Some organizations want to enhance the content of their financial statements, especially at the end of the year. Unusual significant transactions, particularly those recorded near the end of a reporting period, represent red flags and may lead to fraud in the financial statements.
Forensic accountants searching for clues or indicators of fraud closely scrutinize those transactions. To avoid fraudulent financial reporting or assets’ misappropriation auditors must be alert and, if they find unusual transactions, the first thing they should do is to evaluate the business rationale for significant unusual transactions. Lack of a justification is a strong red flag the merits a follow up and in depth analysis.
Although auditors play an important role in preventing fraudulent financial reporting, ultimately the responsibility for financial reporting is vested in three groups (Source: AICPA – The Role of the Audit Committee):
1. The company's board of directors, including the audit committee
2. Financial management, including the internal auditors
3. The independent auditors.
According to the AU 316 (Auditing Standard) – Consideration of Fraud in a Financial Statement Audit, auditors should consider:
o Whether the form of such transactions is overly complex, for example as in the case of Enron, it involves multiple entities within a consolidated group of unrelated third parties.
o Whether management has discussed the nature of an accounting for such transactions with the audit committee or board of directors.
o Whether management is placing more emphasis on the need for a particular accounting treatment than on the underlying economics of the transactions.
o Whether transactions that involve unconsolidated related parties, including special purpose entities, have been properly reviewed and approved by the audit committee or board of directors.
o Whether the transactions involve previously unidentified related parties or parties that do not have the substance or the financial strength to support the transaction without assistance from the entity under audit.
Auditors must pose inquiries to members of the management team and pay attention to their answers. Properly evaluating the answers to these questions is critical to audit effectiveness.
The auditor is charged with determining the truthfulness of management responses and/or the absence of managements’ use of deceptive techniques such as the withholding of information. Assessment of management integrity is a must for auditors and forensic accountants dealing with significant unusual transactions.
Former CEO, CFO, and other top officers of a corporation were accused of falsifying the company’s financial records in order to inflate the organization revenue so that the company would meet analysts’ financial projections. These executives were also accused of self-dealing. They allegedly used over $750,000 in company funds to pay for stock option exercises without the approval of the Board and without making proper disclosures. They are also accused of using corporate funds to pay for personal expenses such as artwork, vacations and country club dues. This is just a sample of many instances where unusual significant transactions occur and go unnoticed because auditors lack professional skepticism.