ch10 70 360

Chapter 10: Fraud Auditing
1
Copyright © 2007 Pearson Education Canada
Chapter 10 objectives
 What are two different types of fraud and when
are they most likely to exist?
 What is the auditor’s responsibility with respect
to fraud?
 How do good corporate governance and control
environment practices reduce fraud risks?
 What should an auditor do when there are
identified fraud risks?
10-2
What is fraud?
 Fraud is a broad legal concept
 In the context of auditing: an intentional
misrepresentation of a fact in the books of
accounts and in the financial statements
 Two types:
– Fraudulent financial reporting
– Misappropriation of assets
10-3
Fraudulent financial reporting (usually
perpetrated by management)
 This is the intentional misstatement or omission
of amounts or disclosure in financial statements
to deceive users
 Earnings management: The purpose of the
misstatement is to help management achieve
earnings targets (e.g. to obtain higher bonuses)
 Income smoothing: Revenues and expenses are
shifted across accounting periods to reduce
fluctuations in earnings
10-4
Misappropriation of assets
 Fraud that involves
theft of an entity’s
assets
 Usually perpetrated at
lower levels of the
organization’s
hierarchy, i.e. by non-
management
employees
10-5
Conditions for fraud
10-6
Risk factors for fraudulent financial
reporting
 Provide examples of the following risk
factors for fraudulent financial reporting
based upon the fraud triangle:
– Incentives
– Opportunities
– Attitudes/rationalizations
10-7
Risk factors for misappropriation of
assets
 Provide examples of the following risk
factors for misappropriation of assets based
upon the fraud triangle:
– Incentives
– Opportunities
– Attitudes/rationalizations
10-8
The auditor needs to maintain
‘‘professional skepticism ’’
 Professional skepticism is needed as the
auditor gathers information during the
audit
 Professional skepticism means ‘‘staying
alert for evidence that contradicts or brings
into question the reliability of documents
or management’’
 Two components: questioning mind and
critical evaluation of audit evidence
10-9
Sources of information gathered to
assess fraud risks
10-10
How corporate governance
oversight reduces fraud risks
 Creates and maintains a culture of honesty
and high ethics
 Evaluates fraud risks and implements
programs and controls to mitigate
identified fraud risks
 Develops an appropriate fraud oversight
process
10-11
Creating and maintaining a culture
of honesty and high ethics
 Setting the tone at the top (management
behaviours demonstrating honesty and integrity)
are an example to employees
 Creation of a positive workplace environment
(improved employee morale reduces the
likelihood of employee fraud)
 Hiring and promoting appropriate employees
(effective screening policies to reduce the
likelihood of hiring and promoting individuals
with low levels of honesty)
10-12
Creating and maintaining a culture
of honesty and high ethics (cont’d)
 Training (about company’s expectations of
employees’ ethical conduct)
 Confirmation (annually of responsibilities for
complying with the code of conduct; see Table
10-3 for example elements for a code of conduct)
 Discipline (employees held accountable for
failing to follow the company’s code of conduct)
 Other declarations (e.g. confidentiality policy,
independence policy, electronic communications
and computer software policies)
10-13
Management’s responsibility to
evaluate risks of fraud
 Identifying and measuring fraud risks:
– Realize that almost any employee is capable of
committing a dishonest act under the right
circumstances
– Assess fraud risks and establish corporate
governance programs and controls to prevent,
deter, and detect fraud
– Conduct a fraud risk assessment (perhaps with
assistance of internal audit department)
10-14
evaluate risks of fraud (cont’d)
 Mitigating fraud risks:
– Design and implement programs and controls
to mitigate fraud risks
– Change business activities and processes
prone to fraud in order to reduce incentives
and opportunities
10-15
evaluate risks of fraud (cont’d)
 Monitoring fraud prevention programs and
controls:
– For high fraud risk areas, periodically evaluate
whether antifraud programs and controls have
been implemented and are operating
effectively
– Internal audit activities can both detect and
deter fraud
10-16
Audit committee oversight
 Audit committee has primary
responsibility to overseen the
organization’s financial reporting and
internal control procedures
 Needs to consider the potential for
management override
 Audit committee may need to investigate
financial reporting issues
10-17
Auditor’s responses to the risk of
fraud
 1. Change the overall conduct of the audit
to respond to identified fraud risks
– Assign more experienced personnel to the
audit (or a forensic specialist)
– Carefully consider management’s choices of
accounting principles
– Incorporate unpredictability into the audit plan
– Gather information from an increased number
of sources
10-18
fraud (cont’d)
 2. Design and perform audit procedures to
address fraud risks:
– Depend upon the type of fraud risk factors or
conditions identified, the account balance,
class of transactions, or assertions affected
– Procedures tend to be corroborative
– May involve examining all of the transactions
in a class rather than just a sample
10-19
fraud (cont’d)
 3. Design and perform procedures to address
management override of controls
– This risk exists in almost all audits and GAAS
requires three specific procedures:
– (1) Examine journal entries and adjustments for
evidence of possible misstatements due to fraud
– (2) Review accounting estimates for biases
– (3) Evaluate the business rationale for significant
unusual transactions
10-20
Practice problem 10-29
(pp. 312-13)
 Assessment of fraud
risk factors and
compliance with
GAAS during the
conduct of an audit
10-21
Ongoing risk assessment requires
auditor alertness
 During fieldwork, the auditor should be
alert for:
– Discrepancies in the accounting records
– Conflicting or missing evidence
– Problematic or unusual relationship between
the auditor and management
– Other issues, e.g. accounting policies
inconsistent with industry norms
10-22
Revenue and accounts receivable
fraud risks
 Fraudulent financial reporting: revenue can be
overstated by:
– Fictitious revenues
– Premature revenue recognition
– Manipulation of adjustments to revenues
 Potential detection methods:
– Analytical revenue (overstatement of gross margin,
lower accounts receivable turnover)
– Documentation discrepancies
10-23
Revenue and accounts receivable
fraud risks (cont’d)
 Misappropriation of assets could occur by
means of taking revenue receipts by:
– Failing to record a sale
– Stealing cash after the sale is recorded
– Careful review of sales returns or allowances,
of customer write-offs, and matching of
payments to sales amounts (to detect lapping)
10-24
Practice question 10-25 (p. 311)
 Examine a situation
with respect to theft
of cash
 How could the theft
have been prevented?
10-25
Inventory fraud risks:
 Fraudulent financial reporting: inventory
can be overstated by:
– Including fictitious inventory
– Deliberate pricing errors (increasing
inventory)
– Analytical review (understatement of cost of
goods sold and overstatement of gross margin)
10-26
Purchases and accounts payable
fraud risks
 Fraudulent financial reporting: accounts payable
can be understated by:
– Not recording accounts payable until the subsequent
period
– Recording fictitious reductions to accounts payable
– Review of subsequent transactions
– Tracing transactions to supporting documentation
10-27
Purchases and accounts payable
fraud risks (cont’d)
 Misappropriation of assets could occur by means
of:
– Payments to fictitious vendors for goods not received
– Kickbacks or other illegal arrangements with suppliers
– Review supporting receiving documentation
– Examine supplier approval process
10-28
Practice problem 10-26 (p. 311)
 Duplicate payments
for an accounts
payable account
 How could this theft
have been detected or
prevented?
10-29
Auditor responsibilities when fraud
is suspected or detected
 Conduct audit procedures to confirm or
dispel
 Inform the appropriate level of
management (above the suspected level of
fraud); inform audit committee when
management fraud is suspected
10-30

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Chapter 10: Fraud Auditing

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