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Fraud detection, redress and reporting by auditors

Harold Hassink, Roger Meuwissen and Laury Bollen
Department of Accounting and Information Management, School of Business and Economics, Maastricht University, Maastricht, The Netherlands
Abstract
Purpose The primary research question of this study is to what extent auditors comply with auditing standards once they encounter fraud and whether compliance is associated with particular fraud characteristics (i.e. material versus immaterial fraud, management versus employee fraud, statutory versus voluntary audit and external versus internal fraud) as well as with auditor (experience) and audit rm characteristics (Big Four versus non-Big Four). The study also aims to provide evidence on the role of auditors in redressing fraud. Redress refers to the auditee taking measures to nullify the consequences of the fraud, insofar as possible, and to prevent any recurrence of such fraud. Design/methodology/approach To gather data on the role of auditors in fraud cases, a survey was conducted among all audit partners of the top 30 Dutch audit rms. In total, 1,218 audit partners were selected and received a postal questionnaire. In total, 326 questionnaires were returned (27 per cent), of which 296 (24 per cent) were usable. Findings The results reveal that auditors fail to comply with some important elements of fraud standards. There are substantial differences among audit rms regarding compliance with the relevant auditing standards. Furthermore, auditors appear to encounter corporate fraud only incidentally. About half of the auditors believe they have a signicant impact on redressing fraud. Research limitations/implications One of the main research ndings is that it is difcult for individual auditors to build up expertise in fraud detection. There appears to be a need for specic training programs for auditors to help them to detect fraud, emphasizing the need for mandatory consultation with the technical department of the audit rm once red ags indicating fraud are found. Indeed, this need for change has been addressed by the Dutch professional accountancy body NIVRA as a direct result of the ndings of this study. Originality/value This study extends existing research by investigating the compliance of auditors with fraud standards and it sheds light on the actual redress experiences of auditors. It focuses on the actions taken by auditors or the lack thereof in situations where auditors encounter fraud signals. The study indicates that in the absence of good oversight, auditors have mixed incentives when they are confronted with signals for fraud, resulting in actions that are not always in line with existing regulatory requirements. Keywords Auditors, Auditing, Fraud, Professional ethics, Regulation, The Netherlands Paper type Research paper

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Received 14 April 2010 Reviewed 25 May 2010 Accepted 21 June 2010

Introduction A study on major European business failures revealed that the role of auditors is most often questioned and audit rms are most likely to be sued in failures that involve management or employee fraud (Bollen et al., 2005). A widely used explanation for the relatively large number of fraud cases in which the role of the auditor has been questioned is the existence of an audit expectation gap, suggesting that society has unfullled expectations concerning the role of the auditor in fraud cases. The potential causes of an audit expectation gap have been addressed extensively in existing literature (for an overview, see Nieschwietz et al., 2000). Studies in the area of fraud have mainly

Managerial Auditing Journal Vol. 25 No. 9, 2010 pp. 861-881 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686901011080044

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focused on the extent to which auditors are able to detect fraud and whether society has unreasonable expectations in this respect (the reasonableness gap). Less attention has been paid to the gap between what can reasonably be expected from auditors once they encounter fraud signals and what they actually achieve. Following Porter (1993), this part of the expectations gap may be a result of either the deciency of standards and regulations with respect to the duties of auditors in fraud situations (the standards gap) or of the (under)performance of auditors regarding existing duties (the performance gap). With respect to the standards gap, the general public may have expectations that are not reected in existing auditing standards. Comparing expectations with existing auditing standards could identify opportunities for changing the standards and for narrowing the standards gap. Although several studies have indicated that auditing standards and regulatory changes have not resulted in an increase in the auditors ability to detect fraud ( Jakubowski et al., 2002; Rezaee et al., 2003) it remains unclear to what extent auditing standards and regulations have impacted the auditors redress and reporting actions in situations where fraud has been detected. Redress refers to the auditee taking measures to nullify the consequences of the fraud, insofar as possible, and to prevent any recurrence of such fraud. Given the existing standards on the role of auditors in fraud situations, the existence of a performance gap in this context can be due to several factors, including the lack of knowledge or competence on how to act once corporate fraud is detected, lack of care in following protocol or the lack of independence of the external auditor, possibly because of conicting interests. All of these explanations touch upon auditors professional ethics[1]. Given the sensitive nature of fraud reporting and societys expectations of auditors in this respect, compliance with fraud standards is important to auditors and to society. The aim of this study is fourfold. The rst objective is to present evidence on the volume and nature of fraud cases detected by auditors. The second objective is to determine the extent of auditors compliance with auditing standards regarding fraud redress and fraud reporting. The third objective is to study the impact of various context variables (i.e. material versus immaterial fraud, management versus employee fraud, statutory versus voluntary audits and external versus internal fraud) as well as auditor (experience) and audit rm characteristics (Big Four versus non-Big Four) on the actions taken by auditors in fraud situations. Finally, this study provides recommendations on how the performance of auditors regarding the detection of corporate fraud and compliance with relevant auditing standards can be improved. The two Dutch professional bodies for auditors, NIVRA and NOvAA, commissioned the study for which the results are presented in this paper. The focus of this study is on the period 1995-2002. This is a useful period to study auditors compliance with regulations because auditing regulations concerning fraud issues remained unchanged during this period; after 2002, various changes were implemented. In addition, during this period, there was virtually no oversight of audit rms concerning their actions in fraud situations; the results of this paper therefore provide a good understanding of the behaviour and incentives of auditors with respect to fraud situations. This study is organised in ve sections. First, existing studies on fraud detection and reporting by auditors will be discussed. After that, the auditors responsibility regarding fraud detection in the Netherlands in the period 1995-2002 will be described.

Next, the research method of the study will be presented. Subsequently, the empirical results of the study will be presented and nally, conclusions will be drawn. Auditors and fraud During the past couple of decades, a fairly large body of research on auditors experiences with fraud has emerged. In their overview study, Nieschwietz et al. (2000) distinguish three branches of empirical research in the eld of fraud detection: (1) research investigating the environmental conditions related to auditors detection of fraud; (2) research on auditors assessment of the risk of fraud; and (3) research on auditing plans related to detecting fraud. In the rst type of fraud-related auditing research, the existence of an expectation gap is used to explain the level of lawsuits against auditors in fraud cases (Palmrose, 1991; Bollen et al., 2005). Such lawsuits have introduced the effect of litigation risk into auditors fraud detection, as a result of which auditors may adjust their audit planning to understate rm performance (Baron et al., 2001). The second type of studies deals with predictors of fraud and auditors use of fraud cues to assess fraud risk, with or without the help of decision aids. The studies on the predictors of fraud have provided empirical evidence on the validity of fraud cues by having partners identify and evaluate fraud cases to determine fraud cues or so-called red ags (Albrecht and Romney, 1986; Loebbecke et al., 1989). The studies on the use of fraud cues are predominantly based on behavioural decision theory and focus on how auditors assess fraud risk (Hackenbrack, 1992; Zimbelman, 1997; Knapp and Knapp, 2000). These studies have found many factors that affect the ability of auditors to detect fraud (e.g. experience and ethical reasoning), and that auditors generally have difculty in assessing fraud risk. Furthermore, research in this area has shown that the use of tools and decision aids improves fraud detection, although auditors typically are very reluctant to use such aids (Eining et al., 1997). The third type of research concerns auditing plans and procedures and the way they relate to the detection of fraud. Studies in this area have shown that as a result of changes in auditing standards, auditors may become more responsive to fraud risk (Glover et al., 2003; Mock and Turner, 2005), while others found no association between fraud risk assessment and the planning of more effective fraud procedures, thus questioning the effectiveness of standard auditing tools in a fraud setting (Asare and Wright, 2004). Actions taken by auditors once fraud is detected All three research areas mentioned focus on the ability of auditors to detect fraud, but ignore the actions taken by auditors once fraud has been detected, and also ignore the role of professional ethics in (refraining from) taking such actions. A study on personal values was conducted by Gowthorpe et al. (2002), looking for the predominant ethical orientation among auditors in New Zealand, and by Arnold et al. (2005) who looked at the dynamics of auditor decision making in a situation where a clean audit opinion is not possible. Although these studies do provide insights on professional ethics in the context of auditing, they provide little evidence on the ethical aspects of the behaviour of auditors once fraud is suspected or detected. There are a number of (case) studies

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that provide anecdotal evidence on the response of the auditor once fraud is suspected or detected; these studies focus on accounting scandals and the auditors role therein (Moriceau, 2004; Melis, 2005). These studies indicate that in some instances auditors were aware of fraud schemes but were unwilling to address the issue in order not to harm the relationship with the client. Inherent in the nature of these studies, the evidence provided on the behaviour of auditors once fraud is suspected or detected is nevertheless focused specically on unique fraud cases and consequently may not be applicable in a broader empirical setting. Overall, the scarce literature on auditors reactions to fraud situations may suggest that auditors encounter fraud cases very infrequently, and that consequently there is no common framework on how to react in such situations. This issue has increased in importance now that both the auditing profession and various regulatory bodies have raised the level of standards which must be adhered to in the context of fraud. Limitations of prior studies Probably, the foremost limitation for studies in all areas of fraud-related auditing research, is the restricted access to data on the actual experiences of external auditors with fraud detection. Given the sensitive nature of fraud situations and because of the rather low frequency of detected fraud cases, most empirical studies in this area use experimental settings or surveys focusing on auditor perceptions, rather than actual fraud cases as a source of data. The only exceptions are a few empirical studies from the 1980s in the USA, in which audit partners are surveyed on actual fraud cases (Romney et al., 1980[2]; Loebbecke et al., 1989[3]). The participants in Romney et al. (1980) were 27 audit partners who detected fraud in a recent audit as well as 36 audit partners who did not encounter fraud. By having these partners evaluate their engagement, evidence was collected on red ags indicating frauds. One-third of the 87 red ags indicated were found to be signicant predictors of fraud. These generally pertain to personal characteristics of management. Loebbecke et al. (1989) surveyed 277 US KPMG audit partners who detected an average of 3.1 fraud cases in their auditing career. Cases of material fraud appear to be rather rare[4]. Management fraud was detected more often than employee fraud (56 versus 44 per cent), and fraud incidence differed across client industries. In addition, material fraud was detected more frequently than immaterial fraud (60 versus 40 per cent). Further conclusions are that a weak control environment, decisions dominated by only a few employees and signicant difcult-to-audit transactions are conditions that increase the likelihood of fraud. The current study expands the Loebbecke et al. (1989) research by not only investigating the detection of fraud but also by looking at the follow-up of auditors, to better understand their redress effectiveness and their resignation behaviour. The study also addresses the effect of further characteristics on auditors actions (i.e. material versus immaterial fraud, management versus employee fraud, statutory versus voluntary audit and external versus internal fraud) as well as auditor (experience) and audit rm characteristics (Big Four versus non-Big Four). The Big Four/non-Big Four dichotomy is relevant in this context given the argument that larger audit rms have fewer incentives to behave opportunistically to ensure retention of clients and thus they may provide higher quality audits in comparison with smaller audit rms (DeAngelo, 1981). Overall, consistent evidence is provided that larger audit rms provide higher quality audits (Palmrose, 1988; Deis and Giroux, 1992; Krishnan, 2003).

Therefore, Big Four auditors are expected to show a higher level of willingness to redress and report fraud cases. Legal context This section describes the legal context with respect to the role of auditors in fraud cases in the Netherlands at the time of this study (1995-2002). In this period, Dutch auditors were required by their professional bodies, NIVRA and NOvAA, to comply with two fraud standards: (1) the Dutch Auditing Standard 240 fraud and error (further referred to as DAS 240); and (2) the by-law on reporting on fraud (further BLF)[5]. DAS 240 was based on the international standard ISA 240 and held the client primarily responsible for preventing and detecting fraud. The auditor was not held responsible for fraud prevention. DAS 240 specied several issues auditors had to take into consideration before and while performing the audit; see also Figure 1 and the Appendix. The BLF extended the scope of ISA 240, by additionally requiring the auditor to inform management in writing if he suspected fraud. If it concerned material or management fraud, he had also to notify the supervisory body in writing. If, after further investigation, fraud was indeed detected, the auditor had to inform management again and redress had to be demanded. The supervisory body was contacted again if management failed to take reasonable steps to redress the fraud. If the supervisory body failed to take appropriate action, the auditor had to resign from his engagement. If the engagement concerned a statutory audit, the auditor had to notify a dedicated governmental agency. Hence, in the window 1995-2002, Dutch auditors had to take the following steps in case fraud signals appeared while an audit was being performed: (1) Inform management in writing when fraud is suspected[6]. (2) Inform the supervisory body in writing: . in case of management fraud; . in case of material fraud with regard to the nancial statements; and . in case the management fails to take reasonable action[7]. (3) Request redress from management when fraud is detected[8]. (4) Resign from his engagement when insufcient steps have been taken to redress material fraud[9]. (5) Notify the relevant governmental agency of the lack of redress in case of a statutory audit[10]. Research method and sample construction To gather information on the role of auditors in fraud cases, a survey was conducted among all audit partners of the top 30 Dutch audit rms. The professional bodies NIVRA (2000) and NOvAA provided a database containing the names and addresses of all audit partners of the top 30 audit rms in The Netherlands. A written questionnaire was used, which had been tested and adjusted in a pilot study[11]. The questionnaire contained three types of questions:

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Start

Inquiries of management and governance (ST)

Planning discussions with audit team (ST)

Risk assessment and planning of audit (ST)

Before the audit During the audit

866

Finish audit as planned/issue opinion (GL)

No

Document risk factors (ST)

Obtain written statement of management/governance (ST)

Yes Inform management (BL) Yes No Inform management about misstatements and sources. Management might have to adjust accounting procedures. Finish audit as planned. (ST) No Finish audit as planned/issue opinion (ST)

Yes Adjust audit plan and risk assessment if necessary (ST)

Redress

YES

Figure 1. Outline of audit procedure according to Dutch Auditing Standard 240 and by-law

Notes: Parts to be found in DAS 240 are tagged with (ST); parts coming from the by-law with (BL)

(1) Questions relating to the features of the fraud cases auditors had experienced in the period 1995-2002. (2) Questions on the reporting and redress of these fraud cases. (3) Questions on the perceived role of the auditor in the redress process.

To improve the response rate and to limit response bias due to the sensitive nature of the subject of the questionnaire, a procedure was designed that fully guaranteed the anonymity of the individual respondents as well as their audit rms. The envelopes, containing a cover letter, the questionnaire and a self-addressed envelope, were mailed by a notary in civil law. The questionnaires were marked with a unique number per audit rm (ve categories: four Big Four audit rms and one category non-Big Four audit rms) that was known only to the notary. Approximately, three weeks after mailing the questionnaires, a reminder was sent to every selected auditor (including those auditors who had already responded)[12]. In total, 1,218 partners of the top 30 Dutch audit rms as measured by revenues were selected. Table I shows that eventually 326 questionnaires were returned (27 per cent), of which 296 (24 per cent) turned out to be usable[13]. Of the respondents, 49 per cent were partners at a Big Four audit rm, while 43 per cent were partners at a non-Big Four audit rm. The miscellaneous category consists of partners who were afliated with both a Big Four and non-Big Four audit rm in the window of the study. About 10 per cent of the respondents were afliated with Audit rm A, 8 per cent with Audit rm B, 14 per cent with Audit rm C, 20 per cent with Audit rm D and 48 per cent with non-Big Four audit rms. On average, the respondents had 9.9 years of experience as an audit partner. Exactly, half of the respondents had limited experience as an audit partner (0-10 years). Average (11-20 years) and extensive (20 years) experiences were exhibited by 38 and 12 per cent of the sample, respectively. Three remarks can be made concerning the quality of the collected data. First, the overall response rate is satisfactory, especially considering the sensitive nature of the topic. Second, although it cannot be guaranteed that the sample is representative for the population as a whole, there are no indications of the existence of a non-response bias. This has been examined by comparing a number of characteristics of the later respondents with the characteristics of the early respondents. The rationale here is that later respondents exhibit some similarities to the non-responding group. t-tests do not indicate signicant differences. Third, an inherent risk of a questionnaire is that the respondents give socially desirable answers. This risk has been mitigated as much
Number of questionnaires sent Number of questionnaires returned Before reminder After reminder Total Number of questionnaires usable for research Big Four audit rm Non-Big Four audit rm Miscellaneous Audit rm A Audit rm B Audit rm C Audit rm D Low partner experience (0-10 years) Medium partner experience (11-20 years) High partner experience (20 years) Note: Values within the parenthesis denote percentage 1,218 216 (18) 110 (9) 326 (27) 296 (24) 144 (49) 127 (43) 25 (8) 29 (10) 23 (8) 41 (14) 60 (20) 148 (50) 113 (38) 35 (12)

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Table I. Response to questionnaires

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as possible by making use of the services of a notary in civil law for the mailing procedure, thereby guaranteeing the anonymity of respondents and audit rms. Also, many questions referred to facts instead of judgments, which increased the probability of receiving reliable answers. Empirical results The detection of fraud In the 296 usable questionnaires, a total of 317 detected fraud cases were mentioned, suggesting that on average audit partners of the top 30 audit rms in the Netherlands detected 1.07 fraud cases in the period 1995-2002. The low number is consistent with previous research, although it is still smaller than the number given by Loebbecke et al. (1989), who reported an average of 3.1 cases. However, the time frame investigated in the current study (eight years) is narrower than the one in Loebbecke et al. (1989). Furthermore, Loebbecke et al. excluded partners who had not encountered fraud (40 per cent of their sample). Translating the ndings of Loebbecke et al. to the parameters of the current study suggests that the respondents in the Loebbecke et al. study would have encountered on average 0.76 fraud cases in the eight-year period, which is more comparable to the empirical ndings of 1.07 fraud cases in the current study[14]. In the remainder of this section, the characteristics of fraud cases mentioned by the respondents will be analyzed in more depth. The analyses will focus on four elements: (1) material versus immaterial fraud; (2) management versus employee fraud; (3) fraud detected during a statutory audit versus voluntary audit; and (4) external versus internal fraud. Table II summarizes the results. 1. Material versus immaterial fraud. Fraud is considered material if it could inuence the decisions of users of nancial statements. The rst two columns of Table II indicate that there are fewer cases of material fraud among the 317 cases detected than there are cases of immaterial fraud (37 versus 63 per cent). Material fraud was found more often by respondents of non-Big Four audit rms than by those of Big Four audit rms (46 versus 35 per cent). However, this difference is not statistically signicant. There were no signicant differences between individual audit rms in the amount of detected material fraud. Respondents indicate that material fraud occurs more often in the services and trade industries than in the manufacturing and non-prot industries, but again these differences are not statistically signicant. Materiality of detected fraud and level of partner experience do not seem to be related. 2. Management versus employee fraud. Management fraud is committed by members of top management, while employee fraud is committed by other employees. Table II reveals that there were more cases of employee fraud than of management fraud (59 versus 41 per cent) among the 317 fraud cases detected. Big Four audit rms discovered relatively fewer cases of management fraud than did non-Big Four audit rms (37 versus 49 per cent). There is some evidence of a relationship between the type of audit rm (A-E) and the proportion of detected management versus employee fraud. This relationship is signicant at the 10 per cent level. There turned out to be no signicant relationship between partner experience and detected management and employee fraud.

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Material fraud 118 37 0.4 63 0.67 65 54 88 66 74 100 93 89 n.a. n.a. n.a. n.a. 79 82 81 n.a. n.a. n.a. n.a. 21 18 19 26 * * * 0 7 11 68 75 70 61 59 64 60 78 62 59 66 38 42 40 62 58 60 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 30 46 30 42 70 * 54 70 58 37 49 63 * 51 12 * * * 34 24 47 32 8 26 21 n.a. n.a. n.a. n.a. 42 29 25 129 41 0.44 59 0.64 19 0.20 258 81 0.87 93 29 0.31 35 46 32 25 30 39 41 36 40 22 38 41 34 199 * * * 188 * * * 59 * * * 224 * * * 71 0.76 76 * * * 53 68 * * * 92 74 79 n.a. n.a. n.a. n.a. 58 * 71 75

Immaterial fraud

Management fraud

Employee fraud

Statutory audit

Voluntary audit

External fraud

Internal fraud

Total 317 100 1.07 100 100 100 100 100 100 100 100 100 100 100 100 100

Number of cases Percentage Number of cases per partner Big Four vs non-Big Four Big Four audit rm (%) Non-Big Four audit rm (%) Big Four auditing rm A (%) B (%) C (%) D (%) Client industries Trade (%) Production (%) Services (%) Non-prot (%) Partner experience High (20 years) (%) Medium (10-20 years) (%) Low (0-10 years) (%)

Notes: Statistical signicance at: *10, * *5 and * * *1 per cent levels (two-tailed test); n.a. not available

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Table II. Detection of fraud

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3. Statutory versus voluntary audit. Most of the 317 fraud cases were detected during statutory audits rather than during voluntary audits (81 versus 19 per cent). Non-Big Four audit rms discovered fraud more often during voluntary audits in comparison with Big Four audit rms (34 versus 12 per cent). Furthermore, differences were found among audit rms with respect to the proportion of fraud cases detected during statutory or voluntary audits. For instance, audit partners in audit rm B detected all fraud cases during statutory audits, while in audit rm E only two-thirds of the fraud cases were detected during statutory audits. These differences are signicant at the 1 per cent level. Finally, partner experience was not related to the detection of fraud during statutory versus voluntary audits. 4. External versus internal fraud. In the survey, external fraud was dened as fraud that predominantly harms external parties, such as the government or customers. In contrast, internal fraud was described as fraud that primarily harms the company of the person who commits fraud. Examples of internal fraud include theft of assets and incorrect claiming of expenses. Table II shows that a large proportion of the 317 cases reported referred to internal fraud rather than external fraud (71 versus 29 per cent). Also, the proportion of detected external versus internal fraud differed between Big Four and non-Big Four audit rms. Big Four audit rms detected external fraud less frequently than did non-Big Four audit rms (24 vs 47 per cent) which is signicant at the 1 per cent level. Table II indicates signicant differences at the 1 per cent level among audit rms in discovering external or internal fraud. In audit rm E, for example, 43 per cent of all cases of detected fraud concerned external fraud, while in audit rm B this is only 8 per cent. Finally, more experienced audit partners detected external fraud more often than did less experienced partners (42 versus 29 and 25 per cent at the 10 per cent signicance level). Auditor redress and reporting of fraud This section focuses on the actions Dutch auditors are required to take once fraud is detected, according to the auditing standards and regulation as dened above. 1. Reporting to management. As soon as the auditor detects fraud or receives signals that could be interpreted as such, the auditor needs to report this to management in writing. The data indicate that the fraud was reported verbally more often than in writing (77 versus 48 per cent, see Table III). These per centages add up to more than 100 per cent, because some fraud cases were reported both verbally and in writing. As far as reporting verbally to management is concerned, differences among types of fraud, audit rms or levels of audit partner experience were not signicant. Still, the results indicate that verbal reports to management were more common for Big Four audit rms (79 versus 72 per cent) and for more experienced partners (87 per cent for extensive experience, 77 and 74 per cent for average and limited experience, respectively). Reporting in writing to management occurred signicantly more often in cases of material fraud (59 versus 41 per cent for immaterial fraud) and signicantly more often in cases of management fraud (57 versus 41 per cent for employee fraud). Both differences are signicant at the 1 per cent level. In cases of statutory audits and in cases of external fraud, respondents indicated that they reported to management in writing slightly more often, though these differences are not signicant. Furthermore, Big Four audit partners reported to management in writing more often than did non-Big Four audit partners (53 versus 41 per cent). Finally, more experienced audit

100 37 63 41 59 81 19 29 71 64 25 16 8 17 29 16 39 44

245 77 152 48 92 78 70 59 153 77 82 * 41 98 76 74 57 147 78 78* 41 202 78 129 50 43 73 23 39 73 78 51 55 172 77 101 45 160 79 107 53 57 72 32*** 41 40 80 28 56 21 88 14 58 42 78 28 52 69 75 45 49 45 87 36 69 96 77 60 48 104 74 56* 40

% Reported to management Reported verbally % Reported in writing % Reported to supervisory board Reported verbally % Reported in writing % 105 33 99 31 46 39 47 40 59 30 52** 26 56 43 53 41 49* 26 46* 24 98 38 93 36 7* 12 6* 10 30 32 28 30 75 33 71 32 87 43 81 40 6* 8 7* 9 20 40 18 36 17 71 10 42 233 43 24 44 6 39 37 40 214 40 19 37 24 34 46 37 2 30 34*** 24

0 8

Redress Redress not requested % Redress requested % 75 24 242 76 28 24 90 76 1 7 7 8 83 92 4 3 65 78 18 22 131** 91 13 9 73 75 24 25 123* 95 7 5 161 88 23 13 31 86 5 14 48 79 13 21 148*** 89 18 11 132 89 17 11 40 80 10 20 30 97 1 3 16 94 1 6 8 5 144 95 11 10 97 90 4** 3 130 97 14 7 184 93 0 0 36 100 8 12 61 88 7*** 4 166 96 7 4 149 96 6 11 50 89 5 14 31 86 1 6 17 94 0 0 50 100 46 92 4 8 1 2 64 98 51 80 13 20 47 24 152 76 21 16 108 84 54** 29 134 71 56 22 198 77 19*** 32 36 61 24 26 69 74 51 23 173 77 47 23 156 77 23 29 56 71 14 28 36 72 6 25 18 75 4 7 50 93 27 29 65 71 15 6 227 94 196 86 31 14

12 23 40 77 4 10 36 90 32 89 4 11

28 22 97 78 6 6 91 94 83 91 8 9

35 25 105 75 5 5 100 95 81 81 19 19

Not redressed % Redressed %

Redressed without pressure % Redressed after pressure %

Resignation Resigned because of fraud % Resigned because of lack of redress (%) 17 5 4 27 13 11 3 43 4* 2 1 13 16 12 4 36 1* 1 0 0 12 5 n.a. n.a. 5 8 n.a. n.a. 10 11 3 38 7** 3 1 14

13 6 3 43

4 5 1 17

4 8 1 20

2 8 1 100

3 6 0 n.a.

4 4 1 100

3 6 n.a. n.a.

6 5 n.a. n.a.

8 6 n.a. n.a.

15 7 2

External notification No. of not redressed No. of should have been reported in the sample No. of actually reported in the total population 7 8 11 4 14 0 1

Notes: Statistical significance at: *1, **5 and ***10 per cent levels (two-tailed test); athe data on redress are based on a subset of 309 cases out of the 317 cases; n.a. data are not available

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Table III. Reporting to management

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partners reported in writing more often than did less experienced partners (69, 48 and 40 per cent for extensive, average and limited experience, respectively). No signicant relationships were found between the frequency of written fraud reports to management and the ve categories of audit rms (A-E). 2. Reporting to the supervisory board. At the time the study was performed, auditing standards explicitly required certain types of fraud to be reported in writing to the supervisory board: cases of management fraud, cases of material fraud and cases where management refuses to redress the fraud. Table III indicates that in 41 per cent of the cases of management fraud and in 40 per cent of the cases of material fraud the auditor actually reported to the supervisory board in writing. Reporting verbally to the supervisory board tended to take place more often in cases of material fraud (39 versus 30 per cent for immaterial fraud), in cases of management fraud (43 versus 26 per cent for employee fraud) and in cases of fraud detected during a statutory audit (38 versus 12 per cent for voluntary audits). The rst difference is not statistically signicant; the other two are signicant at the 1 per cent level. Verbal reporting to the supervisory board was not signicantly related to the external/internal dimension. Big Four auditors reported verbally to the supervisory board more frequently than did non-Big Four auditors (43 versus 8 per cent signicant at the 1 per cent level). Different audit rms reported verbally to the supervisory board with signicantly different frequencies: audit rm B reported verbally most often (71 per cent) while audit rm E did so least often (9 per cent). The data indicate that verbal reporting to the supervisory board is not signicantly related to the amount of audit partner experience, although more experience seems to be consistent with more frequent reporting. When it comes to reporting to the supervisory board in writing, material fraud, management fraud and fraud encountered during a statutory audit were reported more often than other types of fraud. Reporting to the supervisory board in writing appears to be unrelated to the external/internal dimension. Big Four audit partners reported more often to the supervisory board in writing than did non-Big Four auditors (40 versus 9 per cent). Again, differences among the different audit rms were signicant at the 1 per cent level: audit rm C reported in writing most often (44 per cent) and audit rm E did so least often (10 per cent). Auditors with high or medium experience issued more written reports to the supervisory board than did audit partners with low experience (37, 37 and 24 per cent, respectively, signicant at the 10 per cent level). 3. The redress process. When the auditor has detected fraud and management has not yet taken appropriate steps to redress the effects of the fraud, the auditor is required to demand that the fraud be redressed, i.e. the consequences of the fraud have to be rectied as far as possible and recurrence needs to be prevented. In cases where management has already taken appropriate action, the auditor does not demand redress but veries that the actions taken are satisfactory. At the time of the survey, auditing standards required the auditor to demand redress of material fraud. If redress was not accomplished, the auditor was required to withdraw from the engagement and, when the engagement concerned a statutory audit, report this fact to a central governmental agency[15]. The results show that in 76 per cent of the fraud cases, the auditor demanded the entity to redress the fraud. It is possible that in the remaining 24 per cent of the cases the audit client had already taken sufcient measures to redress the fraud on their own initiative; therefore, in those cases there was no need for the auditor to demand redress. Table III indicates that redress was requested more often

in case of management fraud (84 versus 71 per cent for employee fraud), and fraud discovered during a statutory audit (77 versus 61 per cent for voluntary audit). Furthermore, demands for redress were signicantly related to the audit rm: audit rm C requested redress in 93 per cent of the cases, while audit rm D did so only 71 per cent of the time. Demands for redress were not related to the remaining characteristics of fraud or to any other auditor characteristic. Of the fraud cases in which redress was requested, redress was accomplished, eventually, in 94 per cent of the cases. Redress more often took place in cases of employee fraud in comparison with management fraud (97 versus 90 per cent) and more often in cases of internal fraud than in cases of external fraud (96 versus 88 per cent). Redress effectiveness was not signicantly related to fraud materiality and to the statutory-voluntary audit dimension. Respondents of Big Four audit rms tended to achieve a higher redress effectiveness than those of non-Big Four audit rms (96 versus 89 per cent), though this difference is not statistically signicant. A signicant relationship did exist between redress effectiveness and audit rm: audit rm C managed to achieve redress in all requested cases, while audit rm A achieved redress least often (86 per cent). Redress effectiveness tended to decline with auditor experience, but this relationship was not signicant. Furthermore, the auditor can achieve redress with or without putting pressure on the auditee. Table III reveals that the auditor needed to use pressure more frequently in the cases involving material fraud (22 versus 9 per cent), management fraud (25 versus 5 per cent) and external fraud (21 versus 11 per cent). Also, partners of audit rms D and E needed to use pressure signicantly more often than did partners of other audit rms. Whether fraud was detected during a statutory or voluntary audit, by a Big Four or non-Big Four audit partner or by an experienced or less experienced partner did not seem to affect the need for pressure to achieve redress. 4. Auditor resignation. The auditing standards at the time of the study allowed the auditor to resign from the assignment in case of fraud, but required the auditor to resign if a case of material fraud was not redressed[16]. Results indicated that in 17 (5 per cent) of the 317 fraud cases the audit partner resigned. This occurred more often in cases of external, management and material fraud than in other fraud cases. Respondents indicated that in three out of these 17 resignations, resignation resulted from the fact that redress had not taken place although the fraud was material. The data in Table III, however, suggest that there were actually seven cases of material fraud that were not redressed by management, and therefore, should have led to the auditors resignation. Consequently, in four cases of non-redressed material fraud, the auditor did not resign despite an obligation to do so. 5. External reporting of fraud. Finally, auditing standards state that when material fraud discovered during a statutory audit has not been redressed by the audit client within a reasonable time frame, the auditor is not only required to resign from the engagement, but also to notify the dedicated governmental agency. The 296 respondents in this study identied seven material fraud cases for the period 1995-2002 that had not been redressed, all of which were discovered in the course of a statutory audit. This means that in this sample seven cases should have been reported to the central reporting agency. Given the fact that the initial sample of the top 30 audit rms covers the vast majority of the population of Dutch auditors who perform statutory audits, the response rate of 24 per cent (which is almost a quarter of the audit partners of the top 30 audit

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rms) results in an expected number of about 28 cases (7 4) for the entire population, which should have been reported to the government agency[17]. In reality, the agency was notied only twice in the period 1995-2002, indicating that external reporting of fraud is less frequent than might be expected from the results of this study. Perceptions of the role of the auditor in the redress process A nal issue concerns the audit partners perceptions of their role in the redress process. For this analysis, auditors who had not actually detected fraud were eliminated from the sample (Table IV)[18]. Most auditors who do have experience with fraud detection perceived their role in the redress process to be signicant (56 per cent). Results also show that perceptions of the role of the auditor in the redress process differed between Big Four and non-Big Four auditors; Big Four auditors perceive their role in the redress process to be limited more often than do non-Big Four auditors (33 versus 17 per cent). In addition, non-Big Four auditors did not have an opinion on their role in redressing fraud more often than did Big Four auditors (24 versus 13 per cent). The inuences of the different audit rms and years of audit partner experience on auditor role perceptions proved not to be signicant. Conclusions In this study, evidence has been presented on the volume and nature of fraud cases detected by audit partners and the extent of these partners compliance with auditing standards regarding redress of fraud and reporting fraud to a governmental agency. Also, the study provides evidence on the experiences of auditors requesting redress once they have encountered cases of corporate fraud. The rst conclusion to be drawn from this study is that fraud detection by auditors is a relatively rare event; this result is consistent with previous research by Loebbecke et al. (1989). On average, the audit partners in the sample detected 1.07 fraud cases in an eight-year window. Furthermore, non-Big Four auditors seemed to detect the more serious fraud cases (i.e. management fraud with an external scope) more often than did Big Four auditors. These results indicate that most auditors have insufcient opportunity to build expertise in the area of fraud detection, reporting and redress of detected fraud.
No/limited role Total Big Four vs non-Big Four Big Four audit rm Non-Big Four audit rm Big Four audit rm A B C D Experience as a partner High Medium Low 41 (29) 28 (33) 7 (17) 3 4 11 14 (16) (31) (52) (35) Signicant role 79 (56) 47 (55) 24 (59) 14 8 9 19 (74) (62) (43) (48) No opinion 21 (15) 11 (13) 10 (24) 2 1 1 7 (11) (8) (5) (18)

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Table IV. Perceptions of the role of the auditor in the redress process

5 (24) 19 (32) 17 (28)

14 (67) 33 (56) 32 (52)

2 (10) 7 (12) 12 (20)

Note: The values within the parentheses denote percentage

The overall conclusion with respect to the redress process is that Dutch auditors do not comply with certain key elements of the standards. The compulsory written report to management was issued in only 48 per cent of the cases. Also, the written report to the supervisory board was issued in just 41 per cent of all management fraud cases and in 40 per cent of all instances of material fraud. This is more than just a documentation error. If fraud is not reported in writing, the fraud case may not be included in the audit le and in case of a le review, the auditor will not be held responsible if his response was inadequate. Also, data show that the reporting rules were followed more strictly by Big Four auditors and in cases of material and management fraud. In addition, redress effectiveness (i.e. whether redress is actually achieved) was lower in cases of management and external fraud, and pressure was needed in the more serious cases of material, management and external fraud. This indicates that management was less likely to redress a serious instance of fraud than it was to redress a less serious case. When considering the requirement for an auditor to resign when material fraud is not redressed, it turns out that auditors resigned in three out of seven cases. External reporting to a governmental agency took place even less often. In the window of this study, the governmental agency was actually notied with regard to two fraud cases[19]. These empirical ndings cannot be compared to previous work since this concerns a unique feature of the Dutch framework that has not been investigated previously. The results of the current study are generally in line with those reported by Loebbecke et al. (1989). As explained above, both studies concluded that auditors rarely encounter fraud. There are, however, some differences between the current results and those reported by Loebbecke et al. (1989). In the present study, a much smaller proportion of the total number of fraud cases could be classied as management or material fraud (41 and 37 per cent, respectively) than was the case in Loebbecke et al. (56 and 60 per cent). There are several explanations for these differences. First, the population under investigation differed between the studies. Loebbecke et al. focused on the USA, while the focus of the current study was on the Netherlands. Institutional and cultural differences may have an impact on the types of fraud committed and on the willingness of respondents to provide honest answers. Second, the sample of the current study included partners of the top 30 Dutch audit rms, while Loebbecke et al. focused on a single audit rm. This study provided indications that auditor experiences with fraud detection do differ across audit rms, thereby providing an explanation for the observed differences between the two studies. Third, the window differed between the studies. Loebbecke et al. focused on the period prior to 1990, while the current study investigated the window 1995-2002. Fourth, the difference in the classications of fraud cases as either management or employee fraud may be due to inconsistent interpretations among respondents. Given the sensitive nature of reporting fraud and societys expectations of auditors in this respect, compliance with audit standards on fraud detection and reporting is a key issue in auditors professional ethics. Most existing studies in this area have focused on the question of the extent to which auditors are able to detect fraud, implicitly focusing on the fact that society may have unrealistic expectations in this matter. However, the evidence provided in this study suggests that in cases where the auditor has detected fraud, relevant procedures and regulations are not fully complied with.

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There may be several causes for the nding of non-compliance in the current study. Possibly, auditors may decide not to comply with the standards because they face conicts of interest, or because they are careless or for efciency reasons, or it might be they are not fully aware of what the standards require. With regard to this latter possibility, respondents claimed that they hardly ever detect fraud, and therefore, did not build up experience with responding to actual fraud cases in line with auditing standards. This increases the probability that they fail to do so when fraud occurs. Compare this situation to that of airline pilots. The likelihood that an average airline pilot will be confronted with a near crash in his career is extremely low. Since they should nevertheless know how to deal with such situations, aviation authorities require airline pilots to be trained in the procedures for handling near crash situations in ight simulators. Auditors, however, often do not train for similar rare events and as a consequence they do not build up expertise in nding and dealing with corporate fraud. Existing studies have indicated that changes in auditing standards and regulatory changes have not resulted in an increase in auditors ability to detect fraud or in an improvement of audit effectiveness in discovering fraud (Jakubowski et al., 2002; Rezaee et al., 2003). Our results suggest that a lack of knowledge among auditors about the details of such standards and regulations may have further limited their effect on auditors demands for redress and on their reporting actions in fraud cases. In addition to increasing educational efforts, this nding may also lead to the conclusion that in cases of fraud, the audit team should be expanded to ensure the availability of specic expertise that may be available at the technical department of the audit rm. However, as mentioned, auditors may also decide not to comply with the standards because they face conicts of interest, or because they are careless or for efciency reasons, in addition to the lack of knowledge or specic training with regard to detecting and responding to fraud. As a direct result of the outcomes presented here, the Dutch professional body NIVRA took several steps. First, all Dutch auditors have been obliged to take a special course on fraud standards, to make sure that they are well aware of the latest standards regarding corporate fraud. In addition, existing fraud regulations have been amplied with respect to the consultation of experts, to encourage the engagement team to use the expertise of specialists to address potential fraud situations. Furthermore, regulations concerning the reporting of fraud have been strengthened. Previously, the auditor was required to report fraud cases to the supervisory body only in cases of management or material fraud, but under the new standards all cases of fraud must be reported. Furthermore, under the new standards, the auditor should consider resigning from the engagement not only in material cases but also in all cases where management fails to take reasonable steps to redress fraud. These changes should limit the number of situations in which auditors are exempted from taking actions as laid down in standards relating to fraud situations, making what can be expected from the auditor in fraud-related situations more transparent for auditors as well as for the general public. As with all other studies on the occurrence of fraud, this research suffers from an inherent limitation. The sensitive nature of the subject and the tendency of audit partners to protect themselves and their rms may lead to socially desirable answers. There may also be a non-response bias. These risks were mitigated as far as possible by using a notary in civil law as an intermediary in the data-collection process

to guarantee anonymity of the respondent. Also, specic non-response tests were performed. Nevertheless, further research on the role of auditors in fraud cases remains crucial. In future research, it would be interesting to distinguish the power of such factors as: . auditors lack of knowledge or competence on how to act once corporate fraud is detected; . lack of care for following protocol; and . the external auditors lack of independence. Moreover, it would be interesting to investigate in more detail the characteristics of those cases of detected fraud where existing standards were not complied with. More detailed analyses of real-life fraud cases can offer unique opportunities for improving current fraud standards.
Notes 1. Professional ethics concerns the moral issues (e.g. fraud reporting) that arise because of the specialist knowledge that professionals attain, and how the use of this knowledge should be governed when providing a service to the public (Chadwick, 1998). 2. In a later study, Albrecht and Romney (1986) used the same dataset to extend this research. 3. The dataset used in Loebbecke et al. (1989) consisted only of fraud cases. Several later studies have used the same dataset, expanding it with a set of non-fraud cases (Bell et al., 1991; Hansen et al., 1996; Bell and Carcello, 2000). 4. Loebbecke et al. (1989) distinguished between management fraud and defalcations, privately held or publicly held companies, fraud materiality, client industries, deceptive actions, levels of client personnel involved, audit areas, auditing procedures rst indicating the fraud and number of prior audits of the client. 5. Currently, the responsibilities of auditors in the Netherlands with regard to corporate fraud are set in the Audit Firms Supervision Act (2006), the Decree on the Supervision of Audit Firms (2006) and Audit Standard COS 240 The auditors responsibility to consider fraud in an audit of nancial statements. This is a slightly different situation compared to the moment the survey in this study was conducted. The current requirements are essentially the same as the requirements in the situation before 2006 except for the fact that some responsibilities are now set in a national act instead of in professional standards. 6. See DAS 240 and BLF, now: COS 240.93a. 7. See DAS 240 and BLF, now: COS 240.95b. 8. See DAS 240 and BLF, now: BTA 37.1. 9. See BLF Art. 3, now: COS 240.103. Note that COS 240.130 requires the auditor to consider resigning whereas BLF Section 2 requires the auditor to resign. 10. See BTA, COS 240.102a. 11. The questionnaire is available from the auditors upon request. 12. Every received self-addressed envelope was opened by the notary in civil law in the absence of the researchers; the date was put on the questionnaire and the questionnaire was marked by the notary with a new code per auditing rm. This procedure made it possible for the researchers to compare fraud experiences among auditing rms while still guaranteeing the

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anonymity of the respondents and of the auditing rm involved. After recoding the self-addressed envelopes, the notary destroyed the coding table. 13. With respect to non-response bias, a number of characteristics of early versus late respondents have been tested. The corresponding t-tests have not indicated any signicant differences between both groups. 14. To compare the ndings, the average number of fraud cases reported by Loebbecke et al. was multiplied by 0.6, resulting in an average of 1.86 fraud cases per audit partner. To adjust for the larger time frame of Loebbecke et al., we divided this number by the average auditing experience of 19.5 years of the partners sampled in this research and then multiplied this number by eight years, which is the window of the current study. After these adjustments, the number of fraud encounters per audit partner in the Loebbecke et al. study is about 0.76, which is more in line with the ndings of the present study (1.07 fraud cases). 15. Note that in the current auditing standards in this situation the auditor only has to consider withdrawing from the engagement but nevertheless he must report to a central governmental agency. 16. See also BLF. 17. Of the total population of top 30 audit partners in The Netherlands, about a quarter participated in this study. Of approximately 130,000 audits in The Netherlands in the period 1995-2002, about 1,250 instances of fraud would have been detected. In 1,000 of these cases redress would have been requested by the auditor, of which 940 cases would have been redressed eventually. Therefore, in 60 cases, no redress would have taken place, of which 28 cases would have been material fraud detected during a statutory audit. In 16 of these instances, the auditor would have resigned, and 28 cases would have been reported to the external reporting agency. 18. The reason for this removal was that only 15 per cent of this group had an opinion on the auditors role in fraud redress; eight partners considered their role to be small, and 15 partners considered their role to be signicant. The remaining 132 auditors who had no experience with fraud detection did not have an opinion on the auditor role in the redress process. 19. Under the old requirements, it was mandatory for auditors to report the fraud to the governmental central reporting agency (BLF, Section 3) while under the current legislation this is mandatory according to the Audit Firms Supervision Act, Article 26.

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References Albrecht, W.S. and Romney, M.B. (1986), Red-agging management fraud: a validation, Advances in Accounting, Vol. 3, pp. 323-33. Arnold, D.F. Sr, Bernardi, R.A., Neidermeyer, P.E. and Schmee, J. (2005), Personal versus professional ethics in condentiality decisions: an exploratory study in Western Europe, Business Ethics: A European Review, Vol. 14 No. 3, pp. 277-89. Asare, S.K. and Wright, A.M. (2004), The effectiveness of alternative risk assessment and program planning tools in a fraud setting, Contemporary Accounting Research, Vol. 21 No. 2, pp. 325-52. Barron, O., Pratt, J. and Stice, J.D. (2001), Misstatement direction, litigation risk, and planned audit investment, Journal of Accounting Research, Vol. 39 No. 3, pp. 449-62. Bell, T.B. and Carcello, J.V. (2000), A decision aid for assessing the likelihood of fraudulent nancial reporting, Auditing: A Journal of Practice and Theory, Vol. 19 No. 1, pp. 169-84.

Bell, T.B., Szykowny, S. and Willingham, J.J. (1991), Assessing the likelihood of fraudulent nancial reporting: a cascaded logit approach, working paper, KPMG Peat Marwick, Montvale, NJ. Bollen, L., Mertens, G., Meuwissen, R., van Raak, J. and Schelleman, C. (2005), Classication and analysis of major European business failures, Research Project Commissioned by the European Contact Group, London. Chadwick, R. (1998), Professional ethics, in Craig, E. (Ed.), Routledge Encyclopedia of Philosophy, Routledge, London. DeAngelo, L.E. (1981), Auditor size and audit quality, Journal of Accounting and Economics, Vol. 3 No. 4, pp. 183-99. Deis, D.R. and Giroux, G.A. (1992), Determinants of audit quality in the public sector, The Accounting Review, Vol. 67 No. 3, pp. 462-79. Eining, M.M., Jones, D.R. and Loebbecke, J.K. (1997), Reliance on decision aids: an examination of auditors assessment of management fraud, Auditing: A Journal of Practice & Theory, Vol. 16 No. 2, pp. 1-19. Glover, S.M., Prawitt, D.F., Schultz, J.J. Jr and Zimbelman, M.F. (2003), A test of changes in auditors fraud-related planning judgments since the issuance of SAS no. 82, Auditing: A Journal of Practice & Theory, Vol. 22 No. 2, pp. 237-51. Gowthorpe, C., Blake, J. and Dowds, J. (2002), Testing the bases of ethical decision-making: a study of the New Zealand auditing profession, Business Ethics: A European Review, Vol. 11 No. 2, pp. 143-56. Hackenbrack, K. (1992), Implications of seemingly irrelevant audit evidence in audit judgment, Journal of Accounting Research, Vol. 30 No. 1, pp. 126-36. Hansen, J.V., McDonald, J.B., Messier, W.F. Jr and Bell, T.B. (1996), A generalized qualitative-response model and the analysis of management fraud, Management Science, Vol. 42 No. 7, pp. 1022-32. Jakubowski, S.T., Broce, P., Stone, J. and Conner, C. (2002), SAS 82s effects on fraud discovery, CPA Journal, Vol. 72 No. 2, pp. 42-6. Knapp, C.A. and Knapp, M.C. (2000), The effects of experience and explicit fraud risk assessment in detecting fraud with analytical procedures, Accounting, Organizations and Society, Vol. 25 No. 1, pp. 25-37. Krishnan, G.V. (2003), Audit quality and the pricing of discretionary accruals, Auditing: A Journal of Practice & Theory, Vol. 22 No. 1, pp. 109-26. Loebbecke, J.K., Eining, M.M. and Willingham, J.J. (1989), Auditors experience with material irregularities: frequency, nature and detectability, Auditing: A Journal of Practice & Theory, Vol. 9 No. 1, pp. 1-28. Melis, A. (2005), Corporate governance failures: to what extent is Parmalat a particular Italian case?, Corporate Governance: An International Review, Vol. 13 No. 4, pp. 478-88. Mock, T.J. and Turner, J.L. (2005), Auditor identication of fraud risk factors and their impact on audit programs, International Journal of Auditing, Vol. 9 No. 1, pp. 59-77. Moriceau, J.L. (2004), What can we learn from a singular case like Enron, Critical Perspectives on Accounting, Vol. 16 No. 6, pp. 787-96. Nieschwietz, R.J., Schultz, J.J. Jr and Zimbelman, M.F. (2000), Empirical research on external auditors detection of nancial statement fraud, Journal of Accounting Literature, Vol. 19, pp. 190-246. NIVRA (2000), Standards on Auditing, NIVRA, Amsterdam.

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Palmrose, Z.V. (1988), An analysis of auditor litigation and audit service quality, The Accounting Review, Vol. 63 No. 1, pp. 55-73. Palmrose, Z.V. (1991), Trials of legal disputes involving independent auditors: some empirical evidence, Journal of Accounting Research, Vol. 29 No. 3, pp. 149-85. Porter, B. (1993), An empirical study of the audit-expectation-performance gap, Accounting & Business Research, Vol. 24, pp. 49-68. Rezaee, Z., Olibe, K. and Minmier, G. (2003), Improving corporate governance: the role of audit committee disclosures, Managerial Auditing Journal, Vol. 18 Nos 6/7, pp. 530-7. Romney, M.B., Albrecht, W.S. and Cherrington, D.J. (1980), Auditors and the detection of fraud, Journal of Accountancy, Vol. 149 No. 5, pp. 63-9. Zimbelman, M.F. (1997), Effects of SAS 99, Journal of Accounting Research, Vol. 35 No. 1, pp. 76-97. Further reading Farrell, B.J. and Cobbin, D.M. (2000), An analysis of the ethical environment of the international accounting profession, Business Ethics: A European Review, Vol. 9 No. 1, pp. 20-30. Farrell, B.J. and Cobbin, D.M. (2001), Global harmonisation of the professional behaviour of accountants, Business Ethics: A European Review, Vol. 10 No. 3, pp. 257-66. Ferguson, M.J. and Majid, A. (2003), To sue or not to sue: an experimental study of factors affecting Hong Kong liquidators audit litigation decisions, Journal of Business Ethics, Vol. 46 No. 4, pp. 363-74. Kerler, W.A. III and Killough, L.N. (2009), The effects of satisfaction with a clients management during a prior audit engagement, trust, and moral reasoning on auditors perceived risk of management fraud, Journal of Business Ethics, Vol. 85 No. 2, pp. 109-36. Krishnan, J. and Krishnan, J. (1997), Litigation risk and auditor resignations, Accounting Review, Vol. 72 No. 4, pp. 539-60. Lee, H.Y., Mande, V. and Ortman, R. (2004), The effect of audit committee and board of director independence on auditor resignation, Auditing: A Journal of Practice & Theory, Vol. 23 No. 2, pp. 131-46. Majid, A., Gul, F.A. and Tsui, J.S.L. (2001), An analysis of Hong Kong auditors perceptions of the importance of selected red ag factors in risk assessment, Journal of Business Ethics, Vol. 32 No. 3, pp. 263-74. Pratt, J. and Stice, J.D. (1994), The effects of client characteristics on auditor litigation risk judgments, required audit evidence, and recommended audit fees, Accounting Review, Vol. 69 No. 4, pp. 639-56. Raghunandan, K. and Rama, D.V. (1999), Auditor resignations and the market for audit services, Auditing: A Journal of Practice & Theory, Vol. 18 No. 1, pp. 124-34. Shu, S.Z. (2000), Auditor resignations: clientele effects and legal liability, Journal of Accounting & Economics, Vol. 29 No. 2, pp. 173-205. Tatum, K.W. (2008), Analysis of international standards on auditing, AICPA Professional Standards, Vol. 1, AICPA, Durham, NC, Appendix B. Wilks, T.J. and Zimbelman, M.F. (2004a), Decomposition of fraud-risk assessments and auditors sensitivity to fraud cues, Contemporary Accounting Research, Vol. 21 No. 3, pp. 719-45. Wilks, T.J. and Zimbelman, M.F. (2004b), Using game theory and strategic reasoning concepts to prevent and detect fraud, Accounting Horizons, Vol. 18 No. 3, pp. 173-84.

Appendix DAS 240 The main points were as follows. Before starting the audit as such, auditors are required to carry out a pre-assessment, evaluating and documenting the likelihood of nancial misstatements and the presence of risk factors indicating an increased potential for fraud, and making inquiries to better understand the company, its procedures and its management. Based on this pre-assessment, the audit procedure should take into account the estimated level of inherent and control risk, and may have to be adjusted or expanded if circumstances are encountered that may indicate material misstatement. While conducting the audit, a written representation from management should be requested including a statement that management feels obliged to detect and deter the occurrence of fraud, and that the auditor has been informed about all relevant fraud cases. If material errors are detected, the auditor should report this to management and may, again, have to revise the audit procedures based on the new information. At the same time, the integrity of management should be reconsidered, especially if there are indications of management fraud. If there is fraud or an indication of fraud and the auditor believes that it is therefore not possible to continue the audit, he should consider reporting to the entity (or, in some cases, to regulatory authorities) or withdrawing from the engagement. The auditor needs to terminate his appointment if the audit is impeded by any restrictions or limitations imposed by the client, and should inform the appropriate level of management and the supervisory body about his reasons for doing so. BLF The main points were as follows. The BLF came into force in 1994 and remained unchanged throughout the period under study (1995-2002). Both the AS 240 and the Supervision of Auditors Act (Wet toezicht accountantsorganisaties or WTA) were modied after this study was completed. These regulations now contain the main points of the BLF, which then ceased to exist as a separate auditing standard. However, there is one exception to the BLF, and that concerns the provision that auditors must notify the supervisory body if management refuses to redress the detected fraud. This step is not covered, either by the WTA or the accompanying Decree on the Supervision of Auditors (Besluit toezicht accountantsorganisaties, or BTA). The BTA requires that the competent government authority be notied when the audit client fails to redress the fraud (whether this concerns management or the supervisory body), thus omitting the intermediate step of informing the supervisory board. Abbreviations: BLF Dutch by-law on reporting on fraud. BTA Dutch decree on the supervision of audit rms, 2006. COS Dutch audit and other standards (as of 2007). DAS Dutch Auditing Standards (until 2007). ISA International standard on auditing.

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Corresponding author Harold Hassink can be contacted at: h.hassink@maastrichtuniversity.nl

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