2. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 1 Fraud Auditing Chapter 11

3. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 2 Learning Objective 1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.

4. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 3 Types of Fraud Fraudulent financial reporting Misappropriation of assets

5. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 4 Learning Objective 2 Describe the fraud triangle and identify conditions for fraud.

6. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 5 The Fraud Triangle Incentives/Pressures OpportunitiesAttitudes/Rationalization

7. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 6 Examples of Risks 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.

8. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 7 Examples of Risks 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.

9. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 8 Examples of Risks 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.

10. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 9 Examples of Risks Factors for Misappropriation of Assets Personal financial obligations create pressure to misappropriate assets. Adverse relationships between management and employees motivate employees to misappropriate assets.

11. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 10 Examples of Risks 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.

12. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 11 Examples of Risks 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.

13. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 12 Learning Objective 3 Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.

14. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 13 Assessing the Risk of Fraud SAS 99 provides guidance to auditors in assessing the risk of fraud.

15. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 14 Professional Skepticism SAS 1 states that, in exercising professional skepticism, an auditor “neither assumes that management is dishonest nor assumes unquestioned honesty.”

16. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 15 Sources of Information Gathered to Assess Fraud Risks Communication among audit team Inquiries of managementRiskfactorsAnalyticalproceduresOtherinformation Identified risks of material misstatements due to fraud

17. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 16 Documenting Fraud Assessment Discussion Specific risks Procedures Reasons Results Other conditions Nature of communications

18. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 17 Learning Objective 4 Identify corporate governance and other control environment factors that reduce fraud risks.

19. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 18 Corporate Governance Oversight to Reduce Fraud Risks 1. Create and maintain a culture of honesty and high ethics. 2. Evaluate fraud risks and implement programs and controls to mitigate identified fraud risks. 3. Develop an appropriate fraud oversight process.

20. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 19 Example Elements for a Code of Conduct Organizational code of conduct General employee conduct Conflicts of interest Outside activities, employment, and directorships

21. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 20 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

22. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 21 Example Elements for a Code of Conduct Organization records and communications Dealing with outside people and organizations Prompt communications Privacy and confidentiality

23. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 22 Organizational Factors Contributing to Risk of Fraud 200319981994 Collusion between employees and third parties Inadequateinternalcontrols Management override of internal controls 4831 33 39 58 59 31 36 36

24. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 23 Organizational Factors Contributing to Risk of Fraud Collusion between employees and management Lack of control over management be directors Ineffective or nonexistent ethics or compliance program 15 19 23 12 11 6 10 8 7 200319981994

25. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 24 Learning Objective 5 Develop responses to identified fraud risks.

26. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 25 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.

27. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 26 Learning Objective 6 Recognize specific fraud risk areas and develop procedures to detect fraud.

28. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 27 Rates of Fraud Occurrence 20031998 Theft of assets Check fraud 4922 40 26 Expense account abuse 36 13 Credit card fraud 20 13 Payroll fraud 12 3

29. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 28 Rates of Fraud Occurrence 20031998 Conflict of interest Inventory theft 12 9 11 11 Kickbacks 9 6 Financial reporting fraud 7 3

30. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 29 Specific Fraud Risk Areas Inventory fraud risks Revenue and accounts receivable fraud risks Purchases and accounts payable fraud risks Other areas of fraud risk

31. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 30 Learning Objective 7 Understand interview techniques and other activities after fraud is suspected.

32. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 31 Methods of Uncovering Fraud 200319981994 Internal controls Internal audit Notification by employee 77%51% 52% 65% 43% 47% 63% 58% 51%

33. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 32 Methods of Uncovering Fraud 200319981994 Accident Anonymous tip Notification by customer 54% 37% 28% 41% 35% 26% 34% 41% 34%

34. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 33 Methods of Uncovering Fraud 200319981994 Notification by regulatory or law enforcement agency Notification by vendor External audit 19% 16% 8% 8% 16% 11% 15% 12% 4% 4% 5% 5%

35. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 34 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.

36. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 35 Types of Inquiry Techniques Informational inquiry Interrogative inquiry Listening techniques Observing behavioral cues

37. ©2005 Prentice Hall Business Publishing, Auditing and Assurance Services 10/e, Arens/Elder/Beasley 11 - 36 End of Chapter 11