The Effectiveness Of The Auditing Standards To Detect Fraudulent Financial Reporting Activities In Financial Statement Audits In Malaysia

Abstract

In identifying relevant red flags to be used to detect possible fraud in financial statements, this study adopts the International Auditing Standard AI240 and adapts the US-based Statement of Auditing Standard No 99 (SAS 99). Both SAS 99 and AI240 classify the red flags into three categories: Opportunity, Pressure, and Rationalization. Opportunity Red Flags are found in situations that are ideal for people to commit fraud more easily due to ineffective internal controls, inadequate supervision or managers overriding internal controls. Pressure Red Flags are circumstances in which people have a financial incentive to commit fraud such as falsely overstating sales or profits to receive their bonuses or exerting pressure on managers to reduce actual expenses to be under budgeted costs. Rationalization Red Flags are situations where people have certain traits and abilities to commit fraud and justify it with false reasons which they believe are true. A Red Flag Questionnaire which contains 15 demographic multiple choice questions, followed by a five-point Likert scale with questions for 14 Opportunity Red Flags, 15 Pressure Red Flags and 11 Rationalization Red Flags was developed and distributed to three groups of auditors: External, internal and governmental. The study indicates the direct or inverse relationships between each demographic factor and each red flag. These relationships were identified by using multiple regression models. Three types of relationships are possible: direct, inverse and no relationship. These three types of relationships are as follows: (1) the relationship between the level of fraud-detecting effectiveness of each Opportunity Red Flag and each demographic factor, (2) the relationship between the level of fraud-detecting effectiveness of each Pressure Red Flag and each demographic factor, and (3) the relationship between the level of fraud-detecting effectiveness of each Rationalization Red Flag and each demographic factor. These relationships indicate which specific professional demographic factors are more likely associated with more effective fraud-detecting red flags. In contrast, other relationships also indicate which specific demographic factors are more likely associated with less effective fraud-detecting red flags. In conclusion, this research project should be conducted in other countries, so the result from one country can be compared to the results from other countries. Some results may vary between developed countries and developing countries. The learning curve or the period of time necessary for auditors to learn how to use red flags and then interpret the findings may also explain differences in the results between countries. This study may enhance the auditors understanding of the different levels of fraud-detecting effectiveness of red flags as well as when the auditors may benefit from using them in financial statement audits.