The term “audit” has taken on an almost generic quality.  However, words have meaning and what people think an “audit” does in the public accounting space does not mean what most people think it does.  Whenever a fraud occurs and makes the press the masses scream that the organization should have conducted an audit, or that the audit should have caught the fraud.  What they do not realize is that audits are not designed to catch fraud.  What follows are a few examples of cases where audits failed to find fraud, even though these organizations were using the public accounting audit to do just that.

The Government Entity

Many government entities are required to conduct audits on an annual basis.  The audits are designed to review processes and ensure that employees are following them.  In a previous subject we discussed a payroll fraud case study where a payroll employee in a government entity was misdirecting pension funds into her personal account.  In this case, the auditors missed the fraud.  How did they end up missing this?

In this case, the misdirection was an elaborate fraud.  The auditors only checked to see that the percentages of funds going to the pension account matched the percentages that were reported.  Of course, the percentages matched.  What the auditors did not notice was that the funds transfer split between two accounts, the pension fund and the fraudster’s personal bank account.  If the auditor had performed their due diligence to review the pension fund account, they would have noticed that it was over $350,000.00 short over the period of time the fraudster was misdirecting funds.  However, because the reporting met the standard on the auditor’s checklist, the box was marked off as compliant.

Unfortunately, the government entity has not really learned their lesson.  The same public accounting firm that missed the fraud in their audit is still conducting audits for this agency.  They continue to be the lowest bid, which the government entity is required to accept.  The entity has still not conducted a forensic financial analysis of its finance department to ensure that no other frauds are occurring, or that everything is running within compliance.  It is only a matter of time before this government entity is subject to fraud again.

The Higher Education Facility

Our office was contacted by a higher education facility asking if we conducted “audits”.  Although we explained to the representative that we did not and that we conducted forensic financial analysis instead, the representative set forth to engage our services.  I will stress, we discussed the differences between an audit and a financial forensic analysis with the representative along with the time and cost differences.  However, the representative assured us that we met the guidelines of what their organization needed.

We began our engagement with a simple review of transactions in their bookkeeping software.  Red flags popped up immediately.  Several transactions were reflected as payouts, advances and reimbursements to one Department Director and his assistant.  When we asked for supporting documentation for these transactions we were told that they did not keep these records and that they were destroyed once they were recorded in the bookkeeping program.  The amount of these transactions were over several hundred thousand dollars for the year we were reviewing.

We asked about the internal control process in this Department.  It turned out that the Department Director and his assistant both had check writing and signing responsibilities.  Other than the annual audit there really was no oversight on the financial processes of the higher education facility as a whole.  While several other Department Heads had check signing authority, most chose to run purchases through central purchasing or kept detailed supporting documents along with their purchases.

As we continued to ask questions, it became apparent that this Department Director and his assistant were going to be uncooperative with our investigation. They would not respond to requests for information or answer questions.  We approached our representative from the facility for assistance.  After a couple weeks of hitting a wall with this Department the facility representative that engaged our services for the forensic financial investigation relieved us of our engagement.  She cited that it turned out they needed an audit after all.  However, we learned that the Department Director put considerable pressure on the representative to end the investigation into his department.

The higher education facility hired the public accounting firm that previously conducted their audits.  Wouldn’t you know it, they passed with flying colors.  To this day I am always cautious whenever I see fundraisers for the Department in question at this institution.  And yes, the Department Director and his assistant are both still employed at the facility.

The Event Center

The Board of Directors of a publicly funded event center noticed a downward trend in their cash flows since they brought on a new operations manager.  The Board alerted the press which caused a public outcry to investigate the event center Board, staff and management. Due to the public pressure the Board decided to have an audit conducted.

The audit brought back a few financial irregularities but nothing earth shattering. The Operations Manager had been taking some pre-payroll draws but that was really the extent of their findings.  The findings of the audit were released to the press which again, the public outcry wanted to terminate everyone associated with this event center.

A forensic financial analysis was never conducted.  However, the public pressure from the audit caused the Operations Manager to resign.  Performance at the event center has continued to decline due to public trust of the Board, Management and Staff.

We have seen several high-profile cases over the years that highlight audit failures.  The most shining example of which is Enron.  Not all audit failures are high profile cases of major corporations.  As we have just shown in our three examples, audit failures even happen to small government, education and publicly funded venues. Yet, not one of these examples has utilized a full forensic financial analysis to prevent fraud from happening to their organizations and remain susceptible to fraud happening again.