Why validation is key to detecting and preventing financial statement fraud (Sponsored)

Feb 15, 2021

By Fergal MacManus, Account Manager, Ireland & Channel Islands at Confirmation, part of Thomson Reuters

Financial statement fraud schemes are relatively uncommon, but they are the most costly type of fraud, causing a median average loss of $954,000. This is quite evident in the recent scandals at Patisserie Valerie (£94 million pounds missing) and Wirecard (nearly €2 billion euros missing).

In preparing its 2019 report on the future of audit, the UK Parliament’s Business, Energy and Industrial Strategy Committee took evidence from numerous witnesses. During one hearing, Patisserie Valerie’s auditors defended their failure to identify irregularities, saying: “we are not giving a statement that the accounts are correct. We are saying they are reasonable... we are not set up to look for fraud.”

The committee said it was “both surprised and disappointed to hear the view from audit firms that because fraud is difficult to detect, the public should not expect auditors to find it”.

And regulators, such as the Financial Reporting Council (FRC), have expressed their concerns about the “mythology” that auditors are not obliged to detect fraud, particularly in light of an anticipated increase in corporate frauds as a result of the pandemic-driven recession.

The audit reforms being introduced by the FRC are likely to place heavier duties and responsibilities on auditors to detect financial statement fraud.

In this context, it is instructive to examine an aspect of the audit process that auditors and banks often overlook, but which can be a vital indication of fraud. Validation is an essential step in the audit workflow, ensuring that companies and individual respondents have been authenticated – and it is a key component of the confirmation process.

The validation data includes the respondent’s postal, physical and website addresses. We have seen from the Wirecard scandal the impact of an auditor’s failure to identify fraudulent documents and fake third-parties or to investigate suspect addresses.

Nonetheless, many auditors still rely on evidence gained through unsecure channels from unvalidated respondents. Yet the technology to mitigate these kinds of risk has been available for years.

In our own specialism – external confirmations – there exists enhanced technology that can assist auditors in fraud detection, but we have continued to see a steady stream of reported cases where the external confirmation process has failed.

Our technology solution, Confirmation, validates the business details of auditors and bankers before they can use the platform, providing a secure environment within which parties can communicate with one another.

Since 2012, Confirmation has helped uncover billions of dollars worth of fraud. It unearthed a $215 million fraud at PFGBest, a commodity brokerage unit of Peregrine Financial Group, where the CEO had falsified banking and account data and forged confirmation documents. He had resisted using Confirmation because he knew that, as soon as it took effect, the criminal activity would be exposed.

In another case, China Media Express misled investors about its financial condition by overstating cash balances by more than 40,000%. When one of the banks in the case began responding to audit forms exclusively through Confirmation, the CEO of China Media Express could no longer misdirect the auditor’s confirmations and the fraud was discovered.

Confirmation was also used to expose the North Carolina-based hedge fund owner and operator James A. Shepherd, who, for more than seven years, sent out fraudulent audit confirmations, creating fake bank statements and forging signatures of fictitious bank employees.

For audit firms and their clients, reputational risk is increasingly being seen as a strategic risk, and their reputations suffer badly from any financial scandal. In verifying the authenticity of each user, Confirmation improves the quality of audits, reduces risk, and greatly improves investor confidence in the audited financial statements.

By deploying technology that automates the validation process, firms can protect themselves from the increasing risk of fraud and meet the more exacting duties set to be imposed on them by the financial regulators.

Confirmation, part of Thomson Reuters, pioneered the idea of digital confirmations in 2000 and still leads the industry today. More than 16,000 audit firms, 4,000 banks and departments, and 5,000 law firms have put their platform to work. They span 170 countries and process more than one trillion dollars in confirmations each year.

(This article is sponsored by Confirmation.)