1. Copyright © 2016 South-Western/Cengage Learning THE AUDITOR’S RESPONSIBILITIES REGARDING FRAUD AND MECHANISMS TO ADDRESS FRAUD: REGULATION AND CORPORATE GOVERNANCE CHAPTER 2 Auditing A Risk-Based Approach To Conducting A Quality Audit 10 th edition Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

2. Copyright © 2016 South-Western/Cengage Learning 2-2 LEARNING OBJECTIVES 1. Define the various types of fraud that affect organizations 2. Define the fraud triangle and describe its three elements 3. Describe implications for auditors of recent fraudulent financial reporting cases and the third COSO report on fraud 4. Discuss auditors’ fraud-related responsibilities and users’ related expectations 5. Explain how various requirements in the Sarbanes–Oxley Act of 2002 are designed to help prevent the types frauds perpetrated in the late 1990s and early 2000s 6. Define corporate governance, identify the parties involved, and describe their respective activities

3. Copyright © 2016 South-Western/Cengage Learning 2-3 THE AUDIT OPINION FORMULATION PROCESS

4. Copyright © 2016 South-Western/Cengage Learning DEFINE THE VARIOUS TYPES OF FRAUD THAT AFFECT ORGANIZATIONS LEARNING OBJECTIVE 1

5. Copyright © 2016 South-Western/Cengage Learning 2-5 FRAUD An intentional act involving use of deception that results in a misstatement of financial statements Two types of misstatements Misappropriation of assets Fraudulent financial reporting Different from errors Errors occur unintentionally

6. Copyright © 2016 South-Western/Cengage Learning 2-6 ASSET MISAPPROPRIATION Involves theft or misuse of organization’s assets Examples Skimming cash Stealing inventory Payroll fraud A dominant fraud scheme perpetrated against small businesses Perpetrators are commonly employees

7. Copyright © 2016 South-Western/Cengage Learning 2-7 FRAUDULENT FINANCIAL REPORTING The intentional manipulation of reported financial results to misstate the economic condition of the organization Common ways Manipulation, falsification, or alteration of accounting records or supporting documents Misrepresentation or omission of events or transactions Misapplication of accounting principles

8. Copyright © 2016 South-Western/Cengage Learning DEFINE THE FRAUD TRIANGLE AND DESCRIBE ITS THREE ELEMENTS LEARNING OBJECTIVE 2

9. Copyright © 2016 South-Western/Cengage Learning 2-9 EXHIBIT 2.2 - THE FRAUD TRIANGLE

10. Copyright © 2016 South-Western/Cengage Learning 2-10 INCENTIVES TO COMMIT FRAUD Management compensation schemesFinancial pressures for improved earnings or an improved balance sheetDebt covenantsPending retirement or stock option expirationsPersonal wealth tied to either financial results or survival of companyGreedAddictions to gambling or drugs

11. Copyright © 2016 South-Western/Cengage Learning 2-11 OPPORTUNITIES TO COMMIT FRAUD Significant related-party transactionsCompany’s industry positionManagement’s inconsistency involving subjective judgmentsComplex transactionsComplex or difficult to understand transactionsIneffective monitoring of management by the boardComplex or unstable organizational structureWeak or nonexistent internal controls

12. Copyright © 2016 South-Western/Cengage Learning 2-12 RATIONALIZING THE FRAUD Rationalization involves reconciling unlawful or unethical behavior Rationalization for fraudulent financial reporting “Saving” a company Rationalization for asset misappropriation Mistreatment by the company Sense of entitlement by the individual perpetrating the fraud

13. Copyright © 2016 South-Western/Cengage Learning DESCRIBE IMPLICATIONS FOR AUDITORS OF RECENT FRAUDULENT FINANCIAL REPORTING CASES AND THE THIRD COSO REPORT ON FRAUD LEARNING OBJECTIVE 3

14. Copyright © 2016 South-Western/Cengage Learning 2-14 IMPLICATIONS TO KEEP IN MIND WHEN CONDUCTING AN AUDIT Pressure created for top management by the analyst following and earnings expectations Before completing an audit, sufficient time should be allowed to examine major year-end transactions: Especially if there are potential problems with revenue Understanding complex transactions to determine: Their economic substance The parties that have economic obligations Understanding and analyzing weaknesses in an organization’s internal controls

15. Copyright © 2016 South-Western/Cengage Learning 2-15 THE THIRD COSO REPORT - AN ANALYSIS Major findings The amount and incidence of fraud remains high The median size of company perpetrating the fraud rose tenfold Heavy involvement in fraud by the CEO and/or CFO Most common fraud involved revenue recognition One-third of the companies changed auditors during the latter part of the fraud Majority of the frauds took place at companies that were listed on the Over-The-Counter (OTC) market

16. Copyright © 2016 South-Western/Cengage Learning DISCUSS AUDITORS’ FRAUD-RELATED RESPONSIBILITIES AND USERS’ RELATED EXPECTATIONS LEARNING OBJECTIVE 4

17. Copyright © 2016 South-Western/Cengage Learning 2-17 MITIGATING THE RISK OF FRAUDULENT FINANCIAL REPORTING Center for Audit Quality recommends three ways in which individuals involved in the financial reporting process can mitigate risk of fraudulent reporting Need to acknowledge the existence of a strong, highly ethical tone at the top of an organization Need to consistently exercise professional skepticism in evaluating and/or preparing financial reports Need to understand the role of strong communication in the financial reporting process

18. Copyright © 2016 South-Western/Cengage Learning 2-18 MESSAGE TO AUDITORS Assume greater responsibility for detecting fraud Provide assurance that financial statements are free of material fraud

19. Copyright © 2016 South-Western/Cengage Learning EXPLAIN HOW VARIOUS REQUIREMENTS IN THE SARBANES–OXLEY ACT OF 2002 ARE DESIGNED TO HELP PREVENT THE TYPES FRAUDS PERPETRATED IN THE LATE 1990S AND EARLY 2000S LEARNING OBJECTIVE 5

20. Copyright © 2016 South-Western/Cengage Learning 2-20 SARBANES-OXLEY ACT OF 2002 Broad legislation mandating standard setting for audits of public companies and standards for corporate governance Applies to publicly traded companies Not privately held organizations Read Exhibit 2.4 carefully to understand the sections of SOX and the various features of the legislation

21. Copyright © 2016 South-Western/Cengage Learning DEFINE CORPORATE GOVERNANCE, IDENTIFY THE PARTIES INVOLVED, AND DESCRIBE THEIR RESPECTIVE ACTIVITIES LEARNING OBJECTIVE 6

22. Copyright © 2016 South-Western/Cengage Learning 2-22 CORPORATE GOVERNANCE A process by which owners and creditors exert control and require accountability for resources entrusted to organizations Owners elect board of directors to provide: Oversight of organizations’ activities Accountability to stakeholders

23. Copyright © 2016 South-Western/Cengage Learning 2-23 EXHIBIT 2.5 - OVERVIEW OF CORPORATE GOVERNANCE RESPONSIBILITIES AND ACCOUNTABILITIES

24. Copyright © 2016 South-Western/Cengage Learning 2-24 PARTIES INVOLVED IN CORPORATE GOVERNANCE Board of directors: The major representative of stockholders, who ensure that the organization is run according to the organization’s charter and that there is proper accountability Audit committee: A subcommittee of the board of directors responsible for monitoring audit activities and serving as a surrogate for the interests of shareholders

25. Copyright © 2016 South-Western/Cengage Learning 2-25 PARTIES INVOLVED IN CORPORATE GOVERNANCE Board of directors and its audit committee oversee management Expected to protect stockholders’ rights Ensure that controls exist to prevent and detect fraud Stakeholders: Anyone who is influenced, either directly or indirectly, by actions of a company

26. Copyright © 2016 South-Western/Cengage Learning 2-26 RESPONSIBILITIES OF AUDIT COMMITTEES Appointment, compensation, and oversight of work of audit firms Must be independent Establish whistleblowing mechanisms within companies Authority to engage their own independent counsel Companies must provide adequate funding for audit committees