1. Management Fraud and Audit Risk
Chapter 4
Management Fraud and Audit Risk
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2. 1. Errors, Fraud, and Noncompliance
Definitions Errors - unintentional Fraud (irregularities) - intentional Noncompliance with laws and regulations (Illegal acts) violations of the law
Auditor’s responsibilities
History Errors & Fraud: SAS 1, SAS 16, SAS 53, SAS 82, SAS 99 Illegal Acts: SAS 54
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3. 1. Errors, Fraud, and Noncompliance (continued)
Auditor’s Responsibility for Errors and Fraud (AU-C 240)
design and conduct the audit to provide reasonable assurance that material errors and fraud will be discovered, and report the findings to appropriate parties
Auditor’s Responsibility for Noncompliance with laws and regulations (Illegal Acts) (AU-C 250)
direct effect noncompliance — same
indirect effect noncompliance —
have general level of awareness and act on those discovered
make inquiries
carry out some procedures to identify noncompliance
Questions
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4. 1. Errors, Fraud, and Noncompliance (continued)
Steps involved in Considering the Risk of Fraud
Staff discussion
Obtain information needed to identify risks
Identify risks
Assess identified risks
Respond to results of assessment
Evaluate audit evidence
Communicate about fraud
Document consideration of fraud
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5. 2. Fraud Causes of Misstatements Causes Errors Fraud
Misappropriation Fraudulent
of Assets Financial
Reporting
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6. 2. Fraud (continued)
EXHIBIT 3.1
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7. 2. Fraud (continued)
Fraudulent financial reporting (cooking the books) (management fraud)
falsification of financial statements
falsification or omissions of transactions
Misappropriation of assets (employee fraud)
larceny
embezzlement
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8. 2. Fraud (continued)
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9. 2. Fraud (continued) Overview of Fraud (outline) costs discovery
victims
perpetrators
common characteristics
types
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10. The Fraud Triangle PRESSURE PERCEIVED OPPORTUNITY RATIONALIZATION
Video
PERCEIVED
OPPORTUNITY
RATIONALIZATION
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* Misstatements

11. 2. Fraud (continued) Prevalence of fraud Current frauds
Reasons to study fraud
Fraud related job opportunities
ACFE
CFE
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12. 3. Audit Risk
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13. 3. Audit Risk AU-C 320 – Audit Risk General business risks
Engagement risk
Audit Risk Model (Intended to serve as a conceptual model rather than a mathematical model)
AR = RMM x DR
AR = IR x CR x DR
AR = IR x CR x TD x AP
Audit Risk definition
the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated
the danger that the auditor will fail to detect material misstatements in the financial statements and issues the wrong opinion
Must apply AR model at
financial statement level; at assertion level for significant accounts
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14. 3. Audit Risk (continued)
Risk of Material Misstatement
product of inherent risk and control risk
consider at entity level and significant account/assertion level
Inherent Risk
the susceptibility of an account balance to error assuming there are no controls
based on auditor’s judgment considering understanding of entity, nature of account (routine, systematic processing, complexity, etc), and fraud considerations
Control Risk
the risk that IC will not prevent or detect a material error on a timely basis
based on tests of control’s effectiveness
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15. 3. Audit Risk (continued)
Detection Risk
the risk that the auditor’s procedures will not detect a material error
the product of Tests of Details Risk (TD) and Substantive Analytical Procedures Risk (AP)
Tests of Details Risk
the risk that tests of details will not detect a material error
Substantive Analytical Procedures Risk
the risk that analytical procedures (or other procedures that do not utilize sampling) will not detect a material error
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16. 3. Audit Risk (continued)
Risks defined in negative
Auditor’s control over risks
AR components assessed for each significant account and assertion
Relationship between
RMM and DR
DR and amount of substantive testing
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17. 3. Audit Risk (continued)
Subjectively considering Audit Risk
Quantifying Audit Risk
not required
DR = AR / IR x CR
TD = AR / IR x CR x AP
Questions Examples
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18. 3. Audit Risk (continued)
Significant Risk - AU-C
.04 An identified and assessed risk of material misstatement that, in the auditor's professional judgment, requires special audit consideration.
.30 If the auditor has determined that a significant risk exists, the auditor should obtain an understanding of the entity's controls, including control activities, relevant to that risk and, based on that understanding, evaluate whether such controls have been suitably designed and implemented to mitigate such risks.
.A139 - Significant risks often relate to significant nonroutine transactions and matters that require significant judgment (e.g., estimates)…
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19. 3. Audit Risk (continued)
Significant Risk - AS 2110
.70 To determine a significant risk
auditor should evaluate whether risk requires special audit consideration because of the nature of the risk or the likelihood and potential magnitude of misstatement related to the risk
determination of whether a risk of material misstatement is a significant risk is based on inherent risk, without regard to the effect of controls
.71 a fraud risk is a significant risk
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20. 3. Audit Risk (continued)
Significant account AS 2201.A10
An account or disclosure is a significant account or disclosure if there is a reasonable possibility that the account or disclosure could contain a misstatement that, individually or when aggregated with others, has a material effect on the financial statements, considering the risks of both overstatement and understatement. The determination of whether an account or disclosure is significant is based on inherent risk, without regard to the effect of controls.
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21. 3. Audit Risk (continued)
General guidelines
Inherent Risk
High > 60%
Moderate 40% %
Low < 40%
Control Risk
Maximum = 100%
High > 70%
Moderate 40% %
Very Low < 10%
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22. 3. Audit Risk (continued)
Analytical Procedures Risk
High > 50%
Moderate 20% %
Low % %
Very Low < 10%
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23. 4. Analytical Procedures
Definition
Analytical Procedures involve
comparisons of
relationships between f/s accts in absolute amount or ratios between
two or more years
budgets and actual amounts
forecasts and actual amounts
financial measures to nonfinancial data
relationships between entities in same industry
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24. 4. Analytical Procedures (Continued)
Uses in an audit
planning stage
as a substantive test (SAP)
final review stage
Required use
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25. 4. Analytical Procedures (Continued)
Steps
develop an expectation
define a significant difference
compare expectation with recorded amount
investigate significant differences
document each step
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26. 4. Analytical Procedures (Continued)
In planning stage
enhances auditor’s understanding
identifies risk areas
uses highly aggregated data
generally financial data
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27. 4. Analytical Procedures (Continued)
Substantive analytical procedures
based on level of DR
based on auditor judgment
balance sheet data vs. income statement data
often uses non-financial data
Example
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28. 4. Analytical Procedures (Continued)
In final evaluation stage
uses aggregated data
usually financial data
review same data used in planning stage
Questions
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29. 5. Review Questions for Discussion
Chapter 4
4.1
4.2
4.3
4.4
4.12
4.14
4.17
4.18
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