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External vs. Internal Auditors Against Financial Frauds Essay

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Updated: Jan 29th, 2021

We live in the age of financial frauds. Income statement and revenue manipulation has become a common instrument of generating profits. Companies either fail to comply with the basic financial reporting standards or consciously violate them. Recent corporate scandals in America suggest that businesses lack effective procedures to prevent financial fraud. Auditors have long been regarded as a reliable protection against financial frauds. External audit functions were developed to help organisations and businesses detect and eliminate the risks of unethical financial behaviours. This however is no longer the case: only a well-developed internal audit function, as well as changes in corporate governance and culture, can secure businesses from the risks of financial crime.

At the beginning of 2011, BASF published a new external auditors’ report. KPMG AG, the organisation responsible for auditing BASF, presented the results of the recent financial analysis (BASF, 2011). The documents checked by external auditors included the balance sheet and income statement, statement of recognised income and expense, the development in stockholder’s equity form, cash flow statement, and the Notes to the Consolidated Financial Statements (BASF, 2011). The audit was conducted in compliance with the generally accepted standards of financial audit and §317 German commercial code (BASF, 2011). According to the auditors’ report,

the audit included assessing the annual financial statements of those entities includes in consolidation, the determination of entities to be included in consolidation, the accounting and consolidation principles used and significant estimates made by management, as well as evaluating the overall presentation of the Consolidated Financial Statement and Management’s Analysis. (BASF, 2011)

No serious violations were detected, and the auditor decided that BASF gave a fair view of its assets and financial situation (BASF, 2011). However, the case of BASF raises a number of issues, including the relevance of the external audit function and its implications for financial security in business.

Auditors have long been regarded as a reliable protection against financial frauds (Jamal, 2008). This however is no longer the case. Financial fraud is management fraud, and misbehaviors are part of the human condition (Jamal, 2008). External auditors used to give firms a sense of confidence and provide comfort to shareholders worried about their investments and earnings. Having outside members on the board of directors was found to significantly reduce the likelihood of financial statement manipulations (Beasley, 1996). However, it is high time the myth of an omnipotent external auditor gave place to realistic ethical expectations.

External auditors cannot prevent financial misbehaviours, which stem from problems in organisational culture and governance. Organisations that outsource the entire internal audit function are less likely to detect and report fraud than those, which have their own internal auditors (Coram, Ferguson & Moroney, 2008). Internal auditors can control and monitor financial environment within organisations, thus adding value to organisations’ financial decisions (Coram et al, 2008).

Certainly, that internal auditors add value through monitoring firms’ financial environment does not mean that contracting outside fraud security services is not relevant. Firms, especially large ones, need to assess their financial situation from different angles. External auditors can add to organisations’ knowledge of their financial state, but how to make external auditing effective is a difficult question. For example, firms could undergo a forensic audit once in three-five years (Jamal, 2008).

Just another way to ensure financial and accounting compliance is to require publicly traded companies to purchase fraud insurance and give insurance companies freedom to hire external auditors (Jamal, 2008). In light of the global financial instability, firms may turn to financial manipulations, in order to stay profitable. In this situation, only a well-developed internal audit function coupled with fraud insurance can guarantee ethical accounting and financial decision-making in organisations.

References

BASF. (2011). Auditor’s report. BASF. Web.

Beasley, M.S. (1996). An empirical analysis of the relation between the Board of Director composition and financial statement fraud. The Accounting Review, 71(4), 443-465.

Coram, P., Ferguson, C. & Moroney, R. (2008). Internal audit, alternative internal audit structures and the level of misappropriation of assets fraud. Accounting and Finance, 48, 543-559.

Jamal, K. (2008). Mandatory audit of financial reporting: A failed strategy for dealing with fraud. Accounting Perspectives, 7(2), 97-110.

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IvyPanda. 2021. "External vs. Internal Auditors Against Financial Frauds." January 29, 2021. https://ivypanda.com/essays/external-vs-internal-auditors-against-financial-frauds/.

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IvyPanda. (2021) 'External vs. Internal Auditors Against Financial Frauds'. 29 January.

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