1. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 1 Fraud Auditing Chapter 11

2. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 2 Learning Objective 1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.

3. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 3 Types of Fraud  Fraudulent financial reporting  Misappropriation of assets

4. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 4 Learning Objective 2 Describe the fraud triangle and identify conditions for fraud.

5. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 5 The Fraud Triangle Incentives/Pressures OpportunitiesAttitudes/Rationalization

6. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 6 Examples of Risk Factors for Fraudulent Reporting  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 Incentives/Pressures:

7. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 7 Examples of Risk Factors for Fraudulent Reporting  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 Opportunities:

8. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 8 Examples of Risk Factors for Fraudulent Reporting  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 Attitudes/Rationalization:

9. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 9 Examples of Risk Factors for Misappropriation of Assets  Personal financial obligations create pressure to misappropriate assets  Adverse relationships between management and employees motivate employees to misappropriate assets Incentives/Pressures:

10. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 10 Examples of Risk Factors for Misappropriation of Assets  There is a presence of large amounts of cash on hand or inventory items  There is an inadequate internal control over assets Opportunities:

11. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 11 Examples of Risk Factors for Misappropriation of Assets  Disregard for the need to monitor or reduce risk of misappropriating assets exists  There is a disregard for internal controls Attitudes/Rationalization:

12. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 12 Learning Objective 3 Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.

13. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 13 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.”

14. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 14 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

15. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 15 Documenting Fraud Assessment  Discussion  Specific risks  Procedures  Reasons  Results  Other conditions  Nature of communications

16. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 16 Learning Objective 4 Identify corporate governance and other control environment factors that reduce fraud risks.

17. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 17 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

18. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 18 Example Elements for a Code of Conduct  Organizational code of conduct  General employee conduct  Conflicts of interest  Outside activities, employment, and directorships

19. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 19 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

20. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 20 Example Elements for a Code of Conduct  Organization records and communications  Dealing with outside people and organizations  Prompt communications  Privacy and confidentiality

21. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 21 Organizational Factors Contributing to Risk of Fraud 200319981994 Collusion between employees and third parties Inadequate internal controls Management override of internal controls 48 31 33 39 58 59 31 36

22. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 22 Organizational Factors Contributing to Risk of Fraud Collusion between employees and management Lack of control over management by directors Ineffective or nonexistent ethics or compliance program 15 19 23 12 11 6 10 8 7 200319981994

23. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 23 Learning Objective 5 Develop responses to identified fraud risks.

24. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 24 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.

25. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 25 Learning Objective 6 Recognize specific fraud risk areas and develop procedures to detect fraud.

26. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 26 Rates of Fraud Occurrence 20031998 Theft of assets 49 22 Check fraud 40 26 Expense account abuse 36 13 Credit card fraud 20 13 Payroll fraud 12 3

27. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 27 Rates of Fraud Occurrence 20031998 Conflict of interest 12 9 Inventory theft 11 Kickbacks 9 6 Financial reporting fraud 7 3

28. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 28 Specific Fraud Risk Areas  Inventory fraud risks  Revenue and accounts receivable fraud risks  Purchases and accounts payable fraud risks  Other areas of fraud risk

29. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 29 Learning Objective 7 Understand interview techniques and other activities after fraud is suspected.

30. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 30 Methods of Uncovering Fraud Internal controls Internal audit Notification by employee Accident Anonymous tip Notification by customer Notification by regulatory or law enforcement agency Notification by vendor External audit 77 65 63 54 41 34 19 16 12 51 43 58 37 35 41 16 11 4 52 47 51 28 26 34 8 15 5 (Percentages)200319981994

31. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 31 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.

32. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 32 Types of Inquiry Techniques  Informational inquiry  Assessment inquiry  Interrogative inquiry  Evaluating responses  Listening techniques  Observing behavioral cues

33. ©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 33 End of Chapter 11