Chapter 10 Assessing and Responding to Fraud Risks

Types of Fraud (1 of 2)

• Fraud is defined as an intentional misstatement of financial statements. The two main categories are:

  • Fraudulent financial reporting: Intentionally wrong finacial statments

    • Happens at the highest level

    • “Usually” larger

    • Misstate financials

      • Under armor > $400 M</p></li></ul></li></ul></li><li><p>Misappropriation of assets (theft)</p><ul><li><p>Theft of assets</p></li><li><p>happens at lower levels</p></li><li><p>Steal inventory</p><ul><li><p>$

Conditions for Fraud

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

  • *Incentives/Pressure

    • Reaseon

      • Hit a bonus

  • *Opportunity

    • Execute

      • Post the journal entry

  • Attitude/rationalization

    • Justify

      • Why fraud was ok

Figure 10.1
The Fraud Triangle
Figure 10.2
Most Commonly Cited Fraud Risk Conditions
Source: Global Profiles of the Fraudster, KPMG, 2016.
Let’s Discuss (1 of 7)

• What are the three conditions of fraud often referred to as “the fraud triangle”?

• Define misappropriation of assets and give two examples of misappropriation of assets.

• Give examples of risk factors for fraudulent financial reporting for each of the three fraud conditions: incentives/pressures, opportunities, and attitudes/rationalization.

Assessing the Risk of Fraud

• 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 skeptisim, which consists of:

  • Questioning mind

  • Critical evaluation of audit evidence

Sources of Information to Assess Fraud Risk

• 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

Identified Risks of Material Misstatement Due to Fraud

• Auditors evaluate all the sources of information gathered to assess the risk of material misstatment 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

Let’s Discuss (2 of 7)

• The two components of professional skepticism are a questioning mind and a critical assessment of the audit evidence.

  • How do these components help an auditor distinguish an unintentional misstatement from an intentional (fraudulent) misstatement?

Corporate Governance Oversight to Reduce Fraud Risk (1 of 2)

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

  • 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

Let’s Discuss (3 of 7)

• What sources are used by the auditor to gather information to assess fraud risk?

• Distinguish management’s responsibility from the audit committee’s responsibility for designing and implementing antifraud programs and controls within a company.

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

• Post JE

Responding to the Risk of Fraud (1 of 3)

• 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

Let’s Discuss (4 of 7)

• Describe the types of overall responses by auditors to address fraud risk.

Specific Fraud Risk Areas (1 of 4)

• Revenue and accounts receivable fraud risks (1 of 2)

  • 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 include:

  • Failure to record a sale

  • Theft of cash after recorded

• 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 fraud risks

  • Inventory is susceptible to:

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

    • Misappropriation (theft) because it is usually readily saleable

• 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

• Other areas of fraud risk:

  • Fixed assets

  • Intangible assets

  • Payroll expenses

Let’s Discuss (5 of 7)

• You go through the drive-through window of a fast food restaurant and notice a sign that reads, “Your meal is free if we fail to give you a receipt.”

  • Why would the restaurant post this sign?

Figure 10.8
Fraud Detection Methods
Source: Report to the Nations on Occupational Fraud and Abuse, Association of Certified Fraud Examiners, 2018, 2016, 2014.
Responsibilities When Fraud Is Suspected (1 of 3)

• 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

Let’s Discuss (6 of 7)

• You have identified a suspected fraud involving the company’s controller.

  • What must you do in response to this discovery?

  • How might this discovery affect your report on internal control when auditing a public company?

Documenting the Fraud Assessment (1 of 3)

• 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

Let’s Discuss (7 of 7)

• What are the three ways auditors respond to fraud risks?

• Describe the three main techniques used to manipulate revenue.

• Describe the types of information that should be included in the auditor’s working papers as evidence of the auditor’s fraud assessment procedures.