THE IMPACT OF INTERNAL AUDIT ON FRAUD DETECTION AND PREVENTION

1.1 Introduction

Internal auditing is a process carried out by internal auditors to assure owners of a business that their resources are well managed by persons acting on their behalf. The origin of audit dates from ancient times when the landowners allowed tenant farmers to work on their land whilst the landowners themselves did not become involved in the business of farming. Auditing is regulated by statutes, professional regulations in form of accounting standards and auditing standards issued by Institute of Chartered Accountants of Nigeria (ICAN) and in some cases adapted from those of some more developed countries. The criticism of auditors by society reflects in the litigious environment which characterizes auditing today and can be traced to the audit expectation-performance gap (Boyd et al 2001:56).

As a prelude to other parts of this study, this chapter will discuss the background upon which this study was initiated, the statement of problems that led to this study, the Aim and Objectives of the study. Others are Significance of the study, Scope of work, Research hypothesis and questions, Limitations of the Study and Definition of technical terms.

1.2 Background of Study

Auditing fraud is a million dollar business, as several research studies reveal. Among them are important surveys of Price Waterhouse & Coopers (PwC, 2007) and of the Association of Certified Fraud Examiners (ACFE, 2006). The study conducted in the United States by the ACFE in 2004-2005 and the worldwide study, held by PwC in 2006-2007 yields the following insights. No industry seems to be safe and bigger companies seem to be more vulnerable to fraud than smaller ones. Small businesses however suffer disproportionate fraud losses. 43% of companies worldwide have fallen victim to economic crime in the years 2006 and 2007.

The average financial damage to companies subjected to the PwC survey was US$ 2.42 million per company over two years. Participants of the ACFE study estimate a loss of 5% of a company’s annual revenues to fraud. Applied to the 2006 United States Gross Domestic Product of US$ 13,246.6 billion, this would translate to approximately US$ 662 billion in fraud losses for the United States only. These numbers all address corporate fraud, more precisely internal fraud.

About the way fraud is detected, both studies of PwC and the ACFE stress the importance of tips and chance. However, as a number two detection means in studies, internal audit and internal control systems can have a measurable impact on detecting fraud. The more control measures a company puts in place, the more incidents of fraud will be uncovered. Organizations allocate lots of resources to internal audit and controls to prevent internal fraud. These costs, together with the costs of fraud, represent a large economic cost for the business environment.

Academic literature is currently investigating the use of data mining for the purpose of fraud detection. Brockett et al. (2002), Cortes et al. (2002), Est´evez et al. (2006), Fanning and Cogger (1998), Kim and Kwon (2006) and Kirkos et al. (2007) are just a few examples of a more elaborated list of articles concerning the hot topic of fighting fraud. Although a lot of this research may be framed in different settings -going from different techniques to different fraud domains, there are two characteristics that stand for all executed research up till now: the focus is on external fraud and a predictive data mining approach is applied for fraud detection. We however are interested in internal fraud, since this represents mainly these large costs in the PwC and ACFE surveys. Further, it is known that not fraud detection alone, but detection in combination with prevention, is of priceless value for organizations.

Therefore, in Nigeria where the research was carried out, the activities that was conducted is to know the Impact of Internal Audit on Fraud Detection and Prevention.

1.3 Statement of Problems

Investigation revealed that the problem is getting worse. Unfortunately, the poor economy like Nigeria is increasing the pressure to commit fraud in two ways. In addition to placing more personal economic pressures on employees, layoffs are depleting internal control systems. Nearly 60 percent of CFEs who work as in-house fraud examiners reported their companies had layoffs in the past year. Among those who had layoffs, almost 35 percent of companies had eliminated some internal controls.

During the past year, both the number of fraud incidents and the dollar value of fraud increased dramatically, with 55.4 percent of respondents reporting increased fraud in the past twelve months. The economy has driven much of the growth. “Increased pressure” is cited as by far the biggest factor contributing to fraud. At 49.1 percent, it is comfortably ahead of increased opportunity (27.9 percent) and more than twice the rate of “rationalized” acts by the perpetrators (23.7 percent).

As in prior downturns, the problem is expected to worsen. More than 80 percent of respondents indicated that they expect the incidence of fraud to increase. Thirty-six percent expect it to increase significantly. The greatest emerging source of fraud is employee embezzlement which accounted for a disturbing 48.3 percent of last year’s increase. Internally generated fraud e.g. corruption, financial statement fraud, and embezzlement - are also expected to continue to grow substantially.

1.4 Aim and Objectives of Study

The aim of the study is to examine the Impact of Internal Audit on Fraud Detection and Prevention. In achieving this aim, the following specific objectives were laid out as follows:

1. To determine whether well organized internal audit could change orientation of workers towards frauds;
2. To determine the factors that positively or negatively affect the audit quality and audit fraud detection;
3. To examine the free flow of information needed by the management for proper auditing functions; and
4. To determine whether objective evaluation and measurement of the effectiveness of other controls by internal audit could put a stop to fraud.

1.5 Research Questions

The study came up with research questions so as to be able to ascertain the above stated objectives. The specific research questions for the study are stated below as follows:

• Can objective evaluation and measurement of the effectiveness of other controls by internal audit put a stop to fraud?
• Can well organized internal audit change orientation of workers towards frauds?
• What factors of human errors undermine the effective operation of the internal audit?
• Why do client’s transactions go unchecked for arithmetical accuracy?

1.6 Research Hypothesis

In order to pursue the objective of this study, the following generalized statements have been designed to guide and aids in obtaining the result for the experiment to be conducted. For this work, the null hypothesis will be represented with H0 while the alternative hypothesis will be represented with hypothesis H1.

Hypothesis One

• H0: There is no significant relationship between an effective internal audit system and occurrence of fraud in a public sector
• H1: There is a significant relationship between an effective internal audit system and occurrence of fraud in a public sector.

Hypothesis Two

• H0: An effective internal check will not make fraudulent practices and other irregularity difficult to perpetrate in the public sector.
• H1: An effective internal check will make fraudulent practices and other irregularity difficult to perpetrate in the public sector.

1.7 Significance of Study

The relevance of the study entails that there are number of specific ways in which fraud can be thwarted. Many of them provide additional ways to break up closed-off silos or encourage specific reporting.

This study can give an insight on how to protect cash and cash receipts, have checks mailed by someone other than the preparer after signing, have bank statements delivered to the owner unopened and have the bank accounts reconciled by someone independent of the cash receipts and disbursement functions.

Segregated functions and specific purchases are your best strategies on the expense side. Separate requisitioning, purchasing and receiving functions from invoice processing, accounts payable, cash receipts and disbursements, and general ledger functions. Develop an approved vendor list to discourage under-the-table arrangements and shell vendors.

This study will be of immense benefit to other researchers who intend to know more on this study and can also be used by non-researchers to build more on their research work. This study contributes to knowledge and could serve as a guide for other study.

1.8 Scope of Study

The scope of this research focuses on the Impact of Internal Audit on Fraud Detection and Prevention. This research work covers internal audit system and how it could be structured and operated as a measure against fraud perpetration in the public sector i.e. how it can effectively prevent and detect fraud. Public sector as practiced in the Power Holding Company of Nigeria (PHCN). The areas to be covered will include the following:

1. Quality control in Auditing
2. Internal control in Auditing
3. Investigation
4. Statutory Audit
5. All laws guiding the practice of audit in Nigeria

1.9 Limitations of the Study

During the course of this study, many things militated against its completion, some of which are:

1. Time Constraint: The time frame given to accomplish this project was very short due to school academic calendar and it was carried out under pressure which made the researcher not to implement some necessary features.
2. Establishment Policies: Establishment policies posed a serious limitation as most staffs are not ready to release information needed for this project work. There were lots of information needed from the staffs of this establishment to enhance the study which took them time to release or they did not release at all for security purposes, hence the scope was reduced.
3. Research material: availability of research material is a major setback to the scope of the study.
4. Frequent power failure: This made the researcher append more money on fuel to ensure sustainable power.
5. Financial Constraint: Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).

1.10 Definition of Terms

Audit Risk: These are the areas in which international auditors should be on the lookout, in the course of their audit exercise.

Audit Scope: This is the coverage of the firm’s operation in the audit exercise that shall be specifically covered.

Audit Procedure: This is the step by step technique which an auditor follows in his/her work duties or exercise.