1. Fraud Auditing
Chapter 11

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

3. 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.

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

5. 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

6. Why Fraud Occurs

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

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

14. 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.”
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.

15. 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.

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

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

18. 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.

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

20. 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

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

22. Organizational Factors Contributing to Risk of Fraud

23. Learning Objective 5
Develop responses to identified fraud risks.

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 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.

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

26. 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

27. Effect of Fictitious Receivables on Accounting Ratios

28. Effect of Fictitious Inventory on Inventory Turnover

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

30. 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.

31. 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.

32. 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

33. Observing Verbal Cues

34. Observing Non-Verbal Cues

35. End of Chapter 11