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Why don’t auditors find fraud?

Stephen Foley in the FT 

For decades, investors have lamented how rarely external auditors uncover corporate fraud. From Enron to Wirecard, the cry after each scandal is, where were the auditors? The Association of Certified Fraud Examiners’ biennial report on how workplace fraud gets detected has typically shown auditors are the ones uncovering the wrongdoing only 4 per cent of the time. 

Bad news. The latest report out a few weeks ago said the number is down to 3 per cent. Whistleblower hotlines and other internal controls may have helped some companies themselves discover some malfeasance earlier, but what about when management is the perpetrator or a corporate culture is rotten? A survey of investors by the Center for Audit Quality, a trade group for large accounting firms, found that 57 per cent thought the current system “frequently” failed to detect illegal acts. 

Regulators fear auditors are failing in their role as a last line of defence for investors against corporate shenanigans. Audit firms argue that company executives are responsible for the accuracy of financial statements and that the role of an auditor role is only to provide reasonable assurance — not a guarantee — that a financial statement is free from material misstatement. 

It is an argument that has prompted the US Securities and Exchange Commission’s chief accountant, Paul Munter, to exclaim to me on more than one occasion that he is fed up hearing from auditors what they do not do. 

But a series of proposals to clarify and extend auditors’ responsibilities has now been made. In the US, the Public Company Accounting Oversight Board is revamping rules on how auditors must look for and deal with evidence of a client’s non-compliance with laws and regulations (Noclar, in the jargon). The intent is to force auditors to cast a wider net for matters that could have a material effect on a company’s financials, even indirectly by leading to big fines or regulatory action that threatens the business. 

Audit firms have responded that they cannot be expected to make legal judgments, and that the huge amount of extra work implied by the Noclar proposal as currently drafted probably will not uncover anything significant that current procedures do not already. 

A narrower proposal in the UK — which says auditors do not have to probe every minor law or regulation, and can use management’s own compliance programmes as a starting point — has elicited almost as thunderous a set of comment letters in opposition. 

The latest move is by the International Auditing and Assurance Standards Board, which sets rules that are used as a template by scores of countries around the world. It has proposed strengthening standards on fraud detection to emphasise that auditors must look for financial misstatements that might not be “quantitatively material” but which might be “qualitatively material”, depending on who instigated the fraud and why it was perpetrated. 

The emergence of all these proposals is no coincidence, and it is not as if audit firms themselves do not see room for improvement. PwC last year promised it would overhaul its fraud detection procedures and probe its clients’ whistleblower programmes more closely, among other reforms to boost audit quality. PwC boss Tim Ryan tried and failed to get all the Big Four firms to make a common pledge on these issues. 

Other leaders still talk of an “expectations gap” between what investors want an audit to be and what it really is, as if it is the investors that need to be educated instead of the profession that needs to change. 

An alternative response to some of the current proposals would embrace them to strengthen the hand of auditors. They provide new justification to pry open clients’ businesses, push back on hostile finance chiefs and chief executives, and flag more matters of concern to directors, to investors or to the authorities — to follow through on the professional scepticism that is supposed to be at the heart of the auditors’ creed. There is room for agreement, even on the contentious Noclar proposal. 

Better still for auditors, there is evidence investors are willing to pay for a more robust service. The CAQ survey showed a majority would support auditors charging an additional 20 per cent or more to cover the extra work of rooting out non-compliance. 

A high-quality audit is sometimes called a “credence good”, because its value is difficult to calculate. But, as the shareholders of Enron, Wirecard and countless others will tell you, the cost of a bad audit can be so much more.

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How Disinformation Works

From The Economist

Did you know that the wildfires which ravaged Hawaii last summer were started by a secret “weather weapon” being tested by America’s armed forces, and that American ngos were spreading dengue fever in Africa? That Olena Zelenska, Ukraine’s first lady, went on a $1.1m shopping spree on Manhattan’s Fifth Avenue? Or that Narendra Modi, India’s prime minister, has been endorsed in a new song by Mahendra Kapoor, an Indian singer who died in 2008?

These stories are, of course, all bogus. They are examples of disinformation: falsehoods that are intended to deceive. Such tall tales are being spread around the world by increasingly sophisticated campaigns. Whizzy artificial-intelligence (ai) tools and intricate networks of social-media accounts are being used to make and share eerily convincing photos, video and audio, confusing fact with fiction. In a year when half the world is holding elections, this is fuelling fears that technology will make disinformation impossible to fight, fatally undermining democracy. How worried should you be?

Disinformation has existed for as long as there have been two sides to an argument. Rameses II did not win the battle of Kadesh in 1274bc. It was, at best, a draw; but you would never guess that from the monuments the pharaoh built in honour of his triumph. Julius Caesar’s account of the Gallic wars is as much political propaganda as historical narrative. The age of print was no better. During the English civil war of the 1640s, press controls collapsed, prompting much concern about “scurrilous and fictitious pamphlets”.

The internet has made the problem much worse. False information can be distributed at low cost on social media; ai also makes it cheap to produce. Much about disinformation is murky. But in a special Science & technology section, we trace the complex ways in which it is seeded and spread via networks of social-media accounts and websites. Russia’s campaign against Ms Zelenska, for instance, began as a video on YouTube, before passing through African fake-news websites and being boosted by other sites and social-media accounts. The result is a deceptive veneer of plausibility.

Spreader accounts build a following by posting about football or the British royal family, gaining trust before mixing in disinformation. Much of the research on disinformation tends to focus on a specific topic on a particular platform in a single language. But it turns out that most campaigns work in similar ways. The techniques used by Chinese disinformation operations to bad-mouth South Korean firms in the Middle East, for instance, look remarkably like those used in Russian-led efforts to spread untruths around Europe.

The goal of many operations is not necessarily to make you support one political party over another. Sometimes the aim is simply to pollute the public sphere, or sow distrust in media, governments, and the very idea that truth is knowable. Hence the Chinese fables about weather weapons in Hawaii, or Russia’s bid to conceal its role in shooting down a Malaysian airliner by promoting several competing narratives.

All this prompts concerns that technology, by making disinformation unbeatable, will threaten democracy itself. But there are ways to minimise and manage the problem.

Encouragingly, technology is as much a force for good as it is for evil. Although ai makes the production of disinformation much cheaper, it can also help with tracking and detection. Even as campaigns become more sophisticated, with each spreader account varying its language just enough to be plausible, ai models can detect narratives that seem similar. Other tools can spot dodgy videos by identifying faked audio, or by looking for signs of real heartbeats, as revealed by subtle variations in the skin colour of people’s foreheads.

Better co-ordination can help, too. In some ways the situation is analogous to climate science in the 1980s, when meteorologists, oceanographers and earth scientists could tell something was happening, but could each see only part of the picture. Only when they were brought together did the full extent of climate change become clear. Similarly, academic researchers, ngos, tech firms, media outlets and government agencies cannot tackle the problem of disinformation on their own. With co-ordination, they can share information and spot patterns, enabling tech firms to label, muzzle or remove deceptive content. For instance, Facebook’s parent, Meta, shut down a disinformation operation in Ukraine in late 2023 after receiving a tip-off from Google.

But deeper understanding also requires better access to data. In today’s world of algorithmic feeds, only tech companies can tell who is reading what. Under American law these firms are not obliged to share data with researchers. But Europe’s new Digital Services Act mandates data-sharing, and could be a template for other countries. Companies worried about sharing secret information could let researchers send in programs to be run, rather than sending out data for analysis.

Such co-ordination will be easier to pull off in some places than others. Taiwan, for instance, is considered the gold standard for dealing with disinformation campaigns. It helps that the country is small, trust in the government is high and the threat from a hostile foreign power is clear. Other countries have fewer resources and weaker trust in institutions. In America, alas, polarised politics means that co-ordinated attempts to combat disinformation have been depicted as evidence of a vast left-wing conspiracy to silence right-wing voices online.
One person’s fact...

The dangers of disinformation need to be taken seriously and studied closely. But bear in mind that they are still uncertain. So far there is little evidence that disinformation alone can sway the outcome of an election. For centuries there have been people who have peddled false information, and people who have wanted to believe them. Yet societies have usually found ways to cope. Disinformation may be taking on a new, more sophisticated shape today. But it has not yet revealed itself as an unprecedented and unassailable threat.

How to tell good industrial policy from bad

Gillian Tett in The FT

 
Five years ago Reda Cherif and Fuad Hasanov, two economists at the IMF, wrote a paper with the (slightly) sarcastic title: “The Return of the Policy That Shall Not Be Named: Principles of Industrial Policy”. 

This pointed out that while strategic policy intervention was widely viewed as a key reason for the east Asian economic miracle, it had a “bad reputation among policymakers and academics” — so much so that, from the 1970s onwards, the phrase was rarely mentioned in polite company, or by the IMF. 

No longer. Last month the fund reported that it had observed no less than 2,500 industrial policy actions around the world in the last year alone, of which “more than two-thirds were trade-distorting as they likely discriminated against foreign commercial interests”. 

More striking still, industrial policies used to be far “more prevalent in emerging economies” than developed ones; between 2009 and 2022, there were cumulatively 7,000 subsidies tracked in developing countries, and fewer than 6,000 in developed ones. But last year’s surge was “driven by large economies, with China, the EU and the US accounting for almost half of all new [industrial policy] measures”. 

That shift can be seen not just in data, but rhetoric too. Last month, Mario Draghi, former head of the European Central Bank, lamented that Europe “lack[s] a strategy for how to shield our traditional industries from an unlevel global playing field caused by asymmetries in regulations, subsidies and trade policies”. He called for the EU to fight back with industrial policy. 

In the UK, the opposition Labour party is echoing these themes, calling for a “New Deal” and touting what it calls “securonomics”. In the US, Donald Trump wants huge trade tariffs, while Joe Biden has called for tariffs in sectors such as steel. The president’s Inflation Reduction Act is yet more industrial policy. 

But anyone pondering that striking number in the IMF report should remember a crucial point that ought to be obvious but is often overlooked: “industrial policy” can mean many different things. As Cherif and Hasanov told a seminar at Cambridge’s Bennett Institute this week, there is an important difference between policies that try to create growth by shielding domestic companies from foreign competition and those which help those companies compete more effectively on the world stage.  

The former “import substitution” strategy was pursued by many developing countries in recent years, including India. It is also the variant favoured by Trump and the one being considered by some European politicians, for instance in the case of Chinese solar panels. 

But it is this latter approach that has given industrial policy a bad name. On the basis of copious data, Cherif and Hasanov argue that import substitution models undermine growth in the long term since they create excessively coddled, inefficient industries. 

By contrast, the second variant of industrial policy aims instead to make industries more competitive externally in an export-oriented model, while worrying less about imports. This approach is what drove the east Asian miracle, and is what creates sustained growth, the data suggests. 

The difference in approach is embodied by the contrasting fortunes of Malaysian automaker Proton car and South Korea’s Hyundai. The former was developed amid import substitution policies, and never soared; the latter flourished on the back of an export-oriented strategy.  

A cynic might retort that policy is rarely so clear cut as these contrasting car tales might suggest. It is hard for any company to fly on the world stage if its key competitors are excessively subsidised in closed markets — as evidenced by the woes of EU solar-panel makers trying to compete with their Chinese rivals. It is also tough to tell countries to aim for export-driven growth in a world where trade is fragmenting and protectionism rising. 

In any case, while export-oriented strategies work for small or medium-sized countries such as South Korea, they may seem less relevant for a giant such as America. 

Then there is a more fundamental question around economic change. As a thoughtful paper published last year by the economists Réka Juhász, Nathan Lane and Dani Rodrik notes, while “industrial policy has traditionally focused on manufacturing”, it is the service sector that now dominates. Thus “governments are likely to look beyond manufacturing as they consider productivity-enhancing ‘industrial’ policies in the future”. 

Cherif and Hasanov think institutions such as America’s Darpa give one clue to innovation-boosting measures in this space; Juhász, Lane and Rodrik cite worker training and export credit. But this needs holistic policy, which America, say, lacks. 

Either way, the key point is that insofar as western politicians are now increasingly happy to utter the once forbidden words “industrial policy”, they need to define what they mean. Is the goal to exclude competitors from the domestic stage, via tariffs? Or to make domestic producers more competitive and innovative in a global sense and better able to compete? Or is it something else? Investors and markets need clear answers. So, more importantly, do voters.