1. Types of fraud
Fraudulent Financial Reporting—An intentional misstatement or omission of amounts or disclosures with the intent to deceive users.
Most cases involve an attempt to overstate income, but can also understate income.
Earnings management involves fraud to meet earnings goals.
Income smoothing is a form of earnings management that shifts income from year to year to reduce fluctuations.
Misappropriation of Assets—Fraud that involves theft of an entity’s assets. Normally perpetrated by lower level employees, but can involve upper management.
Most people do not understand that financial statement fraud and misappropriation of assets are completely different situations.
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2. Conditions for fraud
Three conditions for fraud are referred to as the fraud triangle:
Incentives/Pressures—Management or other employees have incentives or pressures to commit fraud.
Opportunities—Circumstances provide opportunities for management or employees to commit fraud.
Attitudes/Rationalization—An attitude, character, or set of ethical values exists that allows management or employees to commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.
The fraud triangle is illustrated in Figure 10-1.
Risk factors for fraudulent financial reporting are shown in Table
Fraud can happen anywhere under the right conditions. The fraud triangle includes the three components of the conditions that make fraud more likely.
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4. Conditions for fraud (cont.)
Commonly cited fraud risk conditions are shown in Figure 10-2.
The characteristics of fraud perpetrators are detailed in Figure 10-3.
Risk Factors for Misappropriation of Assets—The same three conditions apply to misappropriation of assts.
However, in assessing risk factors, greater emphasis is placed on individual incentives and opportunities for theft.
Examples of fraud risk factors for each of the three conditions for misappropriation of assets are provided in Table 10-2.
Risk factors for misappropriation of assets are centered around individual incentives or pressures along with the opportunity. Internal controls are intended to remove the opportunity for employees to misappropriate assets.
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6. Assessing the risk of fraud
Professional Skepticism—Auditing standards require that the audit be planned and performed with an attitude of professional skepticism.
This involves two components:
Questioning mind
Critical evaluation of audit evidence
Auditors must assess the risk of fraud throughout the audit process. Professional skepticism gives the auditor the right frame of mind for staying alert for the possibility of fraud.
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7. Assessing the risk of fraud (cont.)
Sources of Information to Assess Fraud Risks (Figure 10-4)
Communication Among Audit Team
How and where the entity’s financial statements might be susceptible to material misstatement due to fraud.
How management could perpetrate and conceal fraudulent financial reporting.
How anyone might misappropriate assets of the entity
How the auditor might respond to the susceptibility of material misstatements due to fraud.
Inquiries of Management
Risk Factors
Analytical Procedures—See horizontal analysis in Figure 10-5.
Other Information
Information with which to assess the risk of fraud comes from many different sources.
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8. Assessing the risk of fraud (cont.)
Identified Risks of Material Misstatement Due to Fraud
Auditors evaluate all of the sources of information to assess the risk of material misstatement due to fraud as part of audit planning.
This assessment continues throughout the audit because the auditor may learn new information while performing audit procedures.
Auditing standards require that the auditor presume there is a risk of fraud in revenue recognition. If the auditor concludes that this assumption does not apply, it must be documented in the working papers.
Some areas of financial reporting have a higher risk of fraud. Revenue recognition has been the source of fraud in several high-profile cases recently, so the standards require that the auditor presume there is a risk of fraud in this area, at least until it can be determined if the assumption applies to this client.
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9. Corporate governance oversight to reduce fraud risks
Management is responsible for implementing corporate governance and control procedures to minimize the risk of fraud, through a combination of prevention, deterrence, and detection measures.
The AICPA identifies three elements to prevent, deter, and detect fraud:
Culture of honesty and high ethics
Management’s responsibility to evaluate risks of fraud
Audit committee oversight
Corporate governance is one of the main factors that can mitigate the risk of fraud.
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10. Responding to the risk of fraud
When an auditor identifies risks of material misstatements due to fraud, the auditor develops responses at three levels:
Overall Responses—Assign more experienced personnel to the audit or bring in a fraud specialist
Responses at the Assertion Level—Changing the nature, timing, and extent of audit procedures
Responses Related to Management Override:
Examine journal entries and other adjustments for evidence of possible misstatements due to fraud.
Review accounting estimates for biases.
Evaluate the business rationale for significant unusual transactions.
The auditor must respond to identified risks at all three levels shown.
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11. Responding to the risk of fraud (cont.)
Update Risk Assessment Process—The auditor’s assessment of risk of material misstatement due to fraud is ongoing throughout the audit.
The auditor should be alert for the following conditions during the audit:
Discrepancies in the accounting records
Conflicting or missing audit evidence
Problematic or unusual relationships between the auditor and management
Results from substantive or final review stage analytical procedures that indicate a previously unrecognized fraud risk
Responses to inquiries made throughout the audit that are vague or implausible or that produce evidence that is inconsistent with other information
Because the assessment of the risk of fraud is ongoing throughout the audit, the auditor must update the process based on the information gathered so far.
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13. Responsibilities when fraud is suspected (cont.)
When fraud is suspected, the auditor may use inquiry to determine whether fraud actually exists.
Use of Inquiry—Inquiry is an effective method of gathering more information and may take the following forms:
Informational inquiry
Assessment inquiry
Interrogative inquiry
The use of inquiry is one of the most effective methods of gathering more evidence when fraud is suspected.
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16. Responsibilities when fraud is suspected (cont.)
Other Responsibilities When Fraud Is Suspected—Besides inquiry, the auditor may use any of the following procedures to determine whether fraud actually exists:
Audit software analysis
Expanded substantive testing
Consider other audit implications
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17. Documenting the fraud assessment
Auditors must document the following matters related to consideration of material misstatements due to fraud:
Significant decisions made during the discussion among engagement team in planning the audit
Procedures performed to obtain information necessary to identify and assess the risks of material fraud
Specific risks of material fraud that were identified at both the overall financial statement level and the assertion level and the auditor’s response to those risks
Reasons supporting a conclusion that there is not a significant risk of material improper revenue recognition
Documentation of audit procedures is always important, but documenting the assessment of fraud is crucial.
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18. Documenting the fraud assessment (cont.)
Auditors must document the following matters related to consideration of material misstatements due to fraud (cont.):
Results of procedures performed to address the risk of management override of controls
Other conditions and analytical relationships indicating that additional auditing procedures or other responses were required, and the actions taken by the auditor in response
The nature of communications about fraud made to management, the audit committee, or others
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