2 Learning Objective 1Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.
3 Types of Fraud Management Fraud Fraudulent Misappropriation financial reportingMisappropriationof assetsFraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users.Earnings management involves deliberate actions taken by management to meet earnings objectives.Misappropriation of assets is fraud that involves theft of an entity’s assets. In many cases, but not all, the amounts involved are not material to the financial statements. However, theft is often a management concern because small thefts can easily increase in size over time.
4 Learning Objective 2Describe the fraud triangle and identify conditions for fraud.
5 The Fraud Triangle Incentives/Pressures Opportunities Management or other employees have incentives or pressures to commit fraudCircumstances provide opportunities for management or employees to commit fraud.An attitude, character or set of ethical values exists that allows management or employees to commit a dishonest act or they are in a situation that allows them to rationalize committing a dishonest act.OpportunitiesAttitudes/Rationalization
7 Examples of Risk Factors for Fraudulent Reporting Incentives/Pressures:Financial stability or profitability is threatened byeconomic, industry, or entity operating conditionsExcessive pressure exists for management tomeet debt requirementsPersonal net worth is materially threatened
8 Examples of Risk Factors for Fraudulent Reporting Opportunities:There are significant accounting estimates thatare difficult to verifyThere is ineffective oversight over financialreportingHigh turnover or ineffective accounting, internalaudit, or information technology staff exists
9 Examples of Risk Factors for Fraudulent Reporting Attitudes/Rationalization:Inappropriate or inefficient communicationand support of the entity’s values is evidentA history of violations of laws is knownManagement has a practice of makingoverly aggressive or unrealistic forecasts
10 Examples of Risk Factors for Misappropriation of Assets Incentives/Pressures:Personal financial obligations create pressureto misappropriate assetsAdverse relationships between managementand employees motivate employees tomisappropriate assets
11 Examples of Risk Factors for Misappropriation of Assets Opportunities:There is a presence of large amounts of cashon hand or inventory itemsThere is an inadequate internal control overassets
12 Examples of Risk Factors for Misappropriation of Assets Attitudes/Rationalization:Disregard for the need to monitor or reducerisk of misappropriating assets existsThere is a disregard for internal controls
13 Learning Objective 3Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.
14 Assessing the Risk of Fraud SAS 99 provides guidance to auditorsin assessing the risk of fraud.SAS 1 states that, in exercising professionalskepticism, an auditor “neither assumes thatmanagement is dishonest nor assumesunquestioned honesty.”Auditing standards emphasize consideration of a client's susceptibility to fraud regardless of the auditor’s beliefs about the likelihood of fraud and management’s honesty and integrity.
15 Sources of Information Gathered to Assess Fraud Risks SAS 99 requires the audit team to conduct discussions to share insights from more experienced audit team members and to “brainstorm” ideas that address the following:How and where they believe the entity's financial statements might be susceptible.How management could perpetrate and conceal fraud.How anyone might misappropriate assets.How the auditor might respond to the susceptibility of material misstatements due to fraud.SAS 99 also requires the auditor to make specific inquiries about fraud in every audit.SAS 99 requires the auditor to evaluate whether fraud risk factors indicate incentives or pressures to perpetrate fraud.Auditors must perform analytical procedures during the planning and completion phases of the audit to help identify unusual transactions.
16 Documenting Fraud Assessment Discussion among engagement teamProcedures performed to assess riskSpecific risks and audit responseReasons supporting conclusionsOther conditions and analyticalrelationshipsNature of communications
17 Learning Objective 4Identify corporate governance and other control environment factors that reduce fraud risks.
18 Corporate Governance Oversight to Reduce Fraud Risks 1. Culture of honesty and high ethics2. Management's responsibilityto evaluate risks of fraud3. Audit committee oversightCultural factors for honesty:Setting the tone at the topCreate a positive workplace environmentHire and promote appropriate employeesTrainingRequire employees to periodically confirm their responsibilities for complying with the code of conduct.Management needs to identify and measure fraud risks and must design and implement controls to mitigate fraud risks. For high fraud risk areas, management should periodically evaluate whether appropriate antifraud programs and controls have been implemented and operating effectively.
19 Example Elements for a Code of Conduct Organizational code of conductGeneral employee conductConflicts of interestOutside activities, employment, anddirectorships
20 Example Elements for a Code of Conduct Relationships with clients and suppliersGifts, entertainment, and favorsKickbacks and secret commissionsOrganization funds and other assets
21 Example Elements for a Code of Conduct Organization records and communicationsDealing with outside people andorganizationsPrompt communicationsPrivacy and confidentiality
22 Organizational Factors Contributing to Risk of Fraud
23 Learning Objective 5Develop responses to identified fraud risks.
24 Responding to the Risk of Fraud Change the overall conduct of the auditto respond to identified fraud risks.Design and perform audit proceduresto address fraud risks.Auditors can choose among several overall responses to an increased fraud risk such as assigning more experienced personnel to the audit or even a fraud specialist.The appropriate audit procedures used to address specific fraud risks depend on the account being audited and type of fraud risk identified.To address risk of override:Examine journal entries and other adjustmentsReview accounting estimates for biasesEvaluate the business rationale for significant unusual transactionsDesign and perform procedures toaddress the risk of managementoverride of controls.
25 Learning Objective 6Recognize specific fraud risk areas and develop procedures to detect fraud.
26 Specific Fraud Risk Areas Revenue and accounts receivable fraud risksInventory fraud risksPurchases and accounts payable fraud risksThree main types of revenue manipulation are:Fictitious revenuesPremature revenue recognitionManipulation of adjustments to revenuesFictitious inventory has been at the center of several major cases of fraudulent financial reporting.Cases of fraudulent financial reporting involving accounts payable are relatively common although less frequent than frauds involving inventory or accounts receivable. Companies may understate accounts payable to overstate income.Other areas of fraud risk may include fixed assets and payroll.Other areas of fraud risk
27 Effect of Fictitious Receivables on Accounting Ratios
28 Effect of Fictitious Inventory on Inventory Turnover
29 Learning Objective 7Understand interview techniques and other activities after fraud is suspected.
30 Responding to Misstatements That May Be the Result of Fraud When fraud is suspected, the auditor gathersadditional information to determine whetherfraud actually exists.
31 Initial Detection Method for Million-Dollar Schemes 42.3%Tip46.2%22.8%By Accident20.0%Type of Detection18.6%Internal Audit19.4%16.7%Internal Controls$1,000,000+23.3%15.8%All CasesExternal Audit9.1%6.0%Notified By Police3.2%0%10%20%30%40%50%Note: The sum of percentages in this chart exceeds 100 percent because in some cases respondents identified more than one detection method.
32 Types of Inquiry Techniques InformationalAssessmentListeningEvaluatingresponsesInformational inquiry is used to obtain information about the facts and details that the auditor does not have.Assessment inquiry is used to corroborate or contradict prior information.Interrogative inquiry is often used to determine if the individual is being deceptive or purposefully omitting disclosure of key facts, events or circumstances.InterrogativeObservingbehavioral cues