Management Fraud and Audit Risk Chapter 4 Management Fraud and Audit Risk ACCT-4080 Chapter 3

1. Errors, Fraud, and Noncompliance Definitions Errors - unintentional Fraud (irregularities) - intentional Noncompliance with laws and regulations (Illegal acts)- violations of the law Auditor’s responsibilities History Errors & Fraud: SAS 1, SAS 16, SAS 53, SAS 82, SAS 99 Illegal Acts: SAS 54 ACCT-4080 Chapter 3

1. Errors, Fraud, and Noncompliance (continued) Errors and Fraud (AU-C 240) design and conduct the audit to provide reasonable assurance that material errors and fraud will be discovered, and report the findings to appropriate parties Noncompliance with laws and regulations (Illegal Acts) (AU-C 250) direct effect noncompliance — same indirect effect noncompliance — have general level of awareness and act on those discovered make inquiries carry out some procedures to identify noncompliance Questions ACCT-4080 Chapter 3

1. Errors, Fraud, and Noncompliance (continued) Steps involved in Considering the Risk of Fraud Staff discussion Obtain information needed to identify risks Identify risks Assess identified risks Respond to results of assessment Evaluate audit evidence Communicate about fraud Document consideration of fraud Chapter 6

2. Fraud Causes of Misstatements Causes Errors Fraud Misappropriation Fraudulent of Assets Financial Reporting ACCT-4080 Chapter 3

2. Fraud (continued) EXHIBIT 3.1 ACCT-4080 Chapter 3

2. Fraud (continued) Fraudulent financial reporting (cooking the books) (management fraud) falsification of financial statements falsification or omissions of transactions Misappropriation of assets (employee fraud) larceny embezzlement ACCT-4080 Chapter 3

2. Fraud (continued) Overview of Fraud (outline) costs discovery victims perpetrators common characteristics types ACCT-4080 Chapter 3

The Fraud Triangle PRESSURE PERCEIVED OPPORTUNITY RATIONALIZATION ISU WU Summer 2009 * Misstatements

2. Fraud (continued) Prevalence of fraud Current frauds Reasons to study fraud Fraud related job opportunities ACFE CFE ACCT-4080 Chapter 3

3. Audit Risk ACCT-4080 Chapter 3

3. Audit Risk AU-C 320 – Audit Risk General business risks Engagement risk Audit Risk Model AR = RMM x DR AR = IR x CR x DR AR = IR x CR x TD x AP Audit Risk definition the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated the danger that the auditor will fail to detect material misstatements in the financial statements at financial statement level; at account balance level ACCT-4080 Chapter 3

3. Audit Risk (continued) Risk of Material Misstatement product of inherent risk and control risk consider at entity level and account/assertion level Inherent Risk the susceptibility of an account balance to error assuming there are no controls based on auditor’s judgment considering understanding of entity, nature of account (routine, systematic processing, complexity, etc), and fraud considerations Control Risk the risk that the ICS will not prevent or detect a material error on a timely basis based on tests of control’s effectiveness ACCT-4080 Chapter 3

3. Audit Risk (continued) Detection Risk the risk that the auditor’s procedures will not detect a material error the product of Tests of Details Risk (TD) and Substantive Analytical Procedures Risk (AP) Tests of Details Risk the risk that tests of details will not detect a material error Substantive Analytical Procedures Risk the risk that analytical procedures (or other procedures that do not utilize sampling) will not detect a material error ACCT-4080 Chapter 3

3. Audit Risk (continued) Risks defined in negative Auditor’s control over risks Relationship between RMM and DR DR and amount of substantive testing ACCT-4080 Chapter 3

3. Audit Risk (continued) Subjectively considering Audit Risk Quantifying Audit Risk not required DR = AR / IR x CR TD = AR / IR x CR x AP Questions ACCT-4080 Chapter 3

3. Audit Risk (continued) General guidelines Inherent Risk High > 60% Moderate 40% - 60% Low < 40% Control Risk Maximum = 100% High > 70% Moderate 40% - 70% Very Low < 10% ACCT-4080 Chapter 3

3. Audit Risk (continued) Analytical Procedures Risk High > 50% Moderate 20% - 50% Low 10% - 20% Very Low < 10% ACCT-4080 Chapter 3

4. Analytical Procedures Definition Uses in an audit planning stage as a substantive test (SAP) final review stage Required use ACCT-4080 Chapter 3

4. Analytical Procedures (Continued) In planning stage enhances auditor’s understanding identifies risk areas uses highly aggregated data generally financial data ACCT-4080 Chapter 3

4. Analytical Procedures (Continued) Steps develop an expectation define a significant difference calculate predictions and compare with recorded amount investigate significant differences document each step ACCT-4080 Chapter 3

4. Analytical Procedures (Continued) Substantive analytical procedures based on level of DR based on auditor judgment balance sheet data vs. income statement data often uses non-financial data ACCT-4080 Chapter 3

4. Analytical Procedures (Continued) In final evaluation stage uses aggregated data usually financial data review same data used in planning stage Questions ACCT-4080 Chapter 3

5. Review Questions for Discussion Chapter 4 4.6 4.7 4.8 4.9 4.12 4.14 4.17 ACCT-4080 Chapter 3