Fraud Risk Assessment

Definitions Related To Fraud Fraud is knowingly making material misrepresentations of fact, with the intent of inducing someone to believe the falsehood, act upon it, and thus suffer a loss or damage. Employee fraud Fraudulent financial reporting 2

Definitions Related To Fraud Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements. Illegal act refers to acts of non-compliance with the laws and regulations of the country or countries in which the auditee organization operates. 3

Fraud Auditing Fraud auditing is defined as a proactive approach to detect financial frauds using accounting records and information, analytical relationships, and an awareness of fraud perpetration and concealment schemes. Auditors have the responsibility 4

Auditors’ Responsibility to Consider Fraud and Error in an Audit of Financial Statements CAS 240 The auditor shall make inquiries of management regarding: (a)Management’s assessment of the risk that the financial statements may be materially misstated due to fraud (b)Management’s process for identifying and responding to the risks of fraud in the entity (c)Management’s communication, if any, to those charged with governance (d)Management’s communication, if any, to employees CAS 240 requires auditors maintain professional skepticism, and ignore the traditional assumption of management’s honesty. 5

How does the auditor justify that the fraud risk is low? Perform analytical procedures of revenues, make enquiries, and scan for unusual entries (especially at year-end), The audit team should have Identify biases in management accounting estimates If the auditors cannot justify that the fraud risk is low 6

Illegal Acts by Auditees Direct-effect illegal acts have direct and material effects on financial statement amounts Indirect-effect illegal acts refer to violations of laws and regulations that are 7

Illegal Acts by Auditees CAS 250 requires auditors to consider the consequences of the illegal acts very broadly If failures to disclose would result in a material misstatement, then the auditor should attempt to reduce this risk to an appropriately low level. CAS 250 acknowledges that illegal acts may be difficult to detect because of Auditors should enquire and obtain representations about awareness and disclosure of possibly illegal acts. Material, possibly illegal, acts should be communicated to 8

Communication with Audit Committees (or Equivalent) CAS 260 requires oral or written communication from the auditors on the following: (a)misstatements other than trivial errors; (b)fraud; (c)misstatements that may cause future financial statements to be materially misstated; (d)illegal or possibly illegal acts, other than ones considered inconsequential; and (e)significant weaknesses in internal control. 9

Materiality and Fraud The auditors should inform the audit committee of Those involving senior management are 10

Conditions That Lead To Frauds. The Fraud Triangle Fraud Incentive Fraud Opportunity Fraud Rationalization For fraud to occur, all three types of factors need to be present. 11

Fraud Incentive The pressure a person experiences and believes cannot be shared with friends and confidants This can lead to committing fraud or can serve as the motive for fraud. Typical pressures: college or university tuition gambling debts drugs alimony and child support expensive lifestyle (homes, cars, boats) business or stock speculation losses taxation on good financial results 12

Fraud Opportunity An open door for solving the unshareable problem by violating a trust. Like an opportunity you cannot ignore. Examples: Nobody counts the inventory, so losses are not known. The petty cash box is often left unattended. Supervisors set a bad example by taking supplies home. Upper management considered a written statement of ethics but decided not to publish one. Another employee was caught and fired, but not prosecuted. The finance vice-president has investment authority without any review. Frequent emergency jobs leave a lot of excess material just lying around. 13

Fraud Rationalization When individuals possess an attitude, character, or set of ethical values allowing them to knowingly and intentionally to commit a dishonest act. I need it more than they do (Robin Hood theory), I’ll pay it back, I’m not hurting anybody, the company can afford it, and everybody does it. 14

Fraud Detection Many frauds are investigated through noticing the signs and signals and then following the trail of missing, mutilated, or false documents that are part of the accounting records cover-up. 15

Red Flags Fraudsters frequently exhibit these characteristics: defensive, argumentative, and blame-shifting behaviours; tiredness; agitation; inability to make eye contact; irritability; and excessive sweating. Telltale hints of a cover-up often appear in the accounting records. transactions that are at odd times of the day, month, or season; too many or too few of them; in the wrong branch location; and in amounts too high, too low, too consistent, or too inconsistent. 16

Internal Control and Fraud Detection 40% of all frauds are detected through tips from employees. Almost 30% of frauds were detected by internal audit. 18% by other internal controls. 21% by accident, and 11% by external auditors. 17

Fraudulent Financial Reporting by Management Fraud that affects financial statements and causes them to be materially misleading Frauds have often accompanied the following conditions and circumstances: high debt unfavourable industry conditions excess capacity profit squeeze strong foreign competition lack of working capital rapid expansion product obsolescence slow customer collections related-party transactions 18

Companies create financial statements that are materially misleading by either (1) (2) (3) Many frauds involve improper recognition of assets or a “dangling debit,” A mechanism that management can use for manipulating financial statements involves 19

A client’s illegal acts may cause financial misstatements, and external auditors should be aware of possible indications of them: unauthorized transactions government investigations regulatory reports of violations payments to consultants, affiliates, and employees for unspecified services excessive sales commissions and agent’s fees unusually large cash payments unexplained payments to government officials failure to file tax returns or pay duties and fees 20

Cheque Forgery Knowledge of the codes for the Canadian banking system’s identification numbers could enable an auditor to spot a crude cheque forgery. Mistakes with the optical identification printing or the magnetic cheque number might be a tip-off. If the amount of a cheque is altered after it has cleared the bank, the change would be noted by comparing the magnetic imprint of the amount paid (in the bank’s records) against the amount written on the cheque face. The back of a cheque carries the endorsement(s) of the payee and others to whom the payee may have endorsed the cheque; and, the date, name, and routing number of the bank where the cheque was deposited; and the date, identification of the bank office, and its routing number for the cheque clearing. Auditors can follow the path of a cancelled cheque to note if it corresponds with the characteristics of the payee. 21

Social Insurance Numbers and Fraud The SIN is a nine-digit number; the ninth digit is a check digit that is calculated using the first eight digits. There are two types of SINs: regular numbers and distinctive numbers. Regular numbers are issued to Canadian citizens, registered Native peoples, and permanent residents. Distinctive numbers start with digit 9 and are issued to people who do not have status as above; e.g., foreign workers, visitors. The first digit, other than 9, indicates the province or territory where the number was issued. The middle seven digits are issued in generally ascending numerical order, making it feasible to apply Benford’s Law to analyzing these digits. Working with Human Resources Development Canada, an auditor may be able to detect fictitious SINs. 22