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----------------------- Page 1----------------------Auditors New Procedures

for Detecting Fraud

THE ASB ISSUED AN EXPOSURE DRAFT designed to expand audit procedures to
address material financial statement fraud. Comments on the proposed changes are
THE ED EMPHASIZES CONSIDERING A CLIENTS susceptibility to fraud, regardless of
the auditors past experience with the entity or prior beliefs about managements ho
and integrity. And it requires
AUDIT TEAMS TO DISCUSS during the planning stage the potential for material
misstatements due to fraud.
AUDITORS TO QUERY MANAGEMENT about its views of the risks of fraud in the entity
and its knowledge of any known or suspected fraud.
AUDITORS TO BROADEN THE RANGE of information they use to assess the risks of
material misstatement due to fraud, beyond the fraud risk factors provided in SA
S no. 82.
and determine whether such programs and controls will mitigate or exacerbate the
Planned procedures should consider the risk of management override of controls:
include auditors examining journal entries and other adjustments, reviewing accou
estimates for bias and evaluating the business rationale for significant unusual
DANIEL D. MONTGOMERY, CPA, is a partner with Ernst & Youngs national professional
practice department in
Cleveland. His e-mail address is daniel.montgomery@ey.com. MARK S. BEASLEY, CPA,
PhD, is associate professor
of accounting at North Carolina State University at Raleigh. His e-mail address
is mark_beasley@ncsu.edu. SUSAN L.
MENELAIDES, CPA, is a partner with Altschuler, Melvoin, and Glasser LLP, a manag
ing director with American
Express Tax & Business Services Inc. in Chicago and a member of the auditing sta
ndards board. Her e-mail address is
Susan.L.Menelaides@aexp.com. ZOE-VONNA PALMROSE, CPA, PhD, is PricewaterhouseCoo
pers Professor of
Auditing at the University of Southern California Marshall School of Business. S
he was a member of the Public
Oversight Boards Panel on Audit Effectiveness. Her e-mail address is zpalmrose@ma
rshall.usc.edu. All the authors
e face a crisis of confidence in our financial reporting system. An increasing n
umber of
restatements and fraud allegations, often in conjunction with large business fai
contributes to concerns about the quality of financial statements. Thus, prevent
ing and
detecting material financial statement fraud are a focus for investors, regulato

management and auditors.

----------------------- Page 2----------------------The AICPA auditing standards board (ASB) took a significant step toward addressi
ng this problem
by issuing an exposure draft of a proposed Statement on Auditing Standards, Cons
ideration of
Fraud in a Financial Statement Audit, which would supersede SAS no. 82. The ED
does not change
any of the auditors current responsibilities for fraud in a financial statement a
udit. However, it
introduces new concepts, requirements and guidance to assist auditors in meeting
responsibilities. In applying the proposed guidance, auditors would plan and per
form every audit with
a questioning mind, recognizing the possibility that a material misstatement due
to fraud could be
present, regardless of past experience with the entity or prior beliefs about ma
nagements honesty
and integrity. Auditors would continue to be responsible for planning and perfor
ming the audit to
obtain reasonable assurance that financial statements are free of material mis
statements due to
fraudwhether arising from fraudulent financial reporting or asset misappropriatio
n. This article
To provide a richer understanding of the environment in which fraud is likely to
occur, the ED
expands the description of fraud and its characteristics. It describes three con
ditions generally present
when fraud occursincentive/pressure, opportunity and attitude/rationalization (se
e The Fraud
Triangle, below). Input from forensic experts, academics and others consistently
showed that
evaluation of information about fraud was enhanced when auditors considered it i
n the context of
To increase awareness and sensitivity to fraud, and to enhance the fraud-risk-as
sessment process, the
ED requires audit team members to discuss during the planning stage the potentia
l for material
misstatements due to fraud. The more experienced team members should share their
insights, and all
the members should exchange ideas about how and where the entitys financial state
ments might be
susceptible to material misstatements due to fraud.
Despite allegations in some recent high-profile cases, material frauds still are
relatively rare in relation
to all financial statement audits. In fact, most auditors never will encounter a
material fraud during
their careers. Most auditors assess their clients honesty and integrity through r
igorous client
acceptance and continuance procedures, which might lead them to assume without q
uestion their
clients are honest. In light of this, the ED emphasizes the importance of mainta
ining the proper
mindset throughout the audit regarding the potential for fraud. Consequently, th

e audit teams
discussion would acknowledge fraud can occur in any entity and be perpetrated by
Forensic experts know inquiry is a highly effective tool in fraud investigations
and that people who are
reluctant to volunteer information about known or suspected fraud will more like
ly do so when asked directly.
The ED requires auditors to query management on its views of the risks of fraud
in the entity and knowledge
of any known or suspected fraud (see sidebar, at the end of this article). It al
so says auditors should query
othersfor example, individuals outside the entitys accounting or financial reporti
ng areas or employees
with varying levels of authority. This requirement is not intended to be oneroust
he nature and extent of
these inquiries would be based on the auditors professional judgment and generall
y directed to employees
with whom the auditor comes into contact during the course of the audit (see Why A
sk? You Ask, JofA,
The ED emphasizes obtaining a broader range of information to serve as the found
ation for an
assessment that goes beyond considering the fraud risk factors provided in SAS n
o. 82. The various
sources of informationthe audit team discussion, inquiries of management and othe
consideration of fraud risk factors, the results of planning analytical procedur
es, information from the
client acceptance or continuance process and from reviews of interim financial s
tatementsall feed
----------------------- Page 3----------------------The auditor uses the information to consider the type of risk that may exist (f
or example, fraudulent
financial reporting or misappropriation of assets), the significance or magnitu
de of that risk, the
likelihood it will result in a material misstatement in the financial statement
s and the pervasiveness
of the risk (that is, whether it relates to the financial statements as a whole
or to a particular account
or assertion). Thus, the assessment process identifies risks of material misstatem
ents due to fraud
Revenue recognition issues have been at the center of numerous instances of frau
dulent financial
reporting and continue to be the number-one reason for restating financial state
ments. To address this
problem, the ED says auditors ordinarily will identify a risk of material missta
tement due to fraud
relating to revenue recognition. Analytical procedures would be required during
planning to help
identify unusual or unexpected relationships involving revenue or related accoun
ts. The ED also
provides expanded guidance to help auditors make sure planned audit procedures f
or revenue
accounts and assertions are appropriate given the identified fraud risks.

When the auditor identifies risks of material misstatements due to fraud, the ED
requires that he or
she consider managements programs and controls to address those risks. They might
include broader
programs or specific controls designed to prevent, deter or detect fraud. As in
SAS no. 82, the
auditor would consider whether such programs and controls will mitigate or exace
rbate those
identified risks. However, in a change from SAS no. 82, the auditor would evalua
te whether these
programs and controls have been suitably designed and placed in operation. The a
uditors ultimate
assessment of the risks of material misstatement due to fraud would take this ev
aluation into account.
The ED requires the auditor to develop an appropriate response for each fraud ri
sk identified and
includes more extensive guidance and examples on how to do so. The auditors respo
nses, which are
influenced by the nature and significance of the risks identified and the evalua
tion of the entitys
programs and controls, might have an overall effect on how the audit is conducte
d (for example,
additional persons with specialized skills or knowledge may be assigned) or migh
t involve changing
the nature, timing or extent of auditing procedures for specific accounts or ass
ertions. The response
typically also will involve performing certain procedures to address the risk of
management override
of controls.
Management is in a unique position to perpetrate fraud because it can override e
stablished controls
that would appear to be operating effectively. This risk exists in virtually all
audits and can occur in a
number of unpredictable ways. Currently, the auditors planned procedures in respo
nse to inherent
and control risks and the auditors assessment of the risk of material fraud consi
der, at least
implicitly, the risk of management override. The ED, however, requires auditors
of public companies
to perform certain procedures to further address this risk. These procedures, wh
ich generally would
apply also for audits of nonpublic companies, except in some limited circumstanc
es as discussed in
the ED, include
Examining journal entries and other adjustments. Several instances of fraudulen
t financial
reporting involved the manipulation of the financial statements through unauthor
ized journal entries
or other so-called top-side adjustments. Many auditors already may review unusua
l or nonstandard
journal entries. However, the ED places more emphasis on the auditors understandi
ng of the entitys
financial reporting process, including automated and manual procedures used to p
repare financial
statements and related disclosures, and how misstatements may occur. This unders
tanding, already
required by SAS no. 94, The Effect of Information Technology on the Auditors Cons
ideration of
Internal Controls in a Financial Statement Audit, provides a basis for determin

ing the nature, timing

and extent of testing of journal entries and other adjustments for evidence of p
ossible material
misstatement due to fraud. This testing would be a matter of professional judgme
nt and would be
based on the auditors assessment of the fraud risks, whether effective controls h
ave been
----------------------- Page 4----------------------Reviewing accounting estimates for bias. Fraudulent financial reporting often i
s accomplished
through intentional misstatement of accounting estimates. Existing auditing stan
dards already require
the auditor to consider the potential for management bias when reviewing signifi
cant estimates. In
addition, the ED requires the auditor to perform a retrospective review of signi
ficant prior-year
estimates for any potential bias that might signal inappropriate earnings manage
ment (for example,
recorded estimates clustered at one end of an acceptable range in the prior year
and at the other end
Evaluating the business rationale for significant unusual transactions. The use
of complex
business structures and sophisticated transactions, especially transactions invo
lving special purpose
entities or related parties, has been making headlines recently. Although the au
ditor typically gains an
understanding of significant transactions, the ED places a greater focus on unde
rstanding the
underlying business rationale for significant unusual transactions. In this con
text, unusual
transactions are those that come to the auditors attention that are outside the
normal course of
The ASB believes the expanded requirements and guidance provided in the ED, if a
dopted, would
substantially change auditor performance and thereby improve the likelihood that
auditors will detect
material misstatements due to fraud in a financial statement audit. The ED shoul
d improve the audit
engagement teams overall awareness of the possibility of fraud and motivate all t
eam members to
think about how and where material fraud might occur. This should lead auditors
to be more alert for
indications of potential material fraud and to carefully consider whether planne
d audit procedures
appropriately respond to identified fraud risks, including the risk of managemen
t override of controls.
An increased focus on professional skepticism in gathering and evaluating audit
evidence also should
lead auditors to further challenge evidence that doesnt make sense and to obtain
corroboration of managements explanations or representations concerning material
The new and strengthened requirements of the ED alone will not guarantee that au
ditors will detect
all material misstatements due to fraud. Fraud often is difficult to detect beca
use it involves

concealment through falsification of documents or collusion. Clearly, the ED is

a significant positive
step, incorporating the substance of a great majority of the specific recommenda
tions of the Panel on
Audit Effectiveness relating to fraud. The ED addresses the auditors effectivenes
s in detecting
material misstatements due to fraud, but broader efforts are needed that focus o
n the roles of
management, the audit committee, regulators and others in addressing this import
ant issue. Although
it is important to improve the likelihood auditors will detect material financia
l statement fraud, a
greater emphasis also is needed on managements responsibility for fraud preventio
n, deterrence and
The auditors role in detecting material fraud in a financial statement audit has
never been under such
scrutiny or been the subject of such controversy. We strongly encourage auditors
and others to consider the
changes the ED proposes and to provide the ASB with comments and feedback. The E
D is available on the
AICPA Web site at www.aicpa.org.
Required Inquiries of Management
The proposed standard requires auditors to ask management about
Its knowledge of fraud or suspected fraud.
Its awareness of any allegations of fraudulent financial reporting.
Its understanding about the risks of fraud in the entity.
Programs and controls established to mitigate specific fraud risks or broader pr
ograms to prevent,
deter or detect fraud and how it monitors such programs and controls.
----------------------- Page 5----------------------For entities with multiple locations, the nature and extent of monitoring of ope
rating locations or
business segments and whether there are particular operating locations or busine
ss segments for
which a risk of fraud may be more likely to exist.
Whether and how it communicates to employees its views on business practices and
ethical behavior.