10-1 Define fraud and distinguish between fraudulent financial
reporting and misappropriation of assets. 10-2 Describe the fraud triangle and identify conditions for fraud. 10-3 Understand the auditors responsibility for assessing the risk of fraud and detecting material misstatements due to fraud. 10-4 Identify corporate governance and other control environment factors that reduce fraud risks.
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CHAPTER 10 LEARNING OBJECTIVES (CONT.)
10-5 Develop responses to identified fraud risk.
10-6 Recognize specific fraud risk areas and develop procedures to detect fraud. 10-7 Understand interview techniques and other activities after fraud is suspected. 10-8 Describe information about the fraud risk assessment that must be documented in the working papers.
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OBJECTIVE 10-1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.
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TYPES OF FRAUD Fraudulent Financial ReportingAn intentional misstatement or omission of amounts or disclosures with the intent to deceive users. Most cases involve an attempt to overstate income, but can also understate income. Earnings management involves fraud to meet earnings goals. Income smoothing is a form of earnings management that shifts income from year to year to reduce fluctuations.
Misappropriation of AssetsFraud that involves theft of an
entitys assets. Normally perpetrated by lower level employees, but can involve upper management.
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OBJECTIVE 10-2 Describe the fraud triangle and identify conditions for fraud.
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CONDITIONS FOR FRAUD Three conditions for fraud are referred to as the fraud triangle: 1. Incentives/PressuresManagement or other employees have incentives or pressures to commit fraud. 2. OpportunitiesCircumstances provide opportunities for management or employees to commit fraud. 3. Attitudes/RationalizationAn attitude, character, or set of ethical values exists that allows management or employees to commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.
The fraud triangle is illustrated in Figure 10-1.
Risk factors for fraudulent financial reporting are shown in Table 10-1.
Commonly cited fraud risk conditions are shown in Figure 10-2.
The characteristics of fraud perpetrators are detailed in Figure 10-3.
Risk Factors for Misappropriation of Assets The same three
conditions apply to misappropriation of assts. However, in assessing risk factors, greater emphasis is placed on individual incentives and opportunities for theft. Examples of fraud risk factors for each of the three conditions for misappropriation of assets are provided in Table 10-2.
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Copyright 2017 Pearson Education, Ltd. 10-11 Copyright 2017 Pearson Education, Ltd. 10-12 Copyright 2017 Pearson Education, Ltd. 10-13 OBJECTIVE 10-3 Understand the auditors responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.
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ASSESSING THE RISK OF FRAUD
Professional SkepticismAuditing standards
require that the audit be planned and performed with an attitude of professional skepticism. This involves two components: Questioning mind Critical evaluation of audit evidence
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ASSESSING THE RISK OF FRAUD (CONT.)
Sources of Information to Assess Fraud Risks (Figure 10-4)
1. Communication Among Audit Team 1. How and where the entitys financial statements might be susceptible to material misstatement due to fraud. 2. How management could perpetrate and conceal fraudulent financial reporting. 3. How anyone might misappropriate assets of the entity 4. How the auditor might respond to the susceptibility of material misstatements due to fraud. 2. Inquiries of Management 3. Risk Factors 4. Analytical ProceduresSee horizontal analysis in Figure 10-5. 5. Other Information
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Copyright 2017 Pearson Education, Ltd. 10-17 Copyright 2017 Pearson Education, Ltd. 10-18 ASSESSING THE RISK OF FRAUD (CONT.)
Identified Risks of Material Misstatement Due to Fraud
Auditors evaluate all of the sources of information to assess the risk of material misstatement due to fraud as part of audit planning. This assessment continues throughout the audit because the auditor may learn new information while performing audit procedures. Auditing standards require that the auditor presume there is a risk of fraud in revenue recognition. If the auditor concludes that this assumption does not apply, it must be documented in the working papers.
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OBJECTIVE 10-4 Identify corporate governance and other control environment factors that reduce fraud risks.
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CORPORATE GOVERNANCE OVERSIGHT TO REDUCE FRAUD RISKS
Management is responsible for implementing
corporate governance and control procedures to minimize the risk of fraud, through a combination of prevention, deterrence, and detection measures. The AICPA identifies three elements to prevent, deter, and detect fraud: 1. Culture of honesty and high ethics 2. Managements responsibility to evaluate risks of fraud 3. Audit committee oversight
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CORPORATE GOVERNANCE OVERSIGHT TO REDUCE FRAUD RISKS (CONT.) Culture of Honesty and High Ethics The most effective way to prevent and deter fraud is to implement antifraud programs and controls that are based on core values embraced by the company. Setting the Tone at the Top: Honesty and integrity by management reinforces honesty and integrity by employees. Table 10-3 shows contents of an effective code of conduct. Creating a Positive Workplace Environment: Wrongdoing occurs less frequently when employees have positive feelings about their employer than when they feel abused, threatened, or ignored. Hiring and Promoting Appropriate Employees: To prevent fraud, companies implement screening policies and promote employees who are trustworthy.
Training: New employees should be trained about the companys expectations of employees ethical behavior. Fraud awareness training should also be included. Confirmation: Employees should periodically confirm their responsibilities for complying with the code of conduct. Discipline: Employees must know that they will be held accountable for failure to follow the code of conduct. Enforcement of violations of the code sends the message that compliance with the code is expected.
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CORPORATE GOVERNANCE OVERSIGHT TO REDUCE FRAUD RISKS (CONT.)
Managements Responsibility to Evaluate Risks of Fraud
Identifying and Measuring Fraud Risks: Effective fraud oversight begins with management recognition that fraud is possible and almost any employee is capable of it. Figure 10-6 reflects the percentage reduction in losses from fraud due to these antifraud controls. Mitigating Fraud Risks: Management is responsible for implementing controls to mitigate fraud risks. Monitoring Fraud Prevention Programs and Controls: Management should periodically evaluate antifraud programs and ensure controls are effective. Internal audit plays a key role in monitoring.
The audit committee has primary responsibility to oversee the organizations financial reporting and internal control process. The audit committee is a deterrent to fraud by senior management by: Direct reporting of key findings by internal auditors to the audit committee Periodic reports by ethics officers about whistleblowing Other reports about lack of ethical behavior or suspected fraud The responsibility of the audit committee for mitigating fraud is shown in Figure 10-7.
When an auditor identifies risks of material misstatements
due to fraud, the auditor develops responses at three levels: Overall ResponsesAssign more experienced personnel to the audit or bring in a fraud specialist Responses at the Assertion LevelChanging the nature, timing, and extent of audit procedures Responses Related to Management Override: Examine journal entries and other adjustments for evidence of possible misstatements due to fraud. Review accounting estimates for biases. Evaluate the business rationale for significant unusual transactions.
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RESPONDING TO THE RISK OF FRAUD (CONT.)
Update Risk Assessment ProcessThe auditors assessment of risk of
material misstatement due to fraud is ongoing throughout the audit. The auditor should be alert for the following conditions during the audit: Discrepancies in the accounting records Conflicting or missing audit evidence Problematic or unusual relationships between the auditor and management Results from substantive or final review stage analytical procedures that indicate a previously unrecognized fraud risk Responses to inquiries made throughout the audit that are vague or implausible or that produce evidence that is inconsistent with other information
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OBJECTIVE 10-6 Recognize specific fraud risk areas and develop procedures to detect fraud.
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SPECIFIC FRAUD RISK AREAS
Revenue and Accounts Receivable Fraud Risks The
Committee of Sponsoring Organizations (COSO) found that more than half of financial statement frauds involve revenue and accounts receivable, and related cash. Three main types of revenue manipulation are: 1. Fictitious revenues 2. Premature revenue recognition 3. Manipulation of adjustments to revenue
Warning Signs of Revenue FraudTwo of the most useful are:
Revenue and Accounts Receivable Fraud Risks (cont.)
Misappropriation of Receipts Involving RevenueRarely as material as fraudulent financial reporting, but is costly because it is a direct loss of assets (cash). Usually involve one of the following: Failure to Record a SaleOne of the most difficult types of fraud to detect. Theft of Cash Receipts After a Sale Is RecordedTo hide the theft, the perpetrator must reduce the customers account in one of three ways: 1. Record a sales return or allowance. 2. Write off the customers account. 3. Apply the payment from another customer to the customers account.
Warning Signs of Misappropriation of Revenues and Cash ReceiptsAnalytical
procedures and comparisons are helpful. An example of the effects of fictitious receivables on accounting ratios are shown in Table 10-4.
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Copyright 2017 Pearson Education, Ltd. 10-35 SPECIFIC FRAUD RISK AREAS (CONT.) Inventory Fraud RisksFictitious inventory has been at the center of several major cases of fraudulent financial reporting. Auditors are required to verify the existence of physical inventories, but audit testing is done on a sample basis. If inventory is stored in several locations, it is relatively easy for the client to move inventory to the sample testing site. Warning Signs of Inventory FraudAnalytical procedures, especially gross profit margin percentage and inventory turnover, are effective. The effects of fictitious inventory on inventory turnover based on the Crazy Eddie case are shown in Table 10-5.
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Copyright 2017 Pearson Education, Ltd. 10-37 SPECIFIC FRAUD RISK AREAS (CONT.) Purchases and Accounts Payable Fraud Risks Companies may deliberately attempt to understate accounts payable and overstate income.
Misappropriation in the Acquisition and Payment Cycle The most
common fraud in the acquisition area is for payments to be issued to fictitious vendors and depositing the cash in fictitious accounts.
Other Areas of Fraud Risk
Fixed AssetsCompanies may capitalize repairs to increase the amount of assets on the balance sheet. Intangible AssetsThe values of intangible assets, especially goodwill, are based on estimates and are susceptible to manipulation. Payroll ExpenseRarely an area for fraudulent financial reporting, but often an area of misappropriation by payment to fictitious employees or overstatement of payroll hours.
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OBJECTIVE 10-7 Understand interview techniques and other activities after fraud is suspected.
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RESPONSIBILITIES WHEN FRAUD IS SUSPECTED
Frauds are often detected by
Anonymous tips Management review, Internal audit, or by accident. Common fraud detection methods are illustrated in Figure 10-8. Auditors continually evaluate the evidence gathered for indication of material misstatement due to fraud throughout the duration of the audit. When fraud is suspected, the auditor gathers additional information to determine whether fraud actually exists.
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Copyright 2017 Pearson Education, Ltd. 10-41 RESPONSIBILITIES WHEN FRAUD IS SUSPECTED (CONT.) When fraud is suspected, the auditor may use inquiry to determine whether fraud actually exists. Use of InquiryInquiry is an effective method of gathering more information and may take the following forms: Informational inquiry Assessment inquiry Interrogative inquiry
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RESPONSIBILITIES WHEN FRAUD IS SUSPECTED (CONT.)
For inquiry to be effective, the auditor must be
skilled in: Evaluating responses to inquiry Listening techniques Observing behavioral cues: Verbal cues are outlined in Table 10-6. Nonverbal cues are outlined in Table 10-7.
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Copyright 2017 Pearson Education, Ltd. 10-44 Copyright 2017 Pearson Education, Ltd. 10-45 RESPONSIBILITIES WHEN FRAUD IS SUSPECTED (CONT.)
Other Responsibilities When Fraud Is Suspected
Besides inquiry, the auditor may use any of the following procedures to determine whether fraud actually exists: Audit software analysis Expanded substantive testing Consider other audit implications
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OBJECTIVE 10-8 Describe information about the fraud risk assessment that must be documented in the working papers.
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DOCUMENTING THE FRAUD ASSESSMENT
Auditors must document the following matters related
to consideration of material misstatements due to fraud: Significant decisions made during the discussion among engagement team in planning the audit Procedures performed to obtain information necessary to identify and assess the risks of material fraud Specific risks of material fraud that were identified at both the overall financial statement level and the assertion level and the auditors response to those risks Reasons supporting a conclusion that there is not a significant risk of material improper revenue recognition
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DOCUMENTING THE FRAUD ASSESSMENT (CONT.) Auditors must document the following matters related to consideration of material misstatements due to fraud (cont.): Results of procedures performed to address the risk of management override of controls Other conditions and analytical relationships indicating that additional auditing procedures or other responses were required, and the actions taken by the auditor in response The nature of communications about fraud made to management, the audit committee, or others