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Fighting fraud: When a watchdog needs a bloodhound

Companies must have a system in place to prevent and investigate fraud, says Alex Hodgson, senior consultant at forensic accounting firm BTVK Advisory.

A series of high-profile scandals and business failures at some of the best-known corporate names in the UK has thrown technical accounting issues into the spotlight. It has also re-ignited the debate about the role of external auditors in detecting fraud.

In 2017 Tesco agreed a Deferred Prosecution Agreement (DPA) and a £129m fine with the Serious Fraud Office for irregularities over supplier payment recognition. Meanwhile, the seeds of Carillion’s collapse were being sown as £1bn was written down from its contracts, based partly on the unique way in which revenue is recognised on large construction projects.

Subsequently, Patisserie Valerie entered administration in January 2019, a collapse caused principally by the discovery of a £94m hole in its accounts, allegedly concealed by overvalued assets, concealed liabilities, and a gaping £54m cash shortfall.

Eyebrows were raised regarding the latter when the chief executive of Grant Thornton – Patisserie Valerie’s auditors – told a House of Commons committee “we are not looking for fraud”, which drew heavy criticism, not least from other auditors. However, responsibility for fraud detection has long been a matter of differing interpretations between the audit profession, stakeholders and the financial press.

The Financial Reporting Council says that the auditor should “obtain reasonable assurance about whether the financial statements… are free from material misstatement, whether due to fraud or error,” suggesting that the auditor must bear at least some responsibility. However, auditing standards clarify that “primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management.” Where should the balance be struck? In the memorable judgement of Lord Justice Lopes in 1896: “An auditor is not bound to be a detective, or… to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watchdog, but not a bloodhound.”

The problem is fuelled by the unique position of the statutory audit among assurance engagements: the accountant must give positive assurance that the financial statements are true and fair, or at least materially so. Colours, in other words, must be nailed to masts. This represents a substantially grave risk to the professional reputation of the accountant, should they get it wrong.

It would be a brave auditor indeed who would stake their reputation on there being zero fraud in a multi-million pound globe-spanning company. Besides, fraud – by design – can be difficult to detect; although some Patisserie Valerie observers have suggested that a £54 million cash shortfall should be within the capability of a reasonably alert auditor to uncover.

For whatever reason, fraud detection by external auditors is low. In its 2018 Report to the Nations, the Association of Certified Fraud Examiners reports that the most common initial detection method for occupational fraud is tip-offs, which accounts for 40% of all detections. Next are internal audit (15%), management review (13%) and “by accident” (7%). At 4%, external audit appears to be just over half as effective as sheer good luck.

Against that background, and with businesses worldwide estimated to lose an average of 5% of their revenues to fraud every year, there is a clear need for specialist forensic accountants and fraud investigators.

Line of defence

Robust internal control procedures such as segregation of duties, enforced holidays and internal audits will always be a business’s first and best line of defence, but a check-up by an external forensic accountant can lend a fresh pair of eyes and valuable fraud-focused experience to a business, and may help to pin-point areas of weakness.

Similarly, review of historic data by a fraud specialist can identify patterns that may flag suspicious activity. In some high-risk areas, fraud ‘health checks’ may incorporate employee and supplier profiling, although clearly there is a delicate balance to be struck between safeguarding the business and avoiding undue intrusion.

More often than not, however, it is when safeguards fail and fraud strikes that a multidisciplinary forensic accounting, investigations and technology team shows its worth. Recovery from a fraud depends on having the right mix of knowledge and skills in place from the outset, and a coherent, workable, yet flexible recovery strategy.

Often at the outset of a fraud investigation the most urgent questions – even before considerations of what has been taken and where has it gone – are: Who knows? Who needs to know? From which suspects, potential suspects or associates of the same must knowledge be kept?

The answers to these questions depend on circumstances, strategy, and the needs and wishes of the victim. The desired outcome may be an informal resolution, termination of employment, asset recovery, civil litigation, private criminal prosecutions or the involvement of the police and Crown prosecuting authorities.

Successful achievement of these varying outcomes may require the involvement of HR, in-house or external counsel, accounting expertise, investigative skills, and IT support, among others. Widening the circle of knowledge to those who must know while keeping it away from those who must not is a delicate exercise, especially in the early stages where the facts may be unclear.

Initial fraud response is a race to discover what has happened and who is responsible before suspects are tipped off, tracks are covered and assets dissipate. This requires a range of skills beyond simple accounting; encompassing discreet enquiries, seizure of electronic and physical evidence, investigative interviewing, data analytics and more.

Additionally, while it may not be intended at the outset to pursue criminal charges, circumstances do change, and an investigation started off on the wrong foot can be very difficult to recover. Therefore, the investigation team should always plan and conduct their investigation with the expectation of having to justify it in a criminal trial.

The size and scope of the global fraud problem means no forensic accountant, no matter how adept, can ever guarantee a positive outcome, either in terms of the prevention or the detection of fraud.

However, the chances of success are maximised by the proper application of forensic accounting and investigative expertise to the problem. In a world full of watchdogs, sometimes you need a bloodhound.

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