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Fraud Auditing
Chapter 11By arens et.al.,
Learning Objective 1
• Define fraud and distinguish• between fraudulent financial• reporting and misappropriation• of assets.
Types of Fraud
Fraudulent financial reporting
Misappropriation of assets
Learning Objective 2
• Describe the fraud triangle and• identify conditions for fraud.
The Fraud Triangle
Incentives/Pressures
Opportunities Attitudes/Rationalization
Examples of Risk Factorsfor Fraudulent Reporting
Financial stability or profitability is threatened byeconomic, industry, or entity operating conditions
Excessive pressure exists for management tomeet debt requirements
Personal net worth is materially threatened
Incentives/Pressures:
Examples of Risk Factorsfor Fraudulent Reporting
There are significant accounting estimates thatare difficult to verify
There is ineffective oversight over financialreporting
High turnover or ineffective accounting, internalaudit, or information technology staff exists
Opportunities:
Examples of Risk Factorsfor Fraudulent Reporting
Inappropriate or inefficient communicationand support of the entity’s values is evident
A history of violations of laws is known
Management has a practice of makingoverly aggressive or unrealistic forecasts
Attitudes/Rationalization:
Examples of Risk Factorsfor Misappropriation of Assets
Personal financial obligations create pressureto misappropriate assets
Adverse relationships between managementand employees motivate employees tomisappropriate assets
Incentives/Pressures:
Examples of Risk Factorsfor Misappropriation of Assets
There is a presence of large amounts of cashon hand or inventory items
There is an inadequate internal control overassets
Opportunities:
Examples of Risk Factorsfor Misappropriation of Assets
Disregard for the need to monitor or reducerisk of misappropriating assets exists
There is a disregard for internal controls
Attitudes/Rationalization:
Learning Objective 3
• Understand the auditor’s• responsibility for assessing• the risk of fraud and detecting• material misstatements due to• fraud.
Assessing 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.”
Sources of Information Gathered to Assess Fraud Risks
Communicationamong audit team
Inquiries ofmanagement
Riskfactors
Analyticalprocedures
Otherinformation
Identified risks of material misstatements due to fraud
Documenting Fraud Assessment
Discussion
Specific risks
Procedures
Reasons
Nature of communications
Other conditions and analytical relationships
Learning Objective 4
• Identify corporate governance• and other control environment• factors that reduce fraud risks.
Corporate Governance Oversightto Reduce Fraud Risks
1. Culture of honesty and high ethics
2. Management's responsibilityto evaluate risks of fraud
3. Audit committee oversight
Example Elements for a Code of Conduct
Organizational code of conduct
General employee conduct
Conflicts of interest
Outside activities, employment, and directorships
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
Example Elements for a Code of Conduct
Organization records and communications
Dealing with outside people and organizations
Prompt communications
Privacy and confidentiality
Organizational Factors Contributing to Risk of Fraud
2003 1998 1994
Collusion betweenemployees and
third partiesInadequate
internalcontrols
Managementoverride of
internal controls
483133
395859
313636
Organizational Factors Contributing to Risk of Fraud
Collusion betweenemployees and
managementLack of control
over managementby directors
Ineffective ornonexistent ethics orcompliance program
151923
1211 6
10 8 7
2003 1998 1994
Learning Objective 5
• Develop responses to identified• fraud risks.
Responding to the Risk of Fraud
Change the overall conduct of the auditto respond to identified fraud risks.
Design and perform audit proceduresto address identified risks.
Design and perform procedures toaddress the risk of managementoverride of controls.
Learning Objective 6
• Recognize specific fraud risk• areas and develop procedures• to detect fraud.
Initial Detection Method for Million Dollar Schemes
Tip
By Accident
Internal Audit
Internal Controls
External Audit
Notified By Police
$1,000,000+
All Cases
0% 10% 20% 30% 40% 50%
Note: The sum of percentages in this chart exceeds 100 percent because in some cases respondents identified more than one detection method.
42.3%
46.2%
22.8%
20.0%
18.6%19.4%
16.7%23.3%
15.8%9.1%
6.0%3.2%
Type
of D
etec
tion
Specific Fraud Risk Areas
Inventory fraud risks
Revenue and accounts receivable fraud risks
Purchases and accounts payable fraud risks
Other areas of fraud risk
Learning Objective 7
• Understand interview techniques• and other activities after fraud• is suspected.
Responding to Misstatements That May Be the Result of Fraud
When fraud is suspected, the auditor gathersadditional information to determine whetherfraud actually exists.
Types of Inquiry Techniques Informational inquiry
Assessment inquiry
Interrogative inquiry
Evaluating responses
Listening techniques
Observing behavioral cues
End of Chapter 11