The Hindu Business Line : Alerting auditors on fraud

Abraham Lincoln once remarked “America will never be destroyed from the outside. If we falter and lose our freedoms, it will be because we destroyed ourselves.” The quote seems so relevant in these times when there is only depressing news forthcoming from the superpower.

Ponzi scheme

The one making the rounds now is the hedge fund operated by a former Securities and Exchange Board (SEC) adviser which turned out to be a mega Ponzi scheme.

A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business.

It usually offers abnormally high short-term returns to entice new investors. The system is destined to collapse because there are little or no underlying earnings from the money received by the promoter.

The numbers present a familiar picture — $7 billion in redemption requests when the fund had only $8-15 billion in assets. The US regulators never inspected the hedge fund’s books as it was registered with the agency in September 2006, which again opens the debate on who should take the blame for such discoveries after the horse has bolted from the stable — the regulator, the auditor or the entity alone.

Staff Alert

The Public Company Accounting Oversight Board (PCAOB), which took birth after one of the most bizarre of scandals, is making a valiant effort to prescribe some regulations to alert investors on such scandals a little bit earlier than the situation at present.

It has issued a Staff Audit Practice Alert No. 3, namely, ‘Audit Considerations in the present Economic environment’. It feels that recent events in the financial markets and the current economic environment may affect companies’ operations and financial reporting and, in turn, may have implications for audits of financial statements and internal control over financial reporting.

Audit risks that may have been identified previously may become more significant or new risks may exist due to current events, and the current uncertainties in the market and the economy may create questions about the valuation, impairment, or recoverability of certain assets and the completeness or valuation of certain liabilities reflected in financial statements.

It identifies six key areas where audit alertness is called for — overall audit considerations, auditing fair value measurements, auditing accounting estimates, auditing the adequacy of disclosures, the going concern concept and additional audit considerations for selected financial reporting areas.

All Risks

One of the critical risks under overall audit considerations in the current scenario would be the risk of fraud, as there could be excessive pressure for the management to meet the expectations or requirements of third parties and a similar pressure is placed on the management or key personnel to meet financial targets, including sales or profitability goals.

Certain kinds of investments such as auction rate securities, commercial paper, mortgage-backed or other asset-backed securities, alternative investments (such as hedge funds, private equity investments, fund of funds, etc.), collateralised debt obligations and other investments may present complexities in valuation because of the current conditions in the financial markets.

Accordingly, difficulties surrounding the measurement of fair value and the adequacy of related disclosures have come under increased focus over the past year. As part of the audit, the auditor also should perform a retrospective review of significant accounting estimates reflected in the financial statements of the prior year to determine whether management judgments and assumptions relating to the estimates indicate a possible bias on the part of the management.

With the benefit of hindsight, a retrospective review should provide the auditor with additional information about whether there may be a possible bias on the part of the management in making the current-year estimates.

(The author is a Hyderabad-based chartered accountant. blfeedback@thehindu.co.in)

The current economic environment may increase the risks regarding the adequacy of disclosures, including those surrounding a company’s risks and uncertainties, which in turn may warrant additional auditor attention. The alert advises on testing the concept of going concern in these testing times and focus on the new-age financial inventions which were responsible for the mess.

Regulate the regulator?

To the auditor, this would be one more in the endless list of checklists that he has to be guided by. As expected, the alert does not prescribe anything new apart from informing the auditor things they already know.

It is a fact that the SEC has missed the bus on quite a few occasions in the past few years prompting critics to point a finger at the regulator than on anyone else. There have been some misses from the auditors too but the simple principle that an auditor can only tell you what has happened and not what is going to would save him from the blushes anytime.

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