Collaboration is key to fighting fraud

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By Cindy Fornelli – Executive Director of the Center for Audit Quality (CAQ)

 

 

 

Accounting is the ‘language of business’ and that language can be challenging indeed. Grey areas, complexities, subjective elements: accounting has all these in abundance. 

Yet, in a sense, confronting the many challenges of accounting is fairly simple. Companies need two things, essentially: 1) sound accounting policies; and 2) the right kind of people to manage those policies. Each of these should be supported by a set of equally simple (and powerful) tenets, including clarity, communication and scepticism.

The Anti-Fraud Collaboration, a coalition of top US groups representing key constituents of the financial reporting supply chain, explored these ideas in depth at a pair of 2016 workshops in New York and San Francisco. The events brought together audit committee members, financial executives, internal auditors, external auditors, as well as regulators from the US Securities and Exchange Commission and the Public Company Accounting Oversight Board. They generated a wealth of insights on leading accounting practices that can help companies enhance financial reporting, deter financial fraud and build thriving businesses.

Policies: clarity and communication are key

At both the New York and San Francisco workshops, an oft-repeated admonition was that companies must strive to adopt policies that are understandable and clear, even (perhaps especially) in areas of accounting complexity. Although policy is often written by a company’s technical accountants, it is primarily non-accountants, such as the sales force, whose actions have an impact on the accounting results.

Moreover, policies must be married to process. Strong communication between the owners of accounting policies and the employees in the field is a must and accounting policies should be reviewed at regular intervals and address how to identify and monitor changes. They must specify what happens when new, unforeseen issues arise – and how to communicate them.

“Revenue recognition is a complex accounting area where application guidance varies by revenue stream. Policy and training are not ‘one-size-fits-all’ in highly diverse and geographically dispersed organisations”

Accounting policies and procedures are thus living documents, undergoing change through an iterative process. Policies and procedures must be tested in the field prior to implementation and then monitored post-implementation to ensure they are being applied consistently. The risk to the organisation from an accounting policy that is either not implemented or not implementable as written is substantial.

Recommendations for implementing accounting policies

1. Create policies that are in lock-step with authoritative guidance and, if possible, in plain language

2. Develop examples to help those in the different business lines understand how to apply the guidance/policy

3. Communicate the policies and examples developed by corporate accounting with operations and perform field tests

4. Embed or involve accounting/finance professionals in or with operations

5. Tie compliance and behaviour to compensation[1]

Policy challenges: revenue recognition

Revenue recognition figured heavily in the discussion at both workshops, in large part because of the new revenue recognition standard that will become effective in the US on 1 January 2018 for calendar year-end public companies. Yet no matter what the state of the standard, revenue recognition is an area where effective accounting policy plays a critical role.

What makes revenue recognition so challenging? For one, it is closely tied to key metrics – earnings, margins and revenue itself – that are reported both externally and internally. Externally, these metrics are crucial to Wall Street’s valuation of the company’s stock. Internally, they have a major impact on employees in the area of compensation and in the C-suite. Therefore, many employees in the organisation are under pressure, in one form or another, to meet expectations for these metrics.

Moreover, revenue recognition is a complex accounting area where application guidance varies by revenue stream. Policy and training are not ‘one-size-fits-all’ in large, highly diverse and geographically dispersed organisations. In some companies, a large percentage of revenue comes from overseas activities, which can lead to extensive communication, training and coordination challenges.

To craft effective accounting policies related to revenue recognition, workshop participants made several recommendations.

First, accounting policies in this area should be granular, because even slight differences in interpretation can have a major impact on revenue recognition. Where possible, the policy should include examples thatare understandable to non-accountants to assist in implementation. This is especially important as companies implement the new revenue recognition standard.

Second, an effort should be made to standardise contract terms and deviations from typical contract terms should be well documented and approved by senior management. The accounting function should be made aware of such deviations. One participant strongly recommended that an accounting expert be involved in contract negotiations. Review of final sales contracts and completion of a revenue recognition checklist are common internal controls.

Third, because accounting policy is affected by the actions of the sales force and other parts of the organisation, internal audit or a business control function should test whether executed contracts have been accounted for in accordance with the accounting policy.

Fourth, clear responsibility and clear lines of communication among legal, business and finance must be created so that all key players understand sales transactions.

Finally, internal controls need to be dynamic and updated as business activities evolve and requirements change under generally accepted accounting principles. This includes controls to adopt and implement the new revenue recognition standard.

People: critical thinking, communication and character are key

No matter what the issue, sound accounting policies are necessary but not sufficient. Even the best accounting policies will fall short without good people to implement them. Hence, the Anti-Fraud Collaboration’s New York and San Francisco workshops also devoted considerable time to the topic of staffing. Simply put, hiring, retaining, training and motivating staff are paramount to navigating a complex accounting environment.

Addressing these human resource challenges is no easy task, yet workshop participants agreed that finding the right people is much more than a hunt for technical expertise. For one, it’s about mindset. When considering potential hires, a few basic questions are in order:

  • Do they possess sufficient critical thinking skills?
  • How do they go about reaching a decision?
  • How do they work with staff at different levels of the organisation to obtain information?
  • Are they comfortable developing and expressing their own views in a team setting, or do they just follow the herd?
  • What examples can they show to demonstrate their thinking had an impact on their organisation?
  • Do they have natural curiosity? (One participant said: “I want my staff to be asking ‘why, why, why?”)

Beyond these basics, communication skills are indispensable. Accounting staff must often deliver news that isn’t welcome, as well as information that may not be considered the highest priority, to both senior and junior members of the organisation. Can the employees communicate with staff in different functions at different levels in a way that will affect their behaviour?

Character, of course, is also key and part of the hiring process should involve attempting to identify applicants who can act with integrity. However, it’s equally important to remember that screens in the hiring process are no guarantee against fraud. Under unusual pressure, even people of integrity and good background may do wrong.

People challenge: staffing for complex accounting issues

Staffing for complex accounting issues, such as derivatives, taxation and securitisation, presents a special challenge. These are areas where knowledge is highly specialised and expertise is limited. The company employee responsible for such an area may be considered an expert. But auditors must obtain sufficient evidence when testing controls for the accounting area to support their audit procedures, regardless of management’s assessment of the expertise of such in-house staff. Some participants suggested that the accounting department (or in some cases the audit committee) be given the resources to confer with an outside expert in such instances.

Complex accounting issues may also create challenges around the segregation of duties. The potential for fraud is heightened by the ‘expert’ in an accounting area who – using the excuse that no one else can do the job – avoids taking mandatory vacations (control failures are often exposed during periods when a replacement takes over the responsibilities of a vacationing employee). Further, even if there are no problems with the employee’s work, the company needs to have sufficient resources and documentation should the staff member be absent for an extended period or leave the organisation.

What controls can be implemented to assess significant assumptions and judgments made by such in-house experts? One solution may be for the audit committee to encourage management to engage someone from outside the company to review the in-house expert’s processes and conclusions. An outsourced or co-sourced internal audit function offers another solution, especially for smaller companies. There may be objections raised that only the in-house expert has the necessary knowledge, but in most accounting areas, there are numerous qualified people who can be enlisted to independently assess an accounting estimate for reasonableness or test a related control. The important thing is that in-house experts cannot be considered ‘untouchable’. Companies need to have people who can question and challenge their findings and conclusions.

The role of auditors: staffing considerations

External and internal auditors can play that questioning role in a variety of contexts, a reality that should influence staffing decisions and practices of both groups.

For internal audit, an important consideration is the remarkable breadth of issues that internal audit covers, including complex accounting areas. Hence, from a staffing perspective, internal auditors should have skill sets necessary to address this wide scope.

What’s more, to be effective, internal auditors must not only have knowledge of the business – they must have the confidence of the management that is being audited. Along these lines, one workshop participant offered some perspective and advice: “I have seen a lot of different ways of staffing internal audit. One that I liked was rotating executives, financial and non-financial, through internal audit. It gave them the ability to learn about the business, plus the mix of expertise helped blend skills.”

While perhaps not as wide in scope as internal audit, staffing considerations for external auditors are varied, in that external auditors are concerned with assessing the adequacy and competency of their clients’ financial reporting staff, as well as finding the right people for their own firms. On the former, in performing the audit, external auditors have an opportunity to assess the technical expertise and professional demeanour of the issuer’s financial reporting staff. External auditors may discuss deficiencies in these areas with senior management and, where necessary, the audit committee.

In hiring for their own firms, the external auditors need to determine whether a candidate will, as an engagement team member, possess those character traits that are likely to manifest sufficient professional scepticism. External audit firms seek to hire people who won’t shrink from asking challenging questions of company staff or from having sensitive conversations with senior management.

Tapping the power of each other

In our dynamic, evolving business environment, complex accounting issues will always pose a stark challenge. Companies have powerful helpers in facing these challenges, including crafting clear, effective accounting policies and hiring the right people. Equally powerful, as these workshops showcased, is the ability of participants in the financial reporting supply chain to come together to share insights for the benefit of all.

 

About the Author:

A securities lawyer, Cindy Fornelli has served as the Executive Director of the Center for Audit Quality (CAQ) since its establishment in 2007. The CAQ is a nonprofit public policy organization dedicated to enhancing public trust in the global capital markets by fostering high quality performance by public company auditors. Fornelli also co-chairs the Anti-Fraud Collaboration, which released a March 2017 report, Addressing Challenges for Highly Subjective and Complex Accounting Areas, from which this article is adapted.

Footnote:

1Anti-Fraud Collaboration, Addressing Challenges for Highly Subjective and Complex Accounting Areas, March 2017