Fraud Auditing Chapter 11 2010 Prentice Hall Business

Learning Objective 1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 2

Types of Fraud Ø Fraudulent financial reporting Ø Misappropriation of assets © 2010 Prentice

Learning Objective 2 Describe the fraud triangle and identify conditions for fraud. © 2010

The Fraud Triangle Incentives/Pressures Opportunities Attitudes/Rationalization © 2010 Prentice Hall Business Publishing, Auditing 13/e,

Examples of Risk Factors for Fraudulent Reporting Incentives/Pressures: Ø Financial stability or profitability is threatened by economic, industry, or entity operating conditions Ø Excessive pressure exists for management to meet debt requirements Ø Personal net worth is materially threatened © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 6

Examples of Risk Factors for Fraudulent Reporting Opportunities: Ø There are significant accounting estimates that are difficult to verify Ø There is ineffective oversight over financial reporting Ø High turnover or ineffective accounting, internal audit, or information technology staff exists © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 7

Examples of Risk Factors for Fraudulent Reporting Attitudes/Rationalization: Ø Inappropriate or inefficient communication and support of the entity’s values is evident Ø A history of violations of laws is known Ø Management has a practice of making overly aggressive or unrealistic forecasts © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 8

Examples of Risk Factors for Misappropriation of Assets Incentives/Pressures: Ø Personal financial obligations create pressure to misappropriate assets Ø Adverse relationships between management and employees motivate employees to misappropriate assets © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 9

Examples of Risk Factors for Misappropriation of Assets Opportunities: Ø There is a presence of large amounts of cash on hand or inventory items Ø There is an inadequate internal control over assets © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 10

Examples of Risk Factors for Misappropriation of Assets Attitudes/Rationalization: Ø Disregard for the need to monitor or reduce risk of misappropriating assets exists Ø There is a disregard for internal controls © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 11

Learning Objective 3 Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 12

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. ” © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 13

Sources of Information Gathered to Assess Fraud Risks Communication among audit team Inquiries of management Risk factors Analytical procedures Other information Identified risks of material misstatements due to fraud © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 14

Documenting Fraud Assessment Ø Discussion Ø Procedures Ø Specific risks Ø Reasons Ø Other conditions and analytical relationships Ø Nature of communications © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 15

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

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 © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 17

Example Elements for a Code of Conduct Ø Organizational code of conduct Ø General employee conduct Ø Conflicts of interest Ø Outside activities, employment, and directorships © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 18

Example Elements for a Code of Conduct Ø Relationships with clients and suppliers Ø Gifts, entertainment, and favors Ø Kickbacks and secret commissions Ø Organization funds and other assets © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 19

Example Elements for a Code of Conduct Ø Organization records and communications Ø Dealing with outside people and organizations Ø Prompt communications Ø Privacy and confidentiality © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 20

Organizational Factors Contributing to Risk of Fraud Collusion between employees and third parties Inadequate internal controls Management override of internal controls 2003 1998 48 31 33 39 58 59 31 36 36 1994 © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 21

Organizational Factors Contributing to Risk of Fraud Collusion between employees and management Lack of control over management by directors Ineffective or nonexistent ethics or compliance program 2003 1998 15 19 23 12 11 6 10 8 7 1994 © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 22

Learning Objective 5 Develop responses to identified fraud risks. © 2010 Prentice Hall Business

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 identified risks. Design and perform procedures to address the risk of management override of controls. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 24

Learning Objective 6 Recognize specific fraud risk areas and develop procedures to detect fraud.

Initial Detection Method for Million Dollar Schemes 42. 3% Type of Detection Tip 46. 2% 22. 8% By Accident 20. 0% 18. 6% 19. 4% Internal Audit 16. 7% 23. 3% Internal Controls $1, 000+ 15. 8% External Audit All Cases 9. 1% 6. 0% 3. 2% Notified By Police 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. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 26

Specific Fraud Risk Areas Ø Revenue and accounts receivable fraud risks Ø Inventory fraud risks Ø Purchases and accounts payable fraud risks Ø Other areas of fraud risk © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 27

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 gathers additional information to determine whether fraud actually exists. © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 29

Types of Inquiry Techniques Ø Informational inquiry Ø Assessment inquiry Ø Interrogative inquiry Ø Evaluating responses Ø Listening techniques Ø Observing behavioral cues © 2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 30