1. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 Management Fraud and Audit Risk "It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently." - - Warren Buffet, billionaire investor

2. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Presentation Outline I.Errors, Fraud, and Illegal Acts II.Steps in Considering the Risk of Fraud (SAS 99) III.The Audit Risk Model IV.Audit Programs and Procedures

3. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. I. Errors, Fraud, and Illegal Acts A.Errors B.Management Fraud C.Consideration of Fraud in a Financial Statement Audit D.Reasons Auditors Fail to Detect Fraud E.Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts

4. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. A. Errors Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements.

5. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. B. Management Fraud Management fraud is intentional misstatements or omissions of amounts or disclosures in financial statements

6. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. C. Consideration of Fraud in a Financial Statement Audit SAS 99 requires auditors to understand fraud, assess fraud risks, design audits to provide reasonable assurance of detecting material management/employee fraud that could have a material effect on the financial statements, and report the findings to management, directors, users of financial statements (sometimes), and outside agencies (under certain conditions).

7. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. D. Reasons Auditors Fail to Detect Fraud  Over reliance on client representations.  Lack of awareness or failure to recognize that an observed condition may indicate a material fraud.  Lack of experience.  Personal relationships with clients.

8. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. E. Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts Responsible for Detection? Must Communicate Findings? Material Immaterial Material Immaterial Errors Yes No Yes (Audit Committee) No Fraud Yes No Yes (Audit Committee) Yes (One level above) Illegal Acts Yes (Direct Effect) No Yes (Audit Committee) Yes (One level above)

9. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. II. Steps in Considering the Risk of Fraud (SAS 99) Step 1: Staff discussion Step 2: Identify information necessary to assess fraud risk factors Step 3: a. Identify and b. Assess fraud risk factors Step 4: Respond to risk assessment Step 5: Evaluate audit evidence Step 6: Communicate fraud matters Step 7: Document

10. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Step 1: D iscussion Among Engagement Personnel  Objectives:  Gain understanding of Previous experiences with client How a fraud might be perpetrated and concealed in the entity Procedures that might detect fraud  Set proper tone  Should be continuous

11. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Step 2: Obtain Information to Identify Risks  Inquiries:  Management  Audit committee  Internal auditors  Others  Planning analytical procedures Analytical procedures are very useful in identifying unusual relationships among financial statement accounts that merit additional investigation.

12. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Step 3a: Identify Risk Factors Related to Fraudulent Financial Reporting 1)Management’s characteristics and influence 2)Industry Conditions 3)Operating Characteristics and Financial Stability

13. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. 1) Management’s Characteristics and Influence  Management has a motivation to engage in fraudulent reporting.  Management decisions are dominated by an individual or a small group.  Management fails to display an appropriate attitude about internal control.  Managers’ attitudes are very aggressive toward financial reporting.  Managers place too much emphasis on earnings projections.  Nonfinancial management participates excessively in the selection of accounting principles or determination of estimates.  The company has a high turnover of senior management.  The company has a known history of violations.  Managers and employees tend to be evasive when responding to auditors’ inquiries.  Managers engage in frequent disputes with auditors.

14. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. 2) Industry conditions  Company profits lag the industry.  New requirements are passed that could impair stability or profitability.  The company’s market is saturated due to fierce competition.  The company’s industry is declining.  The company’s industry is changing rapidly.

15. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. 3) Operating Characteristics  A weak internal control environment prevails.  The company is not able to generate sufficient cash flows to ensure that it is a going concern.  There is pressure to obtain capital.  The company operates in a tax haven jurisdiction.  The company has many difficult accounting measurement and presentation issues.  The company has significant transactions or balances that are difficult to audit.  The company has significant and unusual related-party transactions.  Company accounting personnel are lax or inexperienced in their duties.

16. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Step 3b: Assess Fraud Risks Required risk assessments include:  Presume that improper revenue recognition is a fraud risk.  Identify risks of management override of controls. –Examine journal entries and other adjustments. –Review accounting estimates for biases. –Evaluate business rationale for significant unusual transactions.

17. McGraw-Hill/Irwin ©2007 by the McGraw-Hill Companies, Inc. All rights reserved. Step 4: Respond to Assessed Risks  Assignment of personnel (i.e., level of experience)  Predictability of auditing procedures  Examination of journal entries and other adjustments  Retrospective review of prior year accounting estimates