Considering the Risk of Fraud Chapter 11 Considering the Risk of Fraud 1

Learning Objectives Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets. Describe the fraud triangle and identify conditions for fraud. Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud. Prepare the post-closing trial balance

Learning Objectives Identify corporate governance and other control environment factors that reduce fraud risks. Develop responses to identified fraud risks. Recognize specific fraud risk areas and develop procedures to detect fraud. Understand interview techniques and other activities after fraud is suspected.

1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.

Types of Fraud Management Fraud Fraudulent Misappropriation financial reporting Misappropriation of assets Fraudulent 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.

Describe the fraud triangle and identify conditions for fraud. 2 Describe the fraud triangle and identify conditions for fraud. The second learning objective is to use the worksheet to prepare financial statements.

The Fraud Triangle Incentives/Pressures Opportunities Management or other employees have incentives or pressures to commit fraud Circumstances 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. Opportunities Attitudes/Rationalization

Why Fraud Occurs

Examples of Risk Factors for Fraudulent Reporting Incentives/Pressures: 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

Examples of Risk Factors for Fraudulent Reporting Opportunities: 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

Examples of Risk Factors for Fraudulent Reporting Attitudes/Rationalization: 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

Examples of Risk Factors for Misappropriation of Assets Incentives/Pressures: Personal financial obligations create pressure to misappropriate assets Adverse relationships between management and employees motivate employees to misappropriate assets

Examples of Risk Factors for Misappropriation of Assets Opportunities: There is a presence of large amounts of cash on hand or inventory items There is an inadequate internal control over assets

Examples of Risk Factors for Misappropriation of Assets Attitudes/Rationalization: Disregard for the need to monitor or reduce risk of misappropriating assets exists There is a disregard for internal controls

3 Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.

Assessing the Risk of Fraud Auditing standards provide guidance to Auditors in assessing the risk of fraud. Auditing standards state that, in exercising Professional skepticism, an auditor “neither assumes that management is dishonest nor assumes unquestioned 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.

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.

Documenting Fraud Assessment Discussion among engagement team Procedures performed to assess risk Specific risks and audit response Reasons supporting conclusions Results of procedures performed Other conditions and analytical relationships Nature of communications

4 Identify corporate governance and other control environment factors that reduce fraud risks.

Corporate Governance Oversight to Reduce Fraud Risks 1. Culture of honesty and high ethics 2. Management's responsibility to evaluate risks of fraud 3. Audit committee oversight Cultural factors for honesty: Setting the tone at the top Create a positive workplace environment Hire and promote appropriate employees Training Require 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.

Example Elements for a Code of Conduct Organizational code of conduct General employee conduct Conflicts of interest Outside activities, employment, and directorships

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

Example Elements for a Code of Conduct Organization records and communications Dealing with outside people and organizations Prompt communications Privacy and confidentiality

Organizational Factors Contributing to Risk of Fraud

Develop responses to identified fraud risks. 5 Develop responses to identified fraud risks.

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 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 adjustments Review accounting estimates for biases Evaluate the business rationale for significant unusual transactions Design and perform procedures to address the risk of management override of controls.

6 Recognize specific fraud risk areas and develop procedures to detect fraud.

Specific Fraud Risk Areas Revenue and accounts receivable fraud risks Inventory fraud risks Purchases and accounts payable fraud risks Three main types of revenue manipulation are: Fictitious revenues Premature revenue recognition Manipulation of adjustments to revenues Fictitious 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

Effect of Fictitious Receivables on Accounting Ratios

Effect of Fictitious Inventory on Inventory Turnover

7 Understand interview techniques and other activities after fraud is suspected.

Initial Detection Method for Million-Dollar Schemes

Types of Inquiry Techniques Informational Assessment Listening Evaluating responses Informational 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. Interrogative Observing behavioral cues

Observing Verbal Cues

Observing Non-Verbal Cues

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