1. Auditing & Assurance Services, 6e

2. Management Fraud and Audit Risk
Chapter 04
Management Fraud and Audit Risk
“Profit is the result of risks wisely selected”
Frederick Barnard Hawley
“Risk comes from not knowing what you’re doing”
Warren Buffett
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3. Learning Objectives
Define business risk and understand how management addresses business risk with the Enterprise Risk Management Model
Explain auditors’ responsibility for risk assessment and define and explain the differences among several types of fraud and errors that might occur in an organization.
Describe the audit risk model and explain the meaning and importance of its components in terms of professional judgment and audit planning
Understand sources of inherent risk factors including the client’s business and environment.
Understand sources of information for assessing risks including analytical procedures, brainstorming and inquiries. Explain how auditors respond to assessed risks.
Explain auditors’ responsibilities with respect to a client’s failure to comply with laws or regulations.
Describe the content and purpose of an audit strategy.
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4. Management’s Risks Business Risk—failure to meet objectives
Objectives—overall plans
Strategies—methods to meet objectives
Information Risk---financial statements will be misstated.
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5. Sources of Risk – Exhibit 4.1
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6. ERM – Exhibit 4.2
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7. Auditor’s Risk Responsibilities
Audit Risk—auditor will give unqualified opinion on misstated financial statements
Management Fraud Risk—management intentionally misstates financial statements
Fraudulent financial reporting
Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements.
Auditors’ primary responsibility is to design procedures to provide reasonable assurance that frauds that materially misstate the financial statements are detected.
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8. Other Definitions Related to Fraud
Employee fraud
Larceny
misappropriation of assets
Defalcation
Embezzlement
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9. Overview of Types of Fraud Risk – Exhibit 4.4
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10. General Categories of Errors and Frauds
Invalid transactions are recorded.
Valid transactions are omitted from the accounts.
Unauthorized transactions are executed and recorded.
Transaction amounts are inaccurate.
Transactions are classified in the wrong accounts.
Transaction accounting and posting is incorrect.
Transactions are recorded in the wrong period.
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11. Risk Factors Related to Fraudulent Financial Reporting
Management’s characteristics and influence
Industry conditions
Operating characteristics and financial stability
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12. Fraud Risk Factors: 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.
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13. Fraud Risk Factors: Management’s Characteristics and Influence (cont.)
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
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14. Fraud Risk Factors: 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.
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15. Fraud Risk Factors: 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.
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16. The AUDIT RISK MODEL (ARM)
Audit risk (AR) is the risk (likelihood) that the auditor may unknowingly fail to modify the opinion on financial statements that are materially misstated (e.g., an unqualified opinion on misstated financial statements.)
The AUDIT RISK MODEL decomposes overall audit risk into three components: inherent risk (IR), control risk (CR), and detection risk (DR):
AR = IR x CR x DR
(IR x CR = Risk of Material Misstatement (RMM))
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17. Inherent Risk Factors affecting account inherent risk include:
Dollar size of the account
Liquidity
Volume of transactions
Complexity of the transactions
New accounting pronouncements
Subjective estimates
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18. Control Risk
Control Risk (CR) is the likelihood that a material misstatement would not be caught by the client’s internal controls.
Factors affecting control risk include:
The environment in which the company operates (its “control environment”).
The existence (or lack thereof) and effectiveness of control activities.
Monitoring activities (audit committee, internal audit function, etc.).
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19. Detection Risk
Detection risk (DR) is the risk that a material misstatement would not be caught by audit procedures.
Factors affecting detection risk include:
Nature, timing, and extent of audit procedures
Sampling risk
Risk of choosing an unrepresentative sample.
Nonsampling risk
Risk that the auditor may reach inappropriate conclusions based upon available evidence
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20. Detection Risk and the Nature, Timing, and Extent of Audit Procedures
Lower Detection Risk
Higher Detection Risk
Nature
More effective tests.
Less effective tests.
Timing
Testing performed at year-end.
Testing can be performed at Interim.
Extent
More tests.
Fewer tests.
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21. Audit Risk Process
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22. Factors Affecting Overall Inherent Risk
Company and its environment
Nature of Company
Related parties
Accounting Principles and Disclosures
Objectives and Strategies
Measurement and Analysis of Financial Performance
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23. Information Sources General Business Sources Company Sources
Minutes
Client acceptance, Planning, Past audits, and Other Engagements
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24. Preliminary Analytic Procedures
RECORDED ACCOUNT BALANCE
ESTIMATED ACCOUNT
BALANCE
Attention directing
Identify potential problem areas
An organized approach
A standard starting place to start examining the financial statements
Describe the financial activities
Identify unusual changes in relationships in the data
Ask relevant questions
What could be wrong?
What legitimate reasons are there for these results?
Cash flow analysis
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25. Analytic Procedure Steps
Develop an expectation.
Define a significant difference.
Calculate predictions and compare them with the recorded amount.
Investigate significant differences.
Document each of the above steps.
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26. Analytic Procedures: Stages of Use
Preliminary planning-- required
Substantive testing -- optional
Final review -- required
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27. Audit team discussions (brainstorming)
Required procedure
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 for engagement
Discussions should be ongoing throughout the engagement
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28. Inquiries Management Audit committee Internal auditors Others
Risk of Fraud
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29. Assess Fraud Risks Type of risk Significance of risk
Likelihood of risk
Pervasiveness of risk
Assess controls and programs
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30. Required Risk Assessments
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.
Identify Significant Risks
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31. Respond to Assessed Risks
Respond to Significant Risks
Assignment of personnel
Choice of accounting principles
Predictability of auditing procedures
Retrospective review of prior year accounting estimates
Accumulated Results of Procedures
Extended procedures
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32. Evaluate Audit Evidence
Discrepancies in the accounting records.
Conflicting or missing evidential matter.
Problematic or unusual relationships between the auditor and management.
Results from substantive of final review stage analytical procedures.
Vague, implausible or inconsistent responses to inquiries.
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33. Communicate Fraud Matters
Evidence that fraud may exist must be communicated to appropriate level of management.
Sarbanes Oxley: Significant deficiencies must be communicated to those charged with governance.
Any fraud committed by management (no matter how small) is material.
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34. Document Fraud Matters
Discussion of engagement personnel.
Procedures to identify and assess risk.
Specific risks identified and auditor response.
If revenue recognition not a risk—explain why.
Results of procedures regarding management override.
Other conditions causing auditors to believe additional procedures are required.
Communication to management, audit committee, etc.
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35. Noncompliance With Laws and Regulations
Direct-effect noncompliance produce direct and material effects on the financial statements . The law or regulation can be identified with a specific account or disclosure (e.g., income tax .evasion).
Auditor’s responsibility--design procedures to provide reasonable assurance
Indirect-effect noncompliance are not related to specific accounts or disclosures on the financial statements (e.g., violations relating to insider securities trading, occupational health and safety, food and drug administration, environmental protection, and equal employment opportunity).
Auditor's responsibility—Follow up on suspected violations material to the financial statements
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36. Red Flags of Potential Noncompliance
Unauthorized transactions.
Government investigations.
Regulatory reports of violations.
Payments to consultants, affiliates, or employees for unspecified services.
Excessive sales commissions and agents’ fees.
Unusually large cash payments.
Unexplained payments to government officials.
Failure to file tax returns or to pay duties and fees.
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37. Audit Strategy Memorandum
Identify significant accounts and disclosures
Establish overall audit strategy for each relevant assertion
Take into account
Reporting objectives and communications required
Auditor’s risk assessment.
Other requirements of laws or regulations.
Nature, timing, and extent of necessary resources
Planned tests of controls, substantive procedures, and other planned audit procedures
Memo is basis for preparing detailed audit plans (often called audit programs)
Written audit plan documenting audit strategy is required
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