Fraud Risk Awareness and the Likelihood of Audit Enforcement Action

Abstract

SYNOPSIS Prior research indicates that issuing a going concern opinion to financially stressed clients generally reduces the risk of litigation against the auditor following a bankruptcy (Kaplan and Williams 2013; Carcello and Palmrose 1994). However, we propose that a going concern report may indicate prior knowledge of financial distress, an important fraud risk factor, and this may have repercussions for the auditor if a fraud is subsequently uncovered. Consistent with counterfactual reasoning theory, experimental research suggests that a documented awareness of fraud risk actually increases the likelihood of litigation against the auditor following a fraud (Reffett 2010). This concern has been echoed by the professional community (AICPA 2004; Golden, Skalak, and Clayton 2006) and may be exacerbated by the current outcome-based regulatory environment (Peecher, Solomon, and Trotman 2013). To examine this issue we review Auditing and Accounting Enforcement Releases (AAERs) issued by the Securities and Exchange Commission (SEC) for alleged financial reporting frauds between 1995 and 2012. Results suggest that going concern report modifications accompanying the last set of fraudulently stated financials are associated with a greater likelihood of enforcement action against the auditor. This finding is consistent with counterfactual reasoning theory and suggests that, from a regulatory perspective, auditors may be penalized for documenting their awareness of fraud risk when financial statements are later determined to be fraudulent.

Workload stress and conservatism: An audit perspective

“…This study also shows that the workload stress effect is more pronounced when the clients experience financial difficulties and have high probability to commit fraud. The results, therefore, are consistent with Eutsler et al (2016) that suggests that auditors modify audit opinion to mitigate regulatory litigation.…”

Advances and issues in fraud research: a commentary

“…Asiedu & Deffo, 2017), fraud risk awareness (see. Eutsler et al, 2016), anti-fraud environment (see. Fleming et al, 2016), implementing fraud reporting policies, staff job rotation, fraud hotlines and the use of forensic accountants (see.…”

Research Topics in Accounting Fraud in the 21st Century: A State of the Art

“…The articles included in the review used a wide variety of statistical techniques (Figure 3), most notably the ANOVA analysis (e.g., [68,79,80]), descriptive statistics (e.g., [81,82]) and regression (e.g., [83,84]). These three techniques, along with the use of logit/probit models (e.g., [85,86]), account for almost 80% of the articles reviewed. The rest are mostly theoretical works (e.g., [87][88][89]).…”

“…For auditors, detecting fraud can be a difficult job, mainly because it is an act that is intended to be hidden and, although fraud prediction models are available, they are not totally reliable [33,83]. To assist the auditor in carrying out his/her work, he/she is required to conduct "brainstorming" tasks as a means to develop robust ideas of a potential client fraud [84][85][86][87]. The current audit standards indicate this (SAS No.…”

“…Furthermore, it has been noted that part of the literature focuses on the role of the auditors regarding the motivation they have in detecting fraud taking into account the threats of legal action against them. Along these lines, the research of Reffett [92] and Eutsler, Nickell and Robb [86], using the Theory of Counterfactual Reasoning, concludes that auditors can be penalized and have legal action taken against them for not detecting fraud, even though they have investigated it. This is because those who evaluate their work (Congress and the United States Securities and Exchange Commission (hereinafter SEC)) could draw the conclusion that the auditors have been negligent in their investigation and could have done things differently (Counterfactual Reasoning).…”