5-1

Chapter 5
Audit Evidence and the
Auditors Responsibility for
Fraud Detection
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Audit Evidence and its Role in the
Audit Process
Auditing Standards require the auditor to obtain
sufficient appropriate evidence to reach a
conclusion about whether the financial
statements have been prepared in accordance
with the applicable financial reporting framework
Process relies on professional judgment of auditor
Evidence provides the basis for the audit opinion
issued
Auditor must be familiar with documentation
requirements of the auditing standards
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Evaluating the Sufficiency and
Appropriateness of Evidence
Sufficiency of audit evidence is a measure of the
quantity of evidence needed

Appropriateness is a measure of the quality of
audit evidence needed. Quality is measured by:
Relevance related to the connection between the
audit procedures purpose and the evidence; it is often
related to the assertion being tested
Reliability - related to its source and nature and the
circumstances under which it is obtained
5-4
What are the components of good
judgment?
Logical
Flexible
Unbiased
Consistent and reliable
Appropriately balances experience with knowledge,
intuition, and emotion
Uses the right amount of relevant information, including
professional literature and evidence
4
5-5
Environmental factors affecting
judgment
External Factors:
Time pressure
Limited resources
Client, regulatory,
industry


5
Internal Factors:
Judgment traps
Rush to solve
Judgment triggers
Judgment shortcuts
Bias caused by self -
interest
2010 KPMG International Cooperative (KPMG International), a Swiss entity. Member firms of the KPMG network of
independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm
has any authority to obligate or bind KPMG International or any other member firm third parties, nor does KPMG
International have any such authority to obligate or bind any member firm. All rights reserved.
The KPMG Professional Judgment Framework
6
5-7
Documentation Requirements for Audit
Evidence
Working papers or work papers include a
record of the audit procedures performed,
audit evidence obtained and conclusions
reached by the auditor.
Audit documentation, which is the auditors
property, should be retained for at least
seven years from the report release date
(five years for private companies). It is
confidential information, but may be subject
to subpoena.
5-8

FRAUD:
These Are Interesting Times
More than half of US organizations have
experienced fraud in last 2 years.

54% of fraud over $100,000; 8% over $5Mill

Financial statement up to 23% (2014) from 16%
(2011), bribery/corruption (14% vs. 7%), and
cybercrime moving to forefront.

54% of fraud committed by middle management.
Profile: male, 31 to 40yrs old, employed 3-5 yrs,
and a college graduate.

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Auditors Responsibility- Fraud
Dectection
Auditors are responsible for obtaining reasonable
assurance that the financial statements as a
whole are free from material misstatement,
whether caused by fraud or error
Primary responsibility for fraud prevention rests with
company management
Auditors responsibility is to plan the audit to gather
sufficient appropriate evidence to determine whether the
financial statements are free of material misstatement from
fraud or error
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The Audit Teams Fraud
Discussion
Auditing Standards require the audit team to discuss the susceptibility of
the financial statements to fraud. It should be documented and
include:
A discussion of managements involvement in supervising
employees with access to cash or other assets susceptible to
misappropriation
A consideration of unusual or unexplained changes in the behavior
or lifestyle of employees that have come to the auditors attention
A consideration of the types of circumstances that indicate the
possibility of fraud
A discussion of how an element of unpredictability can be built
into the nature, timing, and extent of audit procedures
A consideration of the types of audit procedures that could be
effective in responding to the susceptibility of the companys
financial statements to material misstatement and whether some
of the audit procedures can be more effective than others
A discussion of any allegations of fraud that have come to the
auditors attention
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Rationalization Opportunity
Pressure
Why does Fraud Happen-Fraud
Triangle
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The Fraud Triangle
Three conditions are present when fraud occurs and
form what is called The Fraud Triangle:
Pressure: when company management feels pressure
from inside or outside the company to meet earnings
targets or a certain level of growth
Opportunity: when an individual believes that internal
controls are weak or not designed to prevent fraud
and can be overridden
Rationalization: when an individual believes that their
actions to commit fraud can be justified
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Fraud Detection
Misstatements in the financial statements can
be caused by errors or fraud
Errors unintentional acts of the company
Fraud intentional acts of the company and may
be from. 2 Types:
1. Fraudulent financial reporting occurs when
a company prepares financial statements
that are materially misstated
2. Assets that are misappropriated occurs
when employees in a company steal its
assets

5-14
Financial Statement Frauds
Revenue/Accounts Receivable Frauds
(Global Crossing, Quest, ZZZZ Best)
Inventory/Cost of Goods Sold Frauds
(PharMor, Crazy Eddies)
Understating Liability/Expense Frauds
(Enron)
Overstating Asset Frauds (WorldCom)
Overall Misrepresentation (Bre-X Minerals)
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Financial Statement Fraud
Financial statement fraud causes a decrease in
market value of stock of approximately 500 to
1,000 times the amount of the fraud.
$7 million fraud
$2 billion drop in
stock value
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Fraud Cost.Two Examples
General Motors
$436 Million Fraud
Profit Margin = 10%
$4.36 Billion in
Revenues Needed
At $20,000 per Car,
218,000 Cars

Bank
$100 Million Fraud
Profit Margin = 10 %
$1 Billion in Revenues
Needed
At $100 per year per
Checking Account,
10 Million New
Accounts
Detecting Financial Statement
Fraud
Detecting Financial
Statement Fraud
1. Management & Board
2. Relationships
With Others
3. Organization & Industry
4. Financial Results &
Operating Characteristics
Transaction Accounts Involved Fraud Schemes
1. Estimate all
uncollectible
accounts receivable
Bad debt expense,
allowance for
doubtful accounts
1. Understate allowance for doubtful
accounts, thus overstating receivables
2. Sell goods and/or
services to
customers
Accounts receivable,
revenues (e.g. sales
revenue) (Note: cost
of goods sold part of
entryh is included in
Chapter 5)
2. Record fictitious sales (related parties,
sham sales, sales with conditions,
consignment sales, etc.)
3. Recognize revenues too early (improper
cutoff, percentage of completion, etc.)
4. Overstate real sales (alter contracts,
inflate amounts, etc.)
3. Accept returned
goods from
customers
Sales returns,
accounts receivable
5. Not record returned goods from
customers
6. Record returned goods after the end of
the period
4. Write off
receivables as
uncollectible
Allowance for
doubtful accounts,
accounts receivable
7. Not write off uncollectible receivables
8. Write off uncollectible receivables in a
later period
5. Collect cash after
discount period
Cash, accounts
receivable
9. Record bank transfers as cash received
from customers
10. Manipulate cash received from related
parties
6. Collect cash within
discount period
Cash, sales
discounts, accounts
receivable
11. Not recognize discounts given to
customers
Revenue-Related Transactions and Frauds
Transaction Accounts Involved Fraud Schemes
1. Purchase inventory Inventory, accounts
payable
1. Under-record purchase
2. Record purchases too late
3. Not record purchases
2. Return merchandise to
supplier
Accounts payable,
inventory
4. Overstate returns
5. Record returns in an earlier period (cutof f
problem)
3. Pay vendor within
discount period
Accounts payable,
inventory, cash
6. Overstate discounts
7. Not reduce inventory cost
4. Pay vendor without
discount
Accounts payable, cash Considered in another chapter
5. Inventory is sold; cost
of goods sold is
recognized
Cost of goods sold,
inventory
8. Record at too low an amount
9. Not record cost of goods sold nor reduce
inventory
6. Inventory becomes
obsolete
Loss on write-down of
inventory, inventory
10. Not write of f or write down obsolete inventory
7. Inventory quantities
are estimated
Inventory shrinkage,
inventory
11. Over-estimate inventory (use incorrect ratios,
etc.)
8. Inventory quantities
are counted
Inventory shrinkage,
inventory
12. Over-count inventory (double counting, etc.)
9. Inventory cost is
determined
Inventory, cost of goods
sold
13. Incorrect costs are used
14. Incorrect extensions are made
15. Record f ictitious inventory
Inventory/Cost of Goods Sold Frauds
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Professional Skepticism
The auditor is expected to conduct the audit
with an attitude of professional skepticism
when considering a companys risk of fraud.
It is an attitude or a state of mind
It involves having a questioning mind and making
a critical assessment of the evidence, especially
the reliability of the evidence gathered and the
controls over the companys preparation of the
statements
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Auditor Tools- Skepticism!
Six Characteristics of Skepticism
Questioning MindA disposition to inquiry, with some sense of
doubt
Suspension of JudgmentWithholding judgment until appropriate
evidence is obtained
Search for KnowledgeA desire to investigate beyond the
obvious, with a desire to corroborate
Interpersonal UnderstandingRecognition that peoples
motivations and perceptions can lead them to provide biased or
misleading information
AutonomyThe self-direction, moral independence and conviction
to decide for oneself, rather than accepting the claims of others
Self-EsteemThe self confidence to resist persuasion and to
challenge assumptions or conclusions
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Auditor Tools- Data Analysis
Build a profile of potential frauds, obtain data, verify data,
cleanse and analyze data

Regression Analysis to find relationships in large data pools

Calculate ratio of maximum to minimums- can be used to verify
accuracy of unit product prices or areas where large variations
not expected

Analyze transactions during non-business hours and weekends

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Fraud Controls
Because of the inherent limitations on the effectiveness of
controls and the possibility for the override of controls, the risk
of fraud can be mitigated but not completely eliminated

Process controls such as reconciliations and physical count
Technology tools to identify anomalies in accounting
entries or activity
Regular management or internal audit reviews of areas
of activity (such as accounting estimates) susceptible
to manipulation

Some controls, such as a whistleblower program, both deter
fraud by their presence and help detect incidents of fraud.
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Evidence to Assess the Risk of
Material Misstatement because of
Fraud
The auditors assessment of fraud determines
the nature, extent, and timing of audit
procedures. If the risk of fraud is high, the
auditor can:
Change the nature of audit testing and obtain
more reliable evidence
Change the timing of audit tests and perform
substantive tests at year-end
Change the extent of audit tests and gather more
audit evidence
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Reporting of Fraud to Management and
the Audit Committee
An auditor who believes that misstatements in the
financial statements can be the result of fraud must
consider its impact on other aspects of the audit and
they may consider withdrawing from the engagement.

The auditor needs to bring the fraud to the attention of the
appropriate level of management, usually, one level
above where the fraud occurred, as soon as possible.
Fraud involving management and that materially
misstates the financial statements should be reported
to the audit committee.
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Reporting of Fraud to Management and
the Audit Committee
PCAOB auditing standards require the external auditor to communicate
various matters to the audit committee, including, but not limited to, the
following:
Significant accounting policies, management judgments, and
accounting estimates
The auditors judgments about the quality, not just the acceptability, of
the companys accounting principles
Significant difficulties, if any, encountered during the audit
Uncorrected misstatements that were determined by management to
be immaterial, individually and in the aggregate
Audit adjustments arising from the audit, either individually or in the
aggregate, that in the auditors judgment could have a significant effect
on the entitys financial reporting process
Significant internal control deficiencies or material weaknesses and
disagreements with management
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Documentation Regarding the
Consideration of Fraud
The auditor is required to document in the work papers
their understanding of:
Significant decisions made during the audit teams
discussion regarding the susceptibility of the
companys financial statements to material
misstatement because of fraud
How and when the fraud discussion occurred and the
audit team members who participated
The identified and assessed risks of material
misstatements due to fraud at both the financial
statement level and the relevant assertion level as well
as the procedures performed to obtain the information
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Documentation Regarding the
Consideration of Fraud
The auditor is required to document in the work papers their
response to:
The assessed risk of material misstatement due to fraud at the
financial statement level; the nature, timing, and extent of audit
procedures at the assertion level; and a linkage between the
audit procedures and the assessed risk of material
misstatement
The results of the audit procedures including those designed to
address the risk of management override of internal controls
Other conditions and analytical procedures that cause the
auditor to believe that additional auditing procedures were
appropriate to address the risk of material misstatement
because of fraud

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Documentation Regarding the
Consideration of Fraud
NEW DEVELOPMENTS:

AntiFraudCollaboration.org: provides resources to help audit
committees, executives, internal and external auditors defer
and detect financial reporting fraud.

Dodd-Frank Act- new whistleblower program allows SEC to pay
financial awards up $1M to whistleblowers who provide
information that leads to successful SEC enforcement action