1. Fraud Auditing Chapter 11

2. Learning Objective 1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets. 3. Types of Fraud Fraudulent financial reporting Misappropriation of assets 4. Learning Objective 2 Describe the fraud triangle and identify conditions for fraud. 5. The Fraud Triangle Incentives/Pressures Opportunities Attitudes/Rationalization 6. Examples of Risks Factors for Fraudulent Reporting Financial stability or profitability is threatened by economic, industry, or entity operating conditions. 1. Incentives/Pressures Excessive pressure exists for management to meet debt requirements. Personal net worth is materially threatened. 7. Examples of Risks Factors for Fraudulent Reporting 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. 2. Opportunities 8. Examples of Risks Factors for Fraudulent Reporting 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. 3. Attitudes/Rationalization 9. Examples of Risks Factors for Misappropriation of Assets Personal financial obligations create pressure to misappropriate assets. Adverse relationships between management and employees motivate employees to misappropriate assets. 1. Incentives/Pressures 10. Examples of Risks Factors for Misappropriation of Assets There is a presence of large amounts of cash on hand or inventory items. There is an inadequate internal control over assets. 2. Opportunities 11. Examples of Risks Factors for Misappropriation of Assets Disregard for the need to monitor or reduce risk of misappropriating assets exists. There is a disregard for internal controls. 3. Attitudes/Rationalization 12. Learning Objective 3 Understand the auditorsresponsibility for assessing the risk of fraud and detecting material misstatements due to fraud. 13. 14. Professional Skepticism SAS 1 states that, in exercising professional skepticism, an auditor neither assumes that management is dishonest nor assumes unquestioned honesty. 15. 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 16. Documenting Fraud Assessment Discussion Specific risks Procedures Reasons Results Other conditions Nature of communications 17. Learning Objective 4 Identify corporate governance and other control environment factors that reduce fraud risks. 18. Corporate Governance Oversight to Reduce Fraud Risks 1. Create and maintain a culture of honesty and high ethics. 2. Evaluate fraud risks and implement programs and controls to mitigate identified fraud risks. 3. Develop an appropriate fraud oversight process. 19. Example Elements for a Code of Conduct Organizational code of conduct General employee conduct Conflicts of interest Outside activities, employment, and directorships 20. 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 21. Example Elements for a Code of Conduct Organization records and communications Dealing with outside people and organizations Prompt communications Privacy and confidentiality 22. Organizational Factors Contributing to Risk of Fraud 2003 1998 1994 Collusion between employees and third parties Inadequate internal controls Management override of internal controls 48 31 33 39 58 59 31 36 36 23. Organizational Factors Contributing to Risk of Fraud Collusion between employees and management Lack of control over management be directors Ineffective or nonexistent ethics or compliance program 15 19 23 12 11 6 10 8 7 2003 1998 1994 24. Learning Objective 5 Develop responses to identified fraud risks. 25. 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. 26. Learning Objective 6 Recognize specific fraud risk areas and develop procedures to detect fraud. 27. Rates of Fraud Occurrence 2003 1998 Theft of assets Check fraud 49 22 40 26 Expense account abuse 36 13 Credit card fraud 20 13 Payroll fraud 12 3 28. Rates of Fraud Occurrence 2003 1998 Conflict of interest Inventory theft 12 9 11 11 Kickbacks 9 6 Financial reporting fraud 7 3 29. Specific Fraud Risk Areas Inventory fraud risks Revenue and accounts receivable fraud risks Purchases and accounts payable fraud risks Other areas of fraud risk 30. Learning Objective 7 Understand interview techniques and other activities after fraud is suspected. 31. Methods of Uncovering Fraud 2003 1998 1994 Internal controls Internal audit Notification by employee 77% 51% 52% 65% 43% 47% 63% 58% 51% 32. Methods of Uncovering Fraud 2003 1998 1994 Accident Anonymous tip Notification by customer 54% 37% 28% 41% 35% 26% 34% 41% 34% 33. Methods of Uncovering Fraud 2003 1998 1994 Notification by regulatory or law enforcement agency Notification by vendor External audit 19% 16% 8% 16% 11% 15% 12% 4% 5% 34. 35. Types of Inquiry Techniques Informational inquiry Interrogative inquiry Listening techniques Observing behavioral cues 36. End of Chapter 11