Chapter 11 Notes

©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens/Elder/Beasley Arens/Elder/Beasley 11 - 1

Fraud AuditingFraud Auditing

Chapter 11Chapter 11

©2010 Prentice Hall Business Publishing, ©2010 Prentice Hall Business Publishing, Auditing 13/e,Auditing 13/e, Arens//Elder/Beasley Arens//Elder/Beasley 11 - 11 - 22

Learning Objective 1Learning Objective 1

Define fraud and distinguishDefine fraud and distinguish

between fraudulent financialbetween fraudulent financial

reporting and misappropriationreporting and misappropriation

of assets.of assets.


Types of FraudTypes of Fraud What is a fraud????Fraudulent financial reporting

Examples? Think casesMost common form?Aggressive accounting vs. fraud?

Misappropriation of assetsExamples?Material?More common Misstatement of F/S? Depends?



Describe the fraud triangle andDescribe the fraud triangle and

identify conditions for fraud.identify conditions for fraud.


The Fraud TriangleThe Fraud Triangle

Incentives/Pressures

Opportunities Attitudes/Rationalization


Examples of Risks FactorsExamples of Risks Factorsfor Fraudulent Reportingfor Fraudulent Reporting

1. Incentives/Pressures

Financial stability or profitability is threatened byeconomic, industry, or entity operating conditions. Business Risk – Dell, necessary, but not sufficient ?: remember airlines, perhaps industry effect (keeping up with the Jones)? Revenue growth NOT significantly different b/w F and NF (why you need to anchor with NFMs).

Excessive pressure exists for managementto meet debt requirements / EPS estimates / budgets – Anonymous Caller, Waste MgtMost fraud firms are just beating a benchmark. Publicly traded = higher incentive.

Personal net worth of mgt is materially threatened (equity-based comp, bonuses).Stock price obsession – Worldcom – you are in the field to OBSERVE

Auditors separate market incentives (public) and debt incentives (private and public)



2. Opportunities

There are significant accounting estimatesthat are difficult to verify – Waste Mgt. HOWEVER – Accruals not seen as an opportunity in practice. Investors don’t appear to react to high accruals either (don’t understand).

There is ineffective oversight overfinancial reporting – less collusion needed: Enron.Strength of corp governance (measure?)

Ineffective internal audit (Worldcom had 3, how do they report?), internal controls (mainly top level control environment factors (effective whistleblower, ST vs. LT focus, commitment to competence – just from a timing perspective – FR prior to most control testing)



3. Attitudes/Rationalization

Inappropriate or inefficient communicationand support of the entity’s values is evident.SOX – code of ethics – Tone from the top (Worldcom CFO ripping up F/S).

Linguistic analysis of MD&A.OBSERVE – Behavior or Tyco mgt

A history of violations of laws is known – SEC disagreements.

Management has a practice of making overlyaggressive or unrealistic forecasts (why stock prices LEAD earnings).

Negotiations of audit adjustments and material weaknessesW & K’s Broken Window Theory – small pressure to meet EPS forecastcan make lower (good) people do the wrong thing. Implementations of ERP – audit↓ info↑



Understand the auditor’sUnderstand the auditor’s

responsibility for assessingresponsibility for assessing

the risk of fraud and detectingthe risk of fraud and detecting

material misstatements due tomaterial misstatements due to

fraud.fraud.


Assessing the Risk of FraudAssessing the Risk of Fraud

SAS 99 provides guidance to auditorsin assessing the risk of fraud.

SAS 1 states that, in exercising professionalskepticism, an auditor “neither assumes thatmanagement is dishonest nor assumesunquestioned honesty.”

Auditors ARE RESPONSIBLE for detecting and reporting material misstatements due to error or FRAUD


Sources of Information GatheredSources of Information Gatheredto Assess Fraud Riskto Assess Fraud Risk

Communicationamong audit team

Inquiries ofmanagement

Riskfactors

Analyticalprocedures

Otherinformation

Identified risks of material misstatements due to fraud



What does the latest research tell us?????What does the latest research tell us?????


ResearchResearch1. Auditors are typically good at FR assessment (∆), butex-ante FR assessments for fraud audits medium2. Auditors could use NFMs to better assess FR 3. Auditors typically bad at responding to FR – nature of testing, usually do OK with staffing, timing, and extent

4. Auditors discount forensic procedure evidence unless FR is high – problem? Yes – given (1) above!

5. Brainstorming (???) is “good”, Group Support Systems may improve bstorming (eliminate pitfalls), and bstorming improves “nature” reaction – let’s bstorm about potential “nature” reactions.


A/P - More reliable expectations, more detailed levelConfirmations - Add sales agreement info or have oral discussions with customersCAATs – search for unusual entries, names, related partiesInquiry - Talk to nonfinancial personnelMore physical observation / external evidence vs. tracing to IT/system dataFV – specialist estimate and compare vs. auditing mgt’s estimate

Changing Nature


Tell me about the avg bstormTell me about the avg bstormsession (179 audits)session (179 audits)

Partner/CFE led (60%), not all members (27%), fraud specialist (31%-only led 4/56), IT/Tax (69/63%), hierarchical participation, use of checklist (72%), held late (35%), no wrap-up in PY (84%), average total time (1.5 hours), more than one session (50%).


Partner/CFE led (60%), not all members (27%), fraud specialist (31%-only led 4/56), IT/Tax (69/63%), hierarchical participation, use of checklist (72%), held late (35%), no wrap-up in PY (84%), average total time (1.5 hours), more than one session (50%).

Distribution of Bstorming Quality

Brainstorming Session Quality Score

1817161514131211109876543

Nu

mb

er

of

En

ga

ge

me

nts

30

20

10

0


Distribution of FR AssessmentsDistribution of FR Assessments


Does Bstorming Quality Does Bstorming Quality Matter??Matter??

FR Factors

FR FR AssessmentAssessment

FR Responses

Brainstorming Quality

Best practices – ptr led, IT auditor present, held early, MC, PC, Discussion of FR factors and responses


Other Findings from ResearchOther Findings from Research1. Red Flags – Insiders on BOD, High Accruals, StockOptions (evidence is mixed), Highly Leveraged, YoungerCompanies, M&A activity, Bad CFOps – need for financing

2. Investors hold SEC and External auditors most accountable for detecting fraud

3. Auditor litigation all about overstated Rev and Assets,fraudulent financial reporting

4. Fraud Experiences – 1989: avg .5 frauds for career2007: avg 71% at least one, 21% at least 2, why?

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Chapter 11 Notes