Of course. Auditors have and will continue to uncover fraud.
But the Enron case is not a good example, since the auditors were complicit in Enron’s fraud.
In a typical contract for audit services, the auditors will generally include a phrase something along the lines of:
Our audit is not designed to uncover fraud, but if we find any, we will notify management.
Audits are designed to look for ordinary errors or fairly simple frauds. As soon as two people start colluding to commit fraud, the fraud becomes much harder to uncover. Which isn’t to say it’s impossible - fraud is discovered by auditors all the time. Usually its internal auditors who find that, but sometimes its the outside audit firm.
The key takeaway is that discovering fraud is NOT the primary purpose of a traditional audit of financial statements, it’s a by-product. Audits are really designed to look for errors, not fraud. And in modern financial work, they also take a close look at management’s choices in how to present the financial statements. Things like putting a specific expense in cost of goods sold vs. Administrative expenses. Or showing liabilities as current or long term - or even leaving certain liabilities off the balance sheet altogether as operating leases rather than financing leases.
Audits could be designed to look for fraud, but that would require substantially more work by the auditor, which translates into higher costs to the company for the audit. Most companies are not willing to pay the higher costs for a fraud audit.
Then we get to the issue of fraud by management. Because of upper management’s unique position in a company, they can cover up their fraud pretty effectively and make it difficult to find.
Here’s a simple example based on my own experience. A company purchases items by the container load from overseas. Containers arrive roughly every week or so. The exact contents vary each time, but are generally in a fairly low range of costs - let’s call it from $75k to $100k. Payments are made by wire transfer, identified only by a reference number on the bank statement. Invoices are kept to back up each container purchase. With today’s tools, how hard would it be for a high level manager to create an invoice which looks just like the ones their customer issues? They then instruct the bank to send a wire transfer to the local car dealer to purchase a car for that manager. The manager’s created invoice matches the dollar amount of the wire transfer. Even if you examine the paperwork for this transfer, it’s not going to look out of place.
In a public company, you probably have some separation of duties such that this might be hard to do. But in a privately held company, owner/managers typically have the necessary authority to commit such a fraud. Granted, they may not be duping investors, but they are certainly engaging in fraud.
Or the owner could deposit funds from their personal accounts into the company, calling it sales and thereby increasing the apparent profits from the company. They could then use those financial statements to induce a lender to loan them money.
Fraud by management - whether in a public company or a privately held company - is very hard to uncover, especially if management is at all skilled in covering their tracks.
It’s not the standard, but it is wise advice to investors. Ultimately, investors have to depend on management to provide good financial information to them. So the first thing to do when considering an investment is to look at the integrity of management. If management lacks integrity, you cannot trust what they tell you about the company and you cannot really do your own due diligence. So the investment should be a hard pass.
–Peter
. 