©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 1 Fraud Auditing Chapter 11

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Auditing 12/e,Auditing 12/e, Arens/Beasley/Elder Arens/Beasley/Elder 11 - 1

Fraud Auditing

Chapter 11

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Auditing 12/e,Auditing 12/e, Arens/Beasley/Elder Arens/Beasley/Elder 11 - 11 - 22

Learning Objective 1

Define fraud and distinguish

between fraudulent financial

reporting and misappropriation

of assets.


Types of Fraud

Fraudulent financial reporting

Misappropriation of assets



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:



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:



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:



There is a presence of large amounts of cashon hand or inventory items

There is an inadequate internal control overassets

Opportunities:



Disregard for the need to monitor or reducerisk of misappropriating assets exists

There is a disregard for internal controls

Attitudes/Rationalization:



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 Gatheredto 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

Results

Other conditions

Nature of communications



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



Relationships with clients and suppliers

Gifts, entertainment, and favors

Kickbacks and secret commissions

Organization funds and other assets



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 parties

Inadequateinternalcontrols

Managementoverride of

internal controls

483133

395859

313636


Organizational Factors Contributing to Risk of Fraud

Collusion betweenemployees and

management

Lack of controlover management

by directors

Ineffective ornonexistent ethics orcompliance program

151923

1211 6

10 8 7

2003 1998 1994



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.



Recognize specific fraud risk

areas and develop procedures

to detect fraud.


Rates of Fraud Occurrence

2003 1998

Theft of assets 4922

Check fraud 4026

Expense accountabuse

3613

Credit card fraud 2013

Payroll fraud 12 3


Rates of Fraud Occurrence

2003 1998

Conflict of interest 12 9

Inventory theft 1111

Kickbacks 9 6

Financial reportingfraud

7 3


Specific Fraud Risk Areas

Inventory fraud risks

Revenue and accounts receivable fraud risks

Purchases and accounts payable fraud risks

Other areas of fraud risk



Understand interview techniques

and other activities after fraud

is suspected.


Methods of Uncovering Fraud

Internal controlsInternal auditNotification by employeeAccidentAnonymous tipNotification by customerNotification by regulatory or law enforcement agencyNotification by vendorExternal audit

77656354413419

1612

51435837354116

11 4

524751282634 8

15 5

(Percentages) 2003 1998 1994


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

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Auditing 12/e,Auditing 12/e, Arens/Beasley/Elder Arens/Beasley/Elder 11 - 33

End of Chapter 11

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©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 1 Fraud Auditing Chapter 11