Fraud Auditing

Chapter 11

2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley

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Learning Objective 1
Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.

2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley

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Types of Fraud
Management Fraud

Fraudulent financial reporting

Misappropriation of assets

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Learning Objective 2
Describe the fraud triangle and identify conditions for fraud.

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The Fraud Triangle

Incentives/Pressures

Opportunities

Attitudes/Rationalization
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Why Fraud Occurs

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Examples of Risk Factors for Fraudulent Reporting

Incentives/Pressures: Financial stability or profitability is threatened by economic, industry, or entity operating conditions Excessive pressure exists for management to meet debt requirements Personal net worth is materially threatened

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Examples of Risk Factors for Fraudulent Reporting

Opportunities: There are significant accounting estimates that are difficult to verify There is ineffective oversight over financial reporting High turnover or ineffective accounting, internal audit, or information technology staff exists
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Examples of Risk Factors for Fraudulent Reporting

Attitudes/Rationalization: Inappropriate or inefficient communication and support of the entitys values is evident A history of violations of laws is known Management has a practice of making overly aggressive or unrealistic forecasts

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Examples of Risk Factors for Misappropriation of Assets

Incentives/Pressures: Personal financial obligations create pressure to misappropriate assets Adverse relationships between management and employees motivate employees to misappropriate assets

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Examples of Risk Factors for Misappropriation of Assets

Opportunities: There is a presence of large amounts of cash on hand or inventory items There is an inadequate internal control over assets

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Examples of Risk Factors for Misappropriation of Assets

Attitudes/Rationalization: Disregard for the need to monitor or reduce risk of misappropriating assets exists There is a disregard for internal controls

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Learning Objective 3
Understand the auditors responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.

2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley

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Assessing the Risk of Fraud

SAS 99 provides guidance to auditors in assessing the risk of fraud. SAS 1 states that, in exercising professional skepticism, an auditor neither assumes that management is dishonest nor assumes unquestioned honesty.

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Sources of Information Gathered to Assess Fraud Risks

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Documenting Fraud Assessment

Discussion among engagement team Procedures performed to assess risk Specific risks and audit response Reasons supporting conclusions Other conditions and analytical relationships Nature of communications

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Learning Objective 4
Identify corporate governance and other control environment factors that reduce fraud risks.

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Corporate Governance Oversight to Reduce Fraud Risks

1. Culture of honesty and high ethics 2. Management's responsibility to evaluate risks of fraud 3. Audit committee oversight

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Example Elements for a Code of Conduct

Organizational code of conduct General employee conduct

Conflicts of interest
Outside activities, employment, and directorships

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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

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Example Elements for a Code of Conduct

Organization records and communications
Dealing with outside people and organizations Prompt communications Privacy and confidentiality

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Organizational Factors Contributing to Risk of Fraud

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Learning Objective 5
Develop responses to identified fraud risks.

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Responding to the Risk of Fraud

Change the overall conduct of the audit to respond to identified fraud risks. Design and perform audit procedures to address fraud risks. Design and perform procedures to address the risk of management override of controls.
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Learning Objective 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 Inventory fraud risks Purchases and accounts payable fraud risks Other areas of fraud risk

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Effect of Fictitious Receivables on Accounting Ratios

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Effect of Fictitious Inventory on Inventory Turnover

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Learning Objective 7
Understand interview techniques and other activities after fraud is suspected.

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Responding to Misstatements That May Be the Result of Fraud

When fraud is suspected, the auditor gathers additional information to determine whether fraud actually exists.

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Initial Detection Method for Million-Dollar Schemes

Tip
Type of Detection 42.3% 46.2% 22.8% 20.0%

By Accident

Internal Audit
Internal Controls External Audit Notified By Police
0%

18.6% 19.4% 16.7 % 23.3% 15.8% 9.1 % 6.0% 3.2%

10% 20% 30% 40% 50%
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$1,000,000 + All Cases

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

2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley

Types of Inquiry Techniques

Informational Assessment Listening Evaluating responses Interrogative

Observing behavioral cues

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Observing Verbal Cues

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Observing Non-Verbal Cues

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End of Chapter 11

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