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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Types of Fraud  Fraudulent financial reporting  Misappropriation of assets

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder The Fraud Triangle Incentives/Pressures OpportunitiesAttitudes/Rationalization

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Examples of Risk Factors for Fraudulent Reporting  Financial stability or profitability is threatened by economic, industry, or entity operating conditions  Excessive pressure exists for management to meet debt requirements  Personal net worth is materially threatened Incentives/Pressures:

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Examples of Risk Factors for Fraudulent Reporting  There are significant accounting estimates that are difficult to verify  There is ineffective oversight over financial reporting  High turnover or ineffective accounting internal audit, or information technology staff exists Opportunities:

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Examples of Risk Factors for Fraudulent Reporting  Inappropriate or inefficient communication and support of the entity’s values is evident  A history of violations of laws is known  Management has a practice of making overly aggressive or unrealistic forecasts Attitudes/Rationalization:

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Examples of Risk Factors for Misappropriation of Assets  Personal financial obligations create pressure to misappropriate assets  Adverse relationships between management and employees motivate employees to misappropriate assets Incentives/Pressures:

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Examples of Risk Factors for Misappropriation of Assets  There is a presence of large amounts of cash on hand or inventory items  There is an inadequate internal control over assets Opportunities:

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Examples of Risk Factors for Misappropriation of Assets  Disregard for the need to monitor or reduce risk of misappropriating assets exists  There is a disregard for internal controls Attitudes/Rationalization:

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Assessing the Risk of Fraud SAS 99 provides guidance to auditors in assessing the risk of fraud. SAS 1 states that, in exercising professional skepticism, an auditor “neither assumes that management is dishonest nor assumes unquestioned honesty.”

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Sources of Information Gathered to Assess Fraud Risks Communication among audit team Inquiries of management Risk factors Analytical procedures Other information Identified risks of material misstatements due to fraud

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Documenting Fraud Assessment  Discussion  Specific risks  Procedures  Reasons  Results  Other conditions  Nature of communications

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Corporate Governance Oversight to Reduce Fraud Risks 1.Culture of honesty and high ethics 2.Management's responsibility to evaluate risks of fraud 3.Audit committee oversight

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Example Elements for a Code of Conduct  Organizational code of conduct  General employee conduct  Conflicts of interest  Outside activities, employment, and directorships

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

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Example Elements for a Code of Conduct  Organization records and communications  Dealing with outside people and organizations  Prompt communications  Privacy and confidentiality

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Organizational Factors Contributing to Risk of Fraud Collusion between employees and third parties Inadequate internal controls Management override of internal controls

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Organizational Factors Contributing to Risk of Fraud Collusion between employees and management Lack of control over management by directors Ineffective or nonexistent ethics or compliance program

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Responding to the Risk of Fraud Change the overall conduct of the audit to respond to identified fraud risks. Design and perform audit procedures to address identified risks. Design and perform procedures to address the risk of management override of controls.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder Responding to Misstatements That May Be the Result of Fraud When fraud is suspected, the auditor gathers additional information to determine whether fraud actually exists.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder End of Chapter 11