2. 11 - 1 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Fraud Auditing Chapter 11

3. 11 - 2 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.

4. 11 - 3 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Types of Fraud Fraudulent financial reporting Misappropriation of assets

5. 11 - 4 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 2 Describe the fraud triangle and identify conditions for fraud.

6. 11 - 5 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder The Fraud Triangle Incentives/Pressures OpportunitiesAttitudes/Rationalization

7. 11 - 6 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Examples of Risks Factors for Fraudulent Reporting Financial stability or profitability is threatened by economic, industry, or entity operating conditions. Excessive pressure exists for management to meet debt requirements. Personal net worth is materially threatened.

8. 11 - 7 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Examples of Risks Factors for Fraudulent Reporting There are significant accounting estimates that are difficult to verify. There is ineffective oversight over financial reporting. High turnover or ineffective accounting internal audit, or information technology staff exists.

9. 11 - 8 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Examples of Risks Factors for Fraudulent Reporting Inappropriate or inefficient communication and support of the entity’s values is evident. A history of violations of laws is known. Management has a practice of making overly aggressive or unrealistic forecasts.

10. 11 - 9 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Examples of Risks Factors for Misappropriation of Assets Personal financial obligations create pressure to misappropriate assets. Adverse relationships between management and employees motivate employees to misappropriate assets.

11. 11 - 10 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Examples of Risks Factors for Misappropriation of Assets There is a presence of large amounts of cash on hand or inventory items. There is an inadequate internal control over assets.

12. 11 - 11 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Examples of Risks Factors for Misappropriation of Assets Disregard for the need to monitor or reduce risk of misappropriating assets exists. There is a disregard for internal controls.

13. 11 - 12 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 3 Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.

14. 11 - 13 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Assessing the Risk of Fraud SAS 99 provides guidance to auditors in assessing the risk of fraud.

15. 11 - 14 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Professional Skepticism SAS 1 states that, in exercising professional skepticism, an auditor “neither assumes that management is dishonest nor assumes unquestioned honesty.”

16. 11 - 15 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Sources of Information Gathered to Assess Fraud Risks Communication among audit team Inquiries of managementRiskfactorsAnalyticalproceduresOtherinformation Identified risks of material misstatements due to fraud

17. 11 - 16 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Documenting Fraud Assessment Discussion Specific risks Procedures Reasons Results Other conditions Nature of communications

18. 11 - 17 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 4 Identify corporate governance and other control environment factors that reduce fraud risks.

19. 11 - 18 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Corporate Governance Oversight to Reduce Fraud Risks 1. Create and maintain a culture of honesty and high ethics. and high ethics. 2. Evaluate fraud risks and implement programs and controls to mitigate identified fraud risks. and controls to mitigate identified fraud risks. 3. Develop an appropriate fraud oversight process.

20. 11 - 19 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Example Elements for a Code of Conduct Organizational code of conduct General employee conduct Conflicts of interest Outside activities, employment, and directorships

21. 11 - 20 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Example Elements for a Code of Conduct Relationships with clients and suppliers Gifts, entertainment, and favors Kickbacks and secret commissions Organization funds and other assets

22. 11 - 21 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Example Elements for a Code of Conduct Organization records and communications Dealing with outside people and organizations Prompt communications Privacy and confidentiality

23. 11 - 22 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Organizational Factors Contributing to Risk of Fraud 200319981994 Collusion between employees and third parties Inadequateinternalcontrols Management override of internal controls 4831 33 39 58 59 31 36 36

24. 11 - 23 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Organizational Factors Contributing to Risk of Fraud Collusion between employees and management Lack of control over management be directors Ineffective or nonexistent ethics or compliance program 15 19 23 12 11 6 10 8 7 200319981994

25. 11 - 24 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 5 Develop responses to identified fraud risks.

26. 11 - 25 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Responding to the Risk of Fraud Change the overall conduct of the audit to respond to identified fraud risks. Design and perform audit procedures to address identified risks. Design and perform procedures to address the risk of management override of controls.

27. 11 - 26 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 6 Recognize specific fraud risk areas and develop procedures to detect fraud.

28. 11 - 27 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Rates of Fraud Occurrence 20031998 Theft of assets 4922 Check fraud 40 26 Expense account abuse36 13 Credit card fraud 20 13 Payroll fraud 12 3

29. 11 - 28 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Rates of Fraud Occurrence 20031998 Conflict of interest 12 9 Inventory theft 11 11 Kickbacks 9 6 Financial reporting fraud 7 3

30. 11 - 29 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Specific Fraud Risk Areas Inventory fraud risks Revenue and accounts receivable fraud risks Purchases and accounts payable fraud risks Other areas of fraud risk

31. 11 - 30 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 7 Understand interview techniques and other activities after fraud is suspected.

32. 11 - 31 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Methods of Uncovering Fraud 200319981994 Internal controls Internal audit Notification by employee 77%51% 52% 65% 43% 47% 63% 58% 51%

33. 11 - 32 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Methods of Uncovering Fraud 200319981994 Accident Anonymous tip Notification by customer 54% 37% 28% 41% 35% 26% 34% 41% 34%

34. 11 - 33 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Methods of Uncovering Fraud 200319981994 Notification by regulatory or law enforcement agency Notification by vendor External audit 19% 16% 8% 8% 16% 11% 15% 12% 4% 4% 5% 5%

35. 11 - 34 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Responding to Misstatements that May be the Result of Fraud When fraud is suspected, the auditor gathers additional information to determine whether fraud actually exists.

36. 11 - 35 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Types of Inquiry Techniques Informational inquiry Assessment inquiry Interrogative inquiry

37. 11 - 36 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Types of Inquiry Techniques Evaluating responses Listening techniques Observing behavioral cues

38. 11 - 37 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder End of Chapter 11