Chapter 10 Assessing and Responding to Fraud Risks

Fraud is defined as

an intentional misstatement of financial statements.

The two main categories of fraud are:

• Fraudulent financial reporting:

• Misappropriation of assets (theft)

Fraudulent financial reporting:

• Intentionally wrong finacial statments

  • Happens at the highest level

  • “Usually” larger

  • Misstate financials

    • Under armor > $400 M

Misappropriation of assets (theft)

• Theft of assets

• happens at lower levels

• Steal inventory

  • $

Three conditions for fraud arising from fraudulent financial reporting and misappropriations of assets are referred to as the fraud triangle: (All 3 must be present)

• *Incentives/Pressure

• *Opportunity

• Attitude/rationalization

*Incentives/Pressure

• Reaseon

  • Hit a bonus

*Opportunity

• Execute

  • Post the journal entry

Attitude/rationalization

• Justify

  • Why fraud was ok

Most Commonly Cited Fraud Risk Conditions

Auditing standards require the auditor to

assess the risk of material misstatement due to fraud

As auditors consider a broad set of information, including fraud risk factors, they must maintain a level of professional skepticism, which consists of:

• Questioning mind

• Critical evaluation of audit evidence

There are five sources of information that help auditors to assess fraud risks:

• Communications among audit team

• Inquiries of management

• Risk factors

• Analytical procedures

• Other information

Auditors evaluate all the sources of information gathered to assess the risk of material misstatement due to fraud as part of

audit planning

While the assessment of fraud is conducted as part of audit planning, the auditor’s assessment of fraud risk should be

on going throughout the audit

Management is responsible for implementing Corprate governance and control procedures to:

• Minimize the risk of fraud,

• Guidance developed for auditors by the AICPA identifies three elements to prevent, deter, and detect fraud:

• Minimize the risk of fraud, which can be reduced through a combination of

  • 
    

• Prevent (Controls)

• Detect (Controls)

• Deter: Include things like prosecution, job loss, etc

• 
  

Guidance developed for auditors by the AICPA identifies three elements to prevent, deter, and detect fraud:

• Culture (Ethics/Interity)

• How does management evaluate the fraud risk

• Audit committee oversight

  • Whistleblower hotline → SOX mandate

  • Report to someone outside management

Adj Entry- Unique Expense

• AI → Can only be approved vendors (Vendor List (Control)(No pmts to fake Vendors))

• Exception report: Can buy Chat GPT

  • Acceptable Override

When the auditor identifies risks of material misstatement due to fraud, auditing standards require the auditor to develop responses to those risks at three levels:

• Overall responses (Errors also have these)

• Responses at the Assertion (Errors also have these)

• Responses related to management override (Unique to Fraud)

The auditor’s assessment of the risks of material misstatement due to fraud should be

Ongoing throughout the audit and coordinated with the auditor’s other risk assessment procedures

• Auditors should be alert for the following conditions when doing the audit (1 of 2):

  • 
    

• Discrepancies in the accounting records

  • Ex: Late JE, Rounded numbers

• Confilicting/missing evidence

  • Ex: Pre-numbered checks and some are missing

• Problematic or unusual relationships between the auditor and management

• Results from substantive or final review stage Analytical Procedures that indicate a previously unrecognized fraud risk

• Responses to Inquries made throughout the audit that are vague or implausible or that produce evidence that is inconsistent with other information

  • Interview at lower levels

    • Do not only talk with management

Specific Fraud Risk Areas

• Revenue and accounts receivable fraud risks+

• Misappropriation (theft) of receipts involving revenue

• Inventory fraud risks

  • Other areas of fraud risk:

    • Fixed assets

    • Intangible assets

    • Payroll expenses

• 
  

Three main types of revenue manipulations are:

• Fictitious (Fake) revenue/Sales

• Premature revenue recognition (wrong period)

• Manipulation of adjustments (bad debt expense, Returns/allowances)

Many potential warning signals or symptoms indicate revenue fraud

• Useful procedures include

• analytical procedures, data analytics, and testing for documentary discrepancies

Revenue: Overstatement

1. Fake

2. Pull ahead

3. Contra Revenue Accounts

   • Mike: Sale UTA →$100 m

     • Inflated sale→ $300 m

       • Account bal $300 M

       • Returns Allow $200 M

Misappropriation (theft) of receipts involving revenue includes:

• Failure to record a sale

• Theft of cash after recorded

Revenue and accounts receivable fraud risks Warning signs

• Internal controls, analytical procedures and other comparisons may be useful

• Sales closing process (Drawer close)

• Electronic payment

• Checks go to bank processing center

Inventory is susceptible to:

• Manipulation by managers who want to achieve certain financial reporting objectives

• Misappropriation (theft) because it is usually readily saleable

Inventory fraud risks Warning signs

• Analytical procedures are one useful technique for

• detecting inventory fraud

Purchases and accounts payable fraud risks

• The most common fraud in the acquisitions area:

  • Payments to Fake Vendors and deposit the cash in a Fiticious or Wrong account

Fraud Detection Methods

Frauds are often detected through:

• The receipt of an anonymous tip

• Management review

• Internal audit

• Accident

When fraud is suspected, the auditor often begins by

• Making additional inquiries to determine whether fraud actually exists

• Auditors can use one or more of the following inquiry categories depending on their objectives:

  • Informational inquiry

  • Assessment inquiry

  • Interrogative inquiry

Auditing standards require the auditor to obtain additional evidence to determine whether

material fraud has occurred

In addition to inquiry, auditors often:

• Apply data analytics

• Expand other substantive testing

  • Gather more evidence

Auditors are required to document the following matters related to their consideration of material misstatements due to fraud (1 of 3):

• Significant Decisions made during the discussion among engagement team in planning the audit

• Procedures performed to obtain information necessary to identify and assess the risks of material fraud

• Specific risks of material fraud that were identified at both the overall financial statement level and the assertion level and the auditor’s reponse to those risks

• Reasons supporting a Conclusion that there is not a significant risk of material improper revenue recognition

• Results of procedures performed to address the risk of management override of controls

• Other conditions and analytical relationships indicating that additional auditing procedures or other responses were required, and the Actions taken by the auditor in response

• The nature of communications about fraud made to management, the audit committee, or others