Fraud Auditing

Chapter 11By arens et.al.,

Learning Objective 1

• Define fraud and distinguish• between fraudulent financial• reporting and misappropriation• of assets.

Types of Fraud

Fraudulent financial reporting

Misappropriation of assets

Learning Objective 2

• Describe the fraud triangle and• identify conditions for fraud.

The Fraud Triangle

Incentives/Pressures

Opportunities Attitudes/Rationalization

Examples of Risk Factorsfor Fraudulent Reporting

Financial stability or profitability is threatened byeconomic, industry, or entity operating conditions

Excessive pressure exists for management tomeet debt requirements

Personal net worth is materially threatened

Incentives/Pressures:

Examples of Risk Factorsfor Fraudulent Reporting

There are significant accounting estimates thatare difficult to verify

There is ineffective oversight over financialreporting

High turnover or ineffective accounting, internalaudit, or information technology staff exists

Opportunities:

Examples of Risk Factorsfor Fraudulent Reporting

Inappropriate or inefficient communicationand support of the entity’s values is evident

A history of violations of laws is known

Management has a practice of makingoverly aggressive or unrealistic forecasts

Attitudes/Rationalization:

Examples of Risk Factorsfor Misappropriation of Assets

Personal financial obligations create pressureto misappropriate assets

Adverse relationships between managementand employees motivate employees tomisappropriate assets

Incentives/Pressures:

Examples of Risk Factorsfor Misappropriation of Assets

There is a presence of large amounts of cashon hand or inventory items

There is an inadequate internal control overassets

Opportunities:

Examples of Risk Factorsfor Misappropriation of Assets

Disregard for the need to monitor or reducerisk of misappropriating assets exists

There is a disregard for internal controls

Attitudes/Rationalization:

Learning Objective 3

• Understand the auditor’s• responsibility for assessing• the risk of fraud and detecting• material misstatements due to• fraud.

Assessing the Risk of Fraud

SAS 99 provides guidance to auditorsin assessing the risk of fraud.

SAS 1 states that, in exercising professionalskepticism, an auditor “neither assumes thatmanagement is dishonest nor assumesunquestioned honesty.”

Sources of Information Gathered to Assess Fraud Risks

Communicationamong audit team

Inquiries ofmanagement

Riskfactors

Analyticalprocedures

Otherinformation

Identified risks of material misstatements due to fraud

Documenting Fraud Assessment

Discussion

Specific risks

Procedures

Reasons

Nature of communications

Other conditions and analytical relationships

Learning Objective 4

• Identify corporate governance• and other control environment• factors that reduce fraud risks.

Corporate Governance Oversightto Reduce Fraud Risks

1. Culture of honesty and high ethics

2. Management's responsibilityto evaluate risks of fraud

3. Audit committee oversight

Example Elements for a Code of Conduct

Organizational code of conduct

General employee conduct

Conflicts of interest

Outside activities, employment, and directorships

Example Elements for a Code of Conduct

Relationships with clients and suppliers

Gifts, entertainment, and favors

Kickbacks and secret commissions

Organization funds and other assets

Example Elements for a Code of Conduct

Organization records and communications

Dealing with outside people and organizations

Prompt communications

Privacy and confidentiality

Organizational Factors Contributing to Risk of Fraud

2003 1998 1994

Collusion betweenemployees and

third partiesInadequate

internalcontrols

Managementoverride of

internal controls

483133

395859

313636

Organizational Factors Contributing to Risk of Fraud

Collusion betweenemployees and

managementLack of control

over managementby directors

Ineffective ornonexistent ethics orcompliance program

151923

1211 6

10 8 7

2003 1998 1994

Learning Objective 5

• Develop responses to identified• fraud risks.

Responding to the Risk of Fraud

Change the overall conduct of the auditto respond to identified fraud risks.

Design and perform audit proceduresto address identified risks.

Design and perform procedures toaddress the risk of managementoverride of controls.

Learning Objective 6

• Recognize specific fraud risk• areas and develop procedures• to detect fraud.

Initial Detection Method for Million Dollar Schemes

Tip

By Accident

Internal Audit

Internal Controls

External Audit

Notified By Police

$1,000,000+

All Cases

0% 10% 20% 30% 40% 50%

Note: The sum of percentages in this chart exceeds 100 percent because in some cases respondents identified more than one detection method.

42.3%

46.2%

22.8%

20.0%

18.6%19.4%

16.7%23.3%

15.8%9.1%

6.0%3.2%

Type

of D

etec

tion

Specific Fraud Risk Areas

Inventory fraud risks

Revenue and accounts receivable fraud risks

Purchases and accounts payable fraud risks

Other areas of fraud risk

Learning Objective 7

• Understand interview techniques• and other activities after fraud• is suspected.

Responding to Misstatements That May Be the Result of Fraud

When fraud is suspected, the auditor gathersadditional information to determine whetherfraud actually exists.

Types of Inquiry Techniques Informational inquiry

Assessment inquiry

Interrogative inquiry

Evaluating responses

Listening techniques

Observing behavioral cues

End of Chapter 11