New standard addresses fraud in financial statement audits

By Randy Bonnecaze

A new Statement on Auditing Standards (SAS) issued by the American Institute of Certified Public Accountants (AICPA) seeks to strengthen the processes auditors use to detect fraud and give companies some insight into preventing and catching wrongdoings.

SAS 99, Consideration of Fraud in a Financial Statement Audit, has been implemented for fiscal years ending after Dec. 15. And as a contractor, you'll soon see differences in how you interact with your auditors and how much documentation they'll request.

Scrutiny starts early. The most noteworthy aspect of SAS 99 is the depth of procedures auditors must now use to evaluate fraud risk within your construction company before and during the audit process.

They'll likely begin by scrutinizing the likelihood that either of the two primary fraud types - fraudulent financial reporting and asset misappropriation - will affect your business. To help determine this, your auditor will consider three conditions:

1. Incentive. This can come in two forms: pressure from within the company or pressure from an individual's personal life. The former may arise from many sources, including bonuses being directly linked to a financial benchmark (such as completion under budget or job completion percentages), or a lax, unfriendly corporate climate that is, therefore, conducive to ill behavior. Life pressures generally arise because of personal financial problems, drug or gambling addictions, or simply greed.

2. Opportunity. The second condition pertains to the internal controls, as well as electronic and physical safeguards, that protect your construction company's assets. This is especially relevant to contractors because of the nature of your operations.

With multiple job sites and employees often working on tasks by themselves or with only a few others, ample fraud opportunities arise. And at the middle and uppermanagement levels, chances come up perhaps daily to shift costs to other jobs, covering up embezzlement or project overruns.

3. Ability to rationalize. Here auditors judge a person's ability to rationalize the act of fraud. Some people believe no one will ever find out or that they can later "fix" the situation. Others think the company somehow owes them money or property and they're doing nothing wrong. Whatever the incentive or reasoning, fraud can happen at any level of a construction company - from laborers to top management.

Skepticism increases. The next step in evaluating your business for fraud risk involves skepticism. In the past, auditors could balance their professional skepticism about a company's vulnerability to fraud with the level of honesty and integrity displayed by its management.

But under SAS 99, they must maximize their professional skepticism regardless of management's reliability. This will increase the number of procedures auditors must perform, ranging from more extensive inquiries to greater demands for evidence of account balances, specific transactions or transaction types.

Thus, your auditors will likely begin by asking you and your managers about how you relate to your employees, as well as about your company's position on ethical behavior and business practices. If you have an audit committee or an internal audit department, they'll submit similar questions to them as well.

But the pre-audit investigation won't stop there. Your auditors may also interview your accounting staff to learn about their job duties and whether they suspect fraud. For example, they could ask about procedural changes that occurred during the year or whether anyone has circumvented procedures for specific transactions.

They may even visit employees on your job sites. Although these workers might not directly contribute to the financial reporting process, they could possess significant information about fraud risks or occurrences - including theft and situations in which managers have overridden or evaded internal controls.

Following these inquiries, your auditors will need to again apply professional skepticism and decide whether they need to go one step further and obtain corroboration for the responses received. This may involve conducting more interviews, reviewing additional supporting documents or acquiring written statements.

Signatures needed. After the pre-audit inquiry, your auditors will consider your construction company's fraud risk. Then they'll tailor audit procedures that specifically address any issues identified. For example, if your auditors encountered allegations of equipment theft, they'll more extensively examine your physical inventory and fixed assets.

You'll notice another change SAS 99 brings about in the management representation letter you must sign before the audit's completion. It will contain additional language to confirm your responsibilities regarding fraud. This includes acknowledging your duty to design and implement internal controls that prevent and detect fraud and to disclose to your auditors any knowledge of fraud occurrences, suspicions or allegations.

Scams must be stopped. One thing SAS 99 doesn't do is increase auditors' responsibility to detect fraud. They can still offer only reasonable assurance that, if wrongdoings were to occur, they would detect them.

Editor's Note: Randy J. Bonnecaze is a Certified Public Accountant (CPA) with Hannis T. Bourgeois LLP, Baton Rouge.