditing standards point out more than 40 possible financial fraud risk indicators but only three possible mitigating factors. The international auditing standards also list a similar 40-plus financial fraud risk factor but have no direct discussion of possible mitigating factors.

There is clearly an imbalance in the discussion of positive versus negative risk indicators. This asymmetric consideration of risk indicators introduces a bias toward identifying positive risk indicators. This could result in auditors overestimating overall fraud risk if they do not appropriately consider negative risk indicators.

T. Jeffrey Wilks and Mark F. Zimbelman comment on this as follows: "The current audit environment seems more concerned with missing an existing fraud than with the costly investigation of a nonexistent fraud" ("Decomposition of Fraud Risk Assessments and Auditors' Sensitivity to Fraud Cues," Contemporary Accounting Research, Fall 2004).

Auditors are reasonably effective in identifying fraud red flags. Research by Lynford Graham and Jean C. Bedard indicates that one red flag was found in 83% of the audits examined, and that the average for their sample was 3.5 per client ("Fraud Risk Factors and Audit Planning," International Journal of Auditing, March 2003, vol. 7, no. 1). Their results were supported by an article by Theodore J. Mock and Jerry L. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

The 'Cry Wolf' Problem in Current Fraud Auditing Standards
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Author Advanced search

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.