AS PROFITS turn to losses in the present market downturn the focus on internal controls on financial statements introduced early this decade to deal with massive accounting fraud are likely to be found wanting, according to a visiting US academic.

Professor Ira Solomon, from University of Illinois at Urbana-Champaign, told an audience at the Australian School of Business this month that internal and external audit needed to expand what they took into account beyond purely financial records if they are to avoid some of the big accounting failures that emerged following the last big crash in 2001 following the dotcom boom.

“Revelations or allegations of financial statement fraud tend to rise during economic downturns,” he said.

“It happens every time, if one looks back over the last 40 or 50 years. It is understandable why it happens, if companies are more stressed, and they are more likely to be stressed in declining economic times, they may get a little bit more aggressive with respect to their accounting and it is possible for aggressive accounting to cross the line to improper accounting,” he told Risk Management.

Given the fact that much of the detected fraud occurred with the collusion of senior management, he said frauds often went undetected for long periods because management ultimately had control of the accounts, and therefore by just looking at the financials, auditors were unable to ascertain whether they were an accurate reflection of the state of the company.

“For example, the FBI has announced they are now investigating Countrywide Financial, the largest mortgage banker in the US … and the FBI is looking at whether their financial statements accurately depicted the quality of their loan portfolio,” he said.

Solomon said it was not clear to him that the Sarbanes-Oxley Act’s section 404, focused on internal controls, will be adequate to prevent improper accounting or fraud.

“We need to have auditors looking at the accounting information, but that is not enough. We need to get them looking at other information systems, for example production information systems, operational information systems, and we need to have them looking outside the entity itself – looking into the real state of the business,” he said.

For example, this could include checking the veracity of company claims, such as the valuations they include in accounts, by researching whether the products the company sells are valued by the consumers as much as the company being audited is claiming.

Educational institutions should also be teaching their audit and accounting students to be checking a range of external factors to verify what is being reported in the financial statements.

“The auditor organisation that is able to go out and truly provide greater assurance with respect to financial statement fraud, will not only be doing society a favour, but also should be viewed as very valuable by well-meaning boards of directors,” Solomon said.