Ch 3: Fraud & Corporate Governance

Error vs. Fraud vs. Illegal Acts

• Error – Unintentional misstatement

• Fraud – Intentional misstatement

• Illegal Act – Violation of law

• Overall auditor concern/responsibility

  • What is the financial statement impact?

  • “Reasonable assurance” and “Material misstatement”

What is fraud?

• Intentional concealment or misrepresentation of material facts in order to deceive.

  • Differentiated from errors by the intent to deceive.

• Traditionally defined in two broad categories:

  • Misappropriation of assets

  • Fraudulent financial reporting.

• Note that Misappropriation of assets is part of a larger category called “Defalcations.” However, fraud is generally defined using the categories of “Misappropriation of assets” and “Fraudulent Financial Reporting”

What is a defalcation?

• Employee takes assets from the organization for personal gain

• Corruption

  • Using influence in a company transaction for personal gain (e.g. kickbacks, conflict of interest, bribery, economic extortion)

  • Broad spectrum

    • Using a personal credit card to pay for business expenses in order to earn points, even though company policy requires use of corporate card

    • Booking a more expensive flight for a business trip on an airline that you fly frequently

• Asset misappropriation

  • Theft or misuse of organization's assets

Fraudulent Financial Reporting

• Intentional manipulation of financial statements, typically committed by management.

• Fraudulent financial reporting usually involves (from textbook and CPA review book):

  • Manipulation, falsification, or alteration of accounting records

  • Misrepresentation or omission of events or transactions

  • Intentional misapplication of accounting principles

• The most common types are:

  • Overstate assets/understate liabilities/overstate equity.

  • Overstate revenues/understate expenses.

  • The ones that make you look better today

When Does Fraud Occur?

• The fraud triangle – three things necessary for fraud to occur.

  • Opportunity – chance to succeed at fraud (lack of internal controls)

  • Incentive – motivation to profit from fraud, pressure to commit fraud

  • Ability to Rationalize

    • Character that allows fraud

    • Capability – personal ego, confidence, intelligence to carry out the fraud

Incentives or Pressures to Commit Fraud – Textbook

•Management compensation schemes

•Financial pressures for improved earnings or an improved balance sheet

•Debt covenants

•Pending retirement or stock option expirations

•Personal wealth tied to either financial results or survival of company

•Greed

•Personal factors

•Pressure from family, friends, or culture

•Addictions to gambling or drugs

Opportunities to Commit Fraud – Textbook

• Significant related-party transactions

• Company’s industry position

• Management’s inconsistency involving subjective judgments

• Complex or difficult to understand transactions

• Ineffective monitoring of management by the board

• Complex or unstable organizational structure

• Weak or nonexistent internal controls

  • Segregation of duties

  • Setting up vendors

Rationalizing the Fraud – Textbook

• Rationalization involves justifying unlawful or unethical behavior with a greater good (even if the greater good is not true or appropriate)

• Rationalization for fraudulent financial reporting

  • “Saving” a company

• Rationalization for asset misappropriation

  • Mistreatment by the company

  • Sense of entitlement by the individual perpetrating the fraud

Auditor Responsibility for fraud

• PROFESSIONAL SKEPTICISM

  • Questioning mind (ongoing)

  • Critical assessment of evidence

  • Trust but verify

  • Demand persuasive evidence

  • Skepticism increases not only the likelihood that fraud will be detected, but also the perception that fraud will be detected, which reduces the risk that fraud will be attempted

• Prior to 1988: No specific guidance with respect to fraud detection

  • Expectation gap – more on this term in legal liability slides

• 1988 SAS 53: Risk of misstatement caused by irregularities

  • Only mentions fraud as part of irregularities

• SAS 53 (con)

  • Irregularities are hard to find, so the fact the auditor missed one is not evidence they did a bad job.

  • We will keep an eye out for fraud, but we might miss it.

• 1997 SAS 82 – describes fraud directly rather than as an irregularity

  • Specifically requires auditor to assess the risk of fraud, but still downplays auditors’ responsibility to detect fraud.

• AU-C 240 (formerly SAS 99, adopted in 2002) Goes even further by requiring specific risk assessment and planning including brainstorming for fraud.

  • Conduct fraud brainstorming sessions

  • Exercise professional skepticism

  • Identify fraud risk factors

  • Evaluate controls with emphasis on fraud prevention and detection

  • Respond to fraud risk assessment with procedures

  • Evaluate audit evidence

  • Communicate possible fraud to management and audit committee

  • Document consideration of fraud

• Presumption of fraud risk is required for...

  • Revenue Recognition

  • Management Override of controls

• Other Considerations

  • Size, complexity, ownership structure of entity

  • Susceptibility of items to manipulation

    • Judgment/subjectivity

    • Complex accounting principles

• Consider withdrawing from engagement if...

  • Underlying problem with management integrity

  • Impossibly high fraud risk

PCAOB and Fraud

• Focus is on financial statement impact, not error vs. fraud

  • The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud (AS 1001, para. 2; AS 2401, para. 1)

  • Detection of material fraud is a reasonable expectation of users

  • AS 2401 contains guidance on responding to fraud risk

• Key take-away from this historical background: Auditing standards evolved toward financial statement users’ expectations.

What if you find fraud?

• Specific guidance in AS 2401

• Report to appropriate management level, usually one above the fraud, and/or the audit committee (para 79)

• Generally not obligated to report to outside parties, but this is extremely complicated.

  • Need to ensure public co. reports it

  • May require disclosures if material in amount in financial statements.

  • Do you want to be associated with a client that does not report to outside parties?

Limitations/ Challenges

• Fraud has some characteristics that make its detection complex and difficult

  • Always intentional (covered up)

  • Often involves top management who have the ability to override existing controls

• It requires some different thinking than just looking for errors.

  • That is why brainstorming and specific fraud assessment are important