Introduction

Fraud is an ever-present threat to the effective utilization of resources and hence will always be an
important concern of management (Brink and Witt, 1982).

Chandler et al. (1995), in their article titled “Changing perceptions of the role of the company auditor;
1880-1940” believe that the problems facing the auditing profession today may stem from ostensible
obsession with fraud detection shown by some Victorian era practitioners. This obsession created an
expectation gap among the public. Emphasizing fraud detection as the primary audit objective lasted
until the 1930s, when the principal audit objective became the verification of the accounts.

According to the 1921 edition of Spicer and Pigler’s Practical Auditing, the principal reason for instituting
an audit are to detect fraud and errors. Walker (1993) observed that auditors have become less
interested in detecting fraud. There is evidence that auditors do not regard the reporting of significant
audit observations to stakeholders as an integral part of the audit and accept no responsibility for the
audited financial statement. In general they are not overly concerned with detecting fraud and errors.

In the late 1940s, the external auditors did not assume a direct responsibility for fraud because f their
inability to detect fraud involving unrecorded transactions, theft, and other irregularities. This was done
to shield accounting firms from lawsuits holding them responsible from frauds (Brink and Witt, 1982).

Fraud has attracted the attention for scholars, investigators, auditing and accounting associations, and
government agencies, nationally and internationally. Fraud’s many definitions include those given
below.

Prosser (1971) describes the elements of fraud as follows:

 False representation of material fact

For Elliot and Willingham (1980), financial fraud is the “ deliberate fraud committed by management
that injures investors and creditors through materially misleading financial statements.”

The Institute of Internal Auditors (1985), in its SIAS No. 3, Deterrence, Detection, Investigation, and
Reporting of Fraud, has referred to fraud as encompassing “an array of irregularities and illegal acts
characterized by intentional deceptions. It can be perpetrated for the benefit or the detriment of the
organization.”

The National Commission and Fraudulent Financial Reporting (1987) defines fraudulent financial
reporting as an “intentional or reckless conduct, wheter by act or omission, that results in materially
misleading financial statements.”
 The American Institute of Certified Public Accountants (1988), in its SAS No. 53, The Auditor’s
Responsibility to Detect and Report Errors and Irregularities, introduced the term irregularities to
describe intentional misstatements (management fraud) and theft of assets (employee fraud).

Sawyer (1988) views fraud as a false representation or concealment of material fact to induce someone
to part with something of value. For Arens and Loebbecke (1994), fraud occurs when “a misstatement is
made and there is both the knowledge of its falsity and the intent to deceive”. For Wallace (1995), fraud
is “a scheme designed to deceive; it can be accomplished with fictitious documents and representations
that support fraudulent financial statements”. For Flesher (1996) fraud means “dishonesty in the form of
intentional deceptions or a willful mispresentation of fact”. For Albrecht (1996), every fraud consists of
three elements:

1. Theft act which involves taking cash, inventory, information, or other assets manually, by
computer, or by telephone
2. Concealment which involves the steps taken by the perpetrators to hide the fraud from
others; and
3. Conversion which involves selling or converting stolen assets into cash and then spending the
cash.
Fraud rulings on management’s and auditor’s liability are of great concern to boards of directors, audit
committees, management, independent auditors, internal auditors, fraud examiners, and regulatory
agencies. The American Association of Certified Public Accountants (AICPA), The Institute of Internal
Auditors (IIA), The Association of Certified Fraud Examiners (ACFE), and other regulatory agencies have
taken bold steps in condemning fraudulent and unlawful acts in their regulations, codes of conduct, an
auditing standards.

Several frauds reported in the last few decades have led the government and the auditing profession to
rethink and re-engineer their audit tools and procedures to safeguard corporate assets better.
Furthermore, the cost of litigation of fraud cases has created a new wave of scandals and the auditor’s
liability has skyrocketed in billions of dollars as attested from the following events:

 An editorial in Fortune (1978) reported that increased time pressure had led independent
auditors to do a sloppy job in their audits. Out of 1,100 practitioners, 58 percent had indicated
that they had signed off on a required audit step without completing the work or nothing the
omission.
 Thornhill (1985) observed that the US military is defrauded by US$500 million to US$1 billion a
year by unscrupulous contractors.
 The Institute of Financial Crime Prevention (1986) reported that situation pressures,
opportunities to commit fraud, and personal integrity are three variables influencing the
likelihood of fraud. Of all internal theft 80 percent are committed by one employee acting alone
 Thomas (1990) reported that fraud has caused billion dollar to financial institutions and greatly
increased the number of lawsuits. The Lincoln Savings and Loan Association and the So-called
“Keating five” lost US$2,3 billion in 1990s second quarter. The 2,500 S&Ls posted US$271
million in losses in the first quarter of 1990. Rankin (1990) also reported that two of the Big Six
firms face over US$13 billion in damages from related lawsuits.
 Schmedel and Berton (1992) reported a tax scandal in the Wall Street Journal concerning in the
Resolution Trust Corporation, a federal thrift cleanup agency, which field a US$400 million civil
suit against Arthur Andersen & Co. claiming that the accounting firm was negligent in auditing
the collapsed Benyamin Franklin Savings Association. Arthur Consulting had failed to withhold
Colorado’s income tax from the pay of 35 nonresident employees. As part of the civil
settlement, Andersen paid Colorado nearly US$1 million in taxes, penalties, and investigation
costs.
 Based on information from the US Chamber of Commerce, Davia et al, (1992) estimated that
the cost of fraud in the USA exceeds US$100 billion dollars annually. They wonder whether or
not anyone is “watching the stores”.
 KPMG Peat Marwick surveyed the 2,000 largest companies in the USA to assess the extent of
fraud in US corporation (1993) these include manufactures, insurance, health care organization,
utilities, and consumer products companies. Of the 330 responding companies, 2 percent
acknowledged that they had experienced fraud during the previous 12-month period. The
average cost to the company was US$200,000 per incident.
  The Wall Street Journal (1994) reported that Montedison, the Italian food and chemical group,
filed a suit against its former auditor Price Waterhouse, Italy, seeking damages of more than
one trillion lire (US$610 million). The suit seeks to recoup losses stemming from alleged “serious
negligence” in Price Waterhouse’s accounting from 1983-1992.
 Schmitt and Berton (1994) reported in the Wall Street Journal that Deloitte agreed to pay
US$312 million to settle US claims related to S&L failure. The 18 pending lawsuits were seeking
over US$14 billion for theft-related work in the 1980s. The accounting firm also agreed to
provide training and supervision for partners auditing financial statements.
 Gardner (1996) reported in The White Paper that GAO has estimated that total year loss to
Medicare because of fraud and abuse is approximately US$47 billion, or 10 percent of total
Medicare spending.

In 1988, Berton reported in The Wall Street Journal that the malpractice claims against the accountants
totaled US$1 billion; by including the charges brought under RICO cases, it would add up to US$4 billion
in damage claims facing the profession as a whole.

On 6 august 1962, the Big Six firms, overwhelmed by the cost of litigation of cases claiming auditors
malpractice, issued a Statement of Position entitled The Liability Crisis in the United States: Impact on
the Accounting Profession. The statement requests a substantive reform of both federal and state
liability laws, specifically the replacement of joint and several liability with a proportionate liability. It
states:
 While other serious problems must also be addressed, the principal cause of unwarranted litigation
against the profession is joint and several liability, which governs the vast majority of actions
brought against accountants at the federal is merely asking for fairness – the replacement of joint
and several liability with a proportionate liability standard that assesses damagers against each
defendant based on that defendant’s degree of fault. Proportionate liability will help restore
balance and equity to the liability system by discouraging suits and giving blameless defendants the
incentive to prove their cases in court rather than settle.

The chairman and senior partner at Price Waterhouse warned that runaway litigation seriously
undermines the ability of the financial reporting system to provide information that supports
competitive decision making by US companies. Unrealistic expectations and the risk-shifting liability
system have combined to create a situation in which auditors are viewed as absolute guarantors against
fraud, failure, and financial ruin. Unwarranted litigation and forced settlements account for the vast
majority of claims against auditors pose a grave threat to the health of many businesses and professions
(O’Malley, 1993a).

Berton (1992a), in his editorial entitled “Holding accountants accountable,” discourages the notion of
“safe harbor” for accountants since it might be an open door for their negligence. Such safe harbor may
hurt their reputation by conveying to the public that they want audit fees without the commensurate
responsibilities. Lee (1992), in his editorial entitled “The Audit liability crisis: they protest too much,”
believe that the contention of Big Six in the US audit firms on curving unwarranted litigation is plain:

They are being extorted by an unfair legal system, and if the public expects their continued
services, the system must be changed so as not to interfere with the maximization of their profits.
The statements ignores a very real audit crisis, involving enormous corporate failures and frauds,
especially in banking and insurance. Auditors have been found “guilty iin court, have been censored
by regulators, and have had their license suspended in some states, yet the Big Six appear obsessed
with their economic entitlement as a virtual monopoly and clueless as to their need to raise their
professional standards.

Baron et al, (1977) conducted a nationwide survey to elicit views within the financial community on two
major issues:

1. The auditor’s responsibility for detecting corporate irregularities and illegal acts; and
2. The auditor’s responsibility for disclosing irregularities and illegal acts.

The survey demonstrates an “expectation gap” between auditors and other segments of the financial
community about the duty to discover deliberate material defalcations of the financial statements. It
also shown an “expectation gap” between auditors and bankers and financial analysts with respect to a
number of possible auditor disclosures.

Lowe and Pany (1993) surveyed 141 members of a municipal court jurors pool and 78 auditors from a
large international accounting firm to assess their attitude toward the auditing profession. The result of
the study reveals an “expectation gap”. The jurors view the auditor’s role as that of public watchdog or
guardian to the extent of expecting the auditor to actively search out the smallest fraud. Auditors
disagree with this characterization of their task.

Epstein and Geiger (1994) conducted a nationwide survey of stock investors which revealed a starting
evidence of the “expectation gap” between the assurance auditors provided on financial statements
compiled by managements and the expectation of investors and other users of financial statements.
Over 70 percent of the 246 investors surveyed believe that auditors should be held responsible for
detecting material misstatements due to fraud, and some 47 percent expect auditors to provide
absolute assurance that financial statements contain no material misstatement due to errors.

Part 1: Fraud and law

In the last few decades, a plethora of fraud suits have been filed under the Securities Acts, the Racketeer
Influence and Corrupt Organizations Act (RICO), and Common Law, some of which will be examined
below.

The role of securities and exchange commission

Auditors must recognize their responsibility to the public investors by including management
activities in their review (SEC, 1940)

To protect users of financial statements, many of whom suffered great losses in the 1929 stock market
crash, the Securities and Exchange Commission (SEC) adopted 1932 New York Stock Exchange rule
requiring all companies, whose stock was listed by the Exchange, to furnish their shareholders audited
financial statements at least annually.

The SEC been very active in protecting the public interest since its inception and has questioned the role
of the auditing and accounting profession when faced with materially misstated financial statements in
violation of the securities law. The SEC has not hesitated to prosecute corporations and auditors several
cases of fraudulent financial statements. The SEC’s proceedings are based on the following 1933 and
1934 securities laws.