1. Learning Objectives LO1 Differentiate among frauds, errors, and illegal acts that might occur in an organization. LO2 Explain the auditing standards related to external, internal, and governmental auditors’ responsibilities to detect and report frauds, errors, and illegal acts. LO3 Outline some of the conditions that lead to frauds. LO4 Explain the audit procedures for detecting common employee fraud schemes. LO5 Explain the audit procedures for detecting common fraudulent financial reporting. LO6 Describe documents that auditors use for fraud risk assessment and detection. 1

2. Fraudulent Financial Reporting by Management Fraud that affects financial statements and causes them to be materially misleading often arises from the perceived need to “get through a difficult period.” LO5 2

3. Fraudulent Financial Reporting by Management Frauds have often accompanied the following conditions and circumstances:  high debt  unfavourable industry conditions  excess capacity  profit squeeze  strong foreign competition  lack of working capital  rapid expansion  product obsolescence  slow customer collections  related-party transactions LO5 3

4. Fraudulent Financial Reporting by Management Companies create financial statements that are materially misleading by either (1) overstating revenues and assets, (2) understating expenses and liabilities, or (3) giving disclosures that are misleading or that omit important information. LO5 4

5. Fraudulent Financial Reporting by Management  Many frauds involve improper recognition of assets or a “dangling debit,” which is an asset amount that is investigated and found to be false or questionable.  A mechanism that management can use for manipulating financial statements involves making false journal entries at the time of closing the books for year-end. LO5 5

6. Fraudulent Financial Reporting by Management A client’s far-removed illegal acts may cause financial misstatements, and external auditors should be aware of possible indications of them:  unauthorized transactions  government investigations  regulatory reports of violations  payments to consultants, affiliates, and employees for unspecified services  excessive sales commissions and agent’s fees  unusually large cash payments  unexplained payments to government officials  failure to file tax returns or pay duties and fees LO5 6