Chapter 11

Considering the Risk of Fraud

Chapter 11 provides a focused discussion on the auditors responsibility for

material misstatements due to fraud, which is critically important to the auditing
profession. While auditors have always had a responsibility for the detection of fraud,
recent examples of fraudulent financial reporting have greatly increased interest in
the subject of fraud auditing. There is tremendous student interest in the subject, and
it is important for students to understand the technical requirements of SAS 99, as
well as the conditions for fraud and areas of specific fraud risk.

Chapter Opening Vignette Accounting Scandal Rocks Public Trust

Students will have a general awareness of several recent high-profile examples

of fraudulent financial reporting, but are generally unaware that there are many other
earlier examples. The vignette makes two central points. First, fraudulent financial
reporting is not just a recent occurrence. Second, major frauds are often followed by
significant changes in the profession. In addition to the requirements for confirmation
of receivables and observation of inventory following the fraud at McKesson-Robbins,
subsequent waves of fraud later gave rise to peer review and the expectation gap
auditing standards issued in the late 1980s. We find that this helps students understand
the underlying reasons for the Sarbanes-Oxley Act and formation of the PCAOB, and it
helps put the recent focus and criticism of the auditing profession into a larger context
of events.

Types of Fraud (page 356)

The two types of fraud considered in the context of auditing financial statements
were first introduced in Chapter 6, so we do not spend a significant amount of time on
this issue. To help illustrate the differences, we ask students to provide specific
examples of fraudulent financial reporting and misappropriation of assets for the revenue
and collection cycle, acquisition and payment cycle, and inventory and warehousing
cycle. We use T-11-1 to record their responses. Students will often be able to provide
many examples of misappropriation of assets that they have personally observed, and
it often leads to a lively discussion. As students identify numerous types of fraud
possibilities, we emphasize that certain immaterial frauds (e.g., petty theft of supplies)
fall below the scope of auditor responsibility. This helps illustrate the auditors
responsibility is in the context of material misstatements in the financial statements.
Review questions 11-1, 11-2, and 11-3 are also useful in distinguishing fraudulent
financial reporting from misappropriation of assets and requiring students to provide
examples of each. Problem 11-29 can be used for the same purpose. Problem 11-26
is good for distinguishing errors from fraud.

(See T-11-1)

11-1
Conditions for Fraud (page 357)

We emphasize the fraud triangle included in Figure 11-1 (page 358). We use
Table 11-1 (page 358) and Table 11-2 (page 360) to describe each of the conditions
for fraud for fraudulent financial reporting and misappropriation assets. We emphasize
many of the reasons why fraud occurs as shown in Figure 11-2 (page 359). We then
ask students to give more specific examples of incentives and opportunities. T-11-2
or Review Questions 11-5 and 11-6 can be used for this purpose. Problem 11-23 is
also good for classifying fraud risk factors.

(See Figures 11-1 and 11-2)

(See Tables 11-1 and 11-2)

(See T-11-2)

Assessing the Risk of Fraud (page 361)

We emphasize the importance of professional skepticism, and sources of

information to assess the risk of fraud in Figure 11-3 (page 363). We also mention
the importance of communication among the audit team and the documentary
requirements in SAS 99. The brainstorming among students about possible fraud
techniques when completing T-11-1 or fraud risk factors when completing T-11-2
provides a nice illustration of how the communication among audit team members
about an entitys susceptibility to fraud risk might be useful in the audit planning
process.

(See Figure 11-3)

Corporate Governance Oversight to Reduce Fraud Risks (page 365)

We use Figure 11-5 (page 368) to illustrate how organizational factors contribute
to the risk of fraud. We use Review Question 11-12 to distinguish managements
responsibility for designing and implementing antifraud programs and controls, and
the audit committees oversight responsibility.
We also emphasize that auditors of public companies must also evaluate the
effectiveness of the audit committee when reporting on internal controls over financial
reporting. PCAOB Standard 5 notes that ineffective oversight by the audit committee
may be a strong indicator of a material weakness in internal control over financial
reporting.

(See Figure 11-5)

11-2
Responding to the Risk of Fraud (page 369)

We emphasize the importance of the auditor responding to the risk of fraud. We

use T-11-3 to discuss the various forms the response can take, and the required
procedures to address management override of controls. We ask students to give
examples of responses involving the overall conduct of the audit, and responses for
specific examples of fraud risk. Review Question 11-13 can also be used for this
purpose, and Review Question 11-14 can be used to cover the procedures to address
management override of controls.

(See T-11-3)

Specific Fraud Risk Areas (page 371)

The amount of coverage of this topic depends upon the amount of time you wish
to spend on fraud auditing, and the extent to which you discuss fraud risk areas in
the cycle chapters that follow. We emphasize that because of materiality, auditors are
specifically concerned with fraudulent financial reporting.
Because we believe that analytical procedures are an effective warning sign of
fraud, we use Table 11-4 (page 373) and Table 11-5 (page 375) to illustrate the
effect of fictitious receivables and inventory on financial ratios.

(See Tables 11-4 and 11-5)

Even though we always cover the sales and collection cycle, we discuss fraud
risks related to revenue in Chapter 11 because SAS 99 requires that revenue
recognition normally be considered a high fraud risk. Review Question 11 -15 is a
good one to review the three main ways in which revenue can be manipulated.
We usually review at least one other fraud risk area. We like to review risk of
fraudulent financial reporting arising from inappropriately capitalized fixed assets
because it is easy for students to understand, and was a central element in WorldCom
and other recent fraud cases.
Problems 11-25, 11-27, 11-28, or 11-30 can be used to discuss fraud risks in
specific accounting cycles. The ACL Problem 11-33 gives students hands-on experience
in how audit software can be effective at identifying potential fraud conditions.

Responsibilities When Fraud is Suspected (page 376)

Figure 11-6 (page 377) is useful to indicate that most frauds are detected by tip,
accident, internal controls, or internal audit. We emphasize the importance of considering
the effect of fraud on the remainder of the audit.

(See Figure 11-6)

11-3
 We generally do not spend too much time on inquiry techniques. The types of
inquiries and verbal and non-verbal cues (Table 11-6, page 378, and Table 11-7,
page 379) can be used for role playing exercises that students generally enjoy.

(See Tables 11-6 and 11-7)

It is also important to emphasize that the discovery of fraud has implications for
public company auditors when auditing internal control over financial reporting.
PCAOB Standard 5 states that fraud of any magnitude by senior management is at
least a significant deficiency and may be a material weakness in internal control over
financial reporting. We emphasize that such a discovery may lead to an adverse
opinion on internal control over financial reporting.

11-4
 CHAPTER 11
CROSS-REFERENCE OF LEARNING OBJECTIVES AND PROBLEM MATERIAL

Multiple Discussion
Review Choice Questions ACL Problem
Learning Objectives Questions Questions and Problems and Cases
11-1 Define fraud and distinguish between fraudulent 11-1, 11-2, 11-3 11-24, 11-26,
financial reporting and misappropriation of assets. 11-29

11-2 Describe the fraud triangle and identify conditions 11-4, 11-5, 11-6 11-20 11-23, 11-24, 11-33, 11-34
for fraud. 11-25, 11-28,
11-30, 11-27
11-5

11-3 Understand the auditors responsibility for 11-7, 11-8, 11-9 11-20 11-24, 11-29 11-33, 11-34
assessing the risk of fraud and detecting material
misstatements due to fraud.

11-4 Identify corporate governance and other control 11-10, 11-11, 11-26, 11-28, 11-33
environment factors that reduce fraud risks. 11-12 11-30, 11-27

11-5 Develop responses to identified fraud risks. 11-13, 11-14 11-21 11-31

11-6 Recognize specific fraud risk areas and develop 11-15, 11-16 11-22 11-25, 11-26, 11-35
procedures to detect fraud. 11-28, 11-30,
11-27, 11-31,
11-32

11-7 Understand interview techniques and other 11-17, 11-18, 11-32

activities after fraud is suspected. 11-19
 EXAMPLES OF
FRAUDULENT FINANCIAL REPORTING
AND MISAPPROPRIATION OF ASSETS

FRAUDULENT
FINANCIAL MISAPPROPRIATION
REPORTING OF ASSETS

Sales
and
Collection
Cycle

Acquisition
and
Payment
Cycle

Inventory
and
Warehousing
Cycle

T-11-1
 EXAMPLES OF FRAUD RISK FACTORS
FOR FRAUDULENT FINANCIAL REPORTING
AND MISAPPROPRIATION OF ASSETS

FRAUDULENT
FINANCIAL MISAPPROPRIATION
REPORTING OF ASSETS

Incentives

Opportunities

T-11-2
 RESPONDING TO THE RISK OF FRAUD

1. Change the overall conduct of the audit

2. Design audit procedures to address identified

risks

3. Design procedures to address management

override of controls

Examine journal entries and adjustments

Review accounting estimates for biases

Evaluate business rationale for unusual

transactions

T-11-3