Fraud Auditing Chapter 11

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

Types of Fraud Fraudulent financial reporting Misappropriation of assets

Learning Objective 2 Describe the fraud triangle and identify conditions for fraud.

The Fraud Triangle Incentives/Pressures Opportunities Attitudes/Rationalization

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

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

Assessing the Risk of Fraud SAS 99 provides guidance to auditors in assessing the risk of fraud. SAS 1 states that, in exercising professional skepticism, an auditor “neither assumes that management is dishonest nor assumes unquestioned honesty.”

Sources of Information Gathered to Assess Fraud Risks Communication among audit team Inquiries of management Risk factors Analytical procedures Other information Identified risks of material misstatements due to fraud

Documenting Fraud Assessment Discussion Procedures Specific risks Reasons Other conditions and analytical relationships Nature of communications

Learning Objective 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

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 Collusion between employees and third parties 48 31 33 Inadequate internal controls 39 58 59 Management override of internal controls 31 36 36 2003 1998 1994

Organizational Factors Contributing to Risk of Fraud Collusion between employees and management 15 19 23 Lack of control over management by directors 12 11 6 Ineffective or nonexistent ethics or compliance program 10 8 7 2003 1998 1994

Learning Objective 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 identified risks. Design and perform procedures to address the risk of management override of controls.

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

Initial Detection Method for Million Dollar Schemes 42.3% Tip 46.2% 22.8% By Accident 20.0% Type of Detection 18.6% Internal Audit 19.4% 16.7% Internal Controls $1,000,000+ 23.3% 15.8% All Cases External Audit 9.1% 6.0% Notified By Police 3.2% 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.

Specific Fraud Risk Areas Revenue and accounts receivable fraud risks Inventory fraud risks Purchases and accounts payable fraud risks Other areas of fraud risk

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

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.

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

End of Chapter 11