1. BA 427 – Assurance and Attestation Services Lecture 15 The Accounting Profession’s Response to Fraud

2. Lecture 15 – The Accounting Profession’s Response to Fraud  The GAO’s Assessment as of 1996  The Evolution of GAAS for Fraud Detection  SAS No. 99  The COSO-sponsored report on Fraudulent Financial Reporting, 1999

3. Lecture 15 – The Accounting Profession’s Response to Fraud  The GAO’s Assessment as of 1996  The Evolution of GAAS for Fraud Detection  SAS No. 99  The COSO-sponsored report on Fraudulent Financial Reporting, 1999

4. GAO: The Accounting Profession, 1996  “… when charges of fraud are leveled against management or others in a company, the inevitable question is: Where were the auditors?”  “… an expectation gap existed between what the public expects of the accounting profession …, and what the profession understands or believes is its proper role.”

5. GAO: The Accounting Profession, 1996  “The Cohen Commission stated in its 1978 report that ‘significant percentages of those who use and rely on the auditor’s work rank the detection of fraud among the most important objectives of an audit.’”  “The public did not understand how a company can fail as a results of management fraud shortly after an unqualified audit report on its financial statements is issued.”

6. GAO: The Accounting Profession, 1996  “The consequences of fraudulent financial reporting and unexpected business failures can be widespread and devastating.”  “Auditing standards have always acknowledged that the auditor has some responsibility to consider the existence of fraud in an audit.” (e.g., SAS 16, 1977)

7. GAO: The Accounting Profession, 1996  “However, interpretations of these standards seemed to emphasize the limitations of the auditor’s role, and in applying the standards, searching for and detecting fraud was always seen as a by-product of the audit process.”  “In 1988, the ASB issued two standards … which directly address the auditor’s responsibility for fraud detection ….”  One of these standards was SAS 53.

8. GAO: The Accounting Profession, 1996  “The 1988 statement … requires the auditor to design the audit to provide reasonable assurance of detecting material errors and irregularities.”  “The statement requires that the auditor inform the audit committee … about irregularities that have been detected.”  “The statement also acknowledged that the auditor should recognize that certain circumstances may exist that pose a duty for the auditor to report outside of the client organization.”

9. GAO: The Accounting Profession, 1996  “In December 1995, the Congress enacted the Private Securities Litigation Reform Act of 1995.”  Section 301 of the Act concerns fraud detection and identifies the procedures, evaluations, and reporting the auditor is required to make in accordance with GAAS, as may be modified or supplemented by the SEC.”

10. GAO: The Accounting Profession, 1996  “The requirements are similar to those in SAS 53; however, the Act alters the existing reporting process.”  Under certain circumstances, the Act requires the auditor to report illegal acts to the SEC, if the company does not itself notify the SEC.

11. Lecture 15 – The Accounting Profession’s Response to Fraud  The GAO’s Assessment as of 1996  The Evolution of GAAS for Fraud Detection  SAS No. 99  The COSO-sponsored report on Fraudulent Financial Reporting, 1999

12. SAS No. 53  “Some recent business failures have caused the public to question the auditor’s role in ferreting out fraud.”  “Responding to these concerns, the ASB issued SAS no. 53, The Auditor’s Responsibility to Detect and Report Errors and Irregularities.”

13. SAS No. 53  “generally effective for audits of financial statements for periods beginning on or after January 1, 1989.”

14. SAS No. 53  “This standard explains the auditor’s responsibility for material misstatements … in a more understandable manner and provides guidance on how to improve the detection of such misstatements.”

15. SAS No. 53  “The new standard supersedes SAS no. 16, The Auditor’s Responsibility for the Detection of Errors and Irregularities (January 1977), which required the auditor to plan the audit to search for material misstatements.”

16. SAS No. 53  “SAS no. 53 increases responsibility by obligating the auditor to design the audit to provide reasonable assurance of detection.”

17. SAS No. 82  “In its March 1993 report, In the Public Interest, the Public Oversight Board … made a number of recommendations about fraud, including issuing a call for auditors to exercise the professional skepticism demanded by SAS no. 53.”  “The ASB concluded that it was crucial to develop a SAS that focused solely on financial statement fraud.”

18. SAS No. 82  “SAS no. 82, Consideration of Fraud in a Financial Statement Audit, provides expanded operational guidance on the auditor’s consideration of material fraud in conducting a financial statement audit.”

19. SAS No. 82  “The new SAS, which supersedes SAS no. 53, … is effective for audits of financial statements for periods ending on or after December 15, 1997.”  “SAS no. 82 clarified but did not increase the auditor’s responsibility to detect fraud.”

20. SAS No. 99  SAS No. 99, Consideration of Fraud in a Financial Statement Audit, supersedes SAS no. 82.  Effective for audits of financial statements for periods beginning on or after December 15, 2002.

21. Lecture 15 – The Accounting Profession’s Response to Fraud  The GAO’s Assessment as of 1996  The Evolution of GAAS for Fraud Detection  SAS No. 99  The COSO-sponsored report on Fraudulent Financial Reporting, 1999

22. SAS No. 99  Consideration of Fraud in a F/S Audit Introduction and Overview Description and Characteristics of Fraud The Importance of Exercising Professional Skepticism Discussion Among Engagement Personnel Regarding the Risks of Material Misstatement Due to Fraud

23. SAS No. 99  “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, whether caused by error or fraud.”  Two types of misstatements are relevant to the auditor’s consideration of fraud— misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets.

24. SAS No. 99  The auditor should conduct the engagement with a mindset that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management’s honesty and integrity.  In exercising professional skepticism in gathering and evaluating evidence, the auditor should not be satisfied with less- than-persuasive evidence because of a belief that management is honest.

25. SAS No. 99  Consideration of Fraud in a F/S Audit Obtaining the Information Needed to Identify the Risks of Material Misstatement Due to Fraud  Making inquiries of management and others within the entity about the risks of fraud.  Considering the results of the analytical procedures performed in planning the audit.  Considering fraud risk factors.  Considering other information that may be helpful in identifying risks of material misstatement due to fraud.

26. SAS No. 99  Consideration of Fraud in a F/S Audit Identifying Risks That May Result in a Material Misstatement Due to Fraud  Using the information gathered to identify risk of material misstatements due to fraud  A presumption that improper revenue recognition is a fraud risk  A consideration of the risk of management override of controls

27. SAS No. 99  Consideration of Fraud in a F/S Audit Assessing the Identified Risks After Taking Into Account an Evaluation of the Entity’s Programs and Controls That Address the Risks

28. SAS No. 99  Consideration of Fraud in a F/S Audit Responding to the Results of the Assessment  Overall responses to the risk of material misstatement

29. SAS No. 99  Consideration of Fraud in a F/S Audit Responding to the Results of the Assessment  Responses involving the nature, timing, and extent of procedures to be performed to address the identified risks Additional examples of responses to identified risks of misstatements arising from fraudulent financial reporting. Examples of responses to identified risks of misstatements arising from misappropriations of assets.

30. SAS No. 99  Consideration of Fraud in a F/S Audit Responding to the Results of the Assessment  Responses to further address the risk of management override of controls Examining journal entries and other adjustments for evidence of possible material misstatement due to fraud.

31. SAS No. 99  Consideration of Fraud in a F/S Audit Responding to the Results of the Assessment  Responses to further address the risk of management override of controls Reviewing accounting estimates for biases that could result in material misstatement due to fraud. Evaluating the business rationale for significant unusual transactions.

32. SAS No. 99  Consideration of Fraud in a F/S Audit Evaluating Audit Evidence  Assessing the risks of material misstatement due to fraud throughout the audit.  Evaluating whether analytical procedures performed as substantive tests or in the overall review stage of the audit indicate a previously unrecognized risk of material misstatement due to fraud.  Evaluating the risks of material misstatement due to fraud at or near the completion of fieldwork.

33. SAS No. 99  Consideration of Fraud in a F/S Audit Evaluating Audit Evidence  Responding to misstatements that may be the result of fraud. Communicating About Possible Fraud to Management, the Audit Committee, and Others Documenting the Auditor’s Consideration of Fraud

34. SAS No. 99  Consideration of Fraud in a F/S Audit, Appendix Examples of Fraud Risk Factors Risk Factors Relating to Misstatements Arising from Fraudulent Financial Reporting  Incentives/Pressures  Opportunities  Attitudes/Rationalizations

35. SAS No. 99  Incentives/Pressures Financial stability or profitability is threatened by economic, industry or entity operating conditions. Excessive pressure exists for management to meet the requirements or expectations of third parties. Management or the board of directors’ personal financial situation is threatened. Excessive pressure on management … to meet financial targets.

36. SAS No. 99  Opportunities The nature of the industry or the entity’s operations provides opportunities to engage in fraudulent financial reporting. There is ineffective monitoring of management. There is a complex or unstable organizational structure. Internal control components are deficient.

37. SAS No. 99  Attitudes/Rationalizations Ineffective communication or enforcement of the entity’s values. Nonfinancial management’s excessive participation with the selection of accounting principles. Known history of violations of laws. The relationship between management and the current or predecessor auditor is strained.

38. SAS No. 99  Consideration of Fraud in a F/S Audit, Appendix Risk Factors Relating to Misstatements Arising from Misappropriation of Assets  Incentives/Pressures  Opportunities  Attitudes/Rationalizations

39. Lecture 15 – The Accounting Profession’s Response to Fraud  The GAO’s Assessment as of 1996  The Evolution of GAAS for Fraud Detection  SAS No. 99  The COSO-sponsored report on Fraudulent Financial Reporting, 1999

40. Fraudulent Financial Reporting: 1987-1997  Commissioned by COSO  Study conducted by three accounting professors  Examined approximately 200 instances of fraudulent financial reporting  Sample is drawn from SEC Accounting and Auditing Enforcement Releases (AAERs)

41. Fraudulent Financial Reporting: 1987-1997  Key findings: nature of the companies involved Relative to public companies, companies committing fraud are relatively small. 78% of the sample was not listed on the NYSE or American Stock Exchange. Between 25% and 50% of companies committing fraud were experiencing losses or were near to break-even prior to the fraud.

42. Fraudulent Financial Reporting: 1987-1997  Key findings: nature of the companies involved One-third of the companies were from the following industries:  Computer hardware or software  Financial services (banks, etc.)  Healthcare

43. Fraudulent Financial Reporting: 1987-1997  Key findings: Control Environment Top management was frequently involved. In 83% of the cases, the CEO and/or the CFO were implicated in the fraud. Most audit committees met only once or twice a year. 25% of the companies did not have an audit committee. 65% of audit committee members seemed not to be knowledgeable about accounting.

44. Fraudulent Financial Reporting: 1987-1997  Key findings: Control Environment Boards of Directors were dominated by insiders and “grey” directors with significant equity ownership. Family relationships among directors and/or officers were fairly common. In nearly 50% of the instances, the founder and current CEO were the same person or the original CEO/President was still in place.

45. Fraudulent Financial Reporting: 1987-1997  Key findings: Nature of the Frauds Average financial statement misstatement or misappropriation was $25 million while the average total assets was $533 million. Median financial statements misstatement or misappropriation was $4.1 million while the median total assets was $16 million. Most frauds were not isolated to a single fiscal period. Average fraud period extended over two years.

46. Fraudulent Financial Reporting: 1987-1997  Key findings: Nature of the Frauds Typical financial statement fraud techniques involved overstatement of revenues and assets.  Revenues recorded prematurely.  Fictitious revenues recorded, especially near the end of the reporting period.  Understating allowances for receivables.  Overstating inventories.  Overstating property, plant and equipment.  Recording assets that did not exist.

47. Fraudulent Financial Reporting: 1987-1997  Key findings: External Auditors 56% of companies were audited by the Big 8/6 firms. 55% of the audit reports issued in the last year of the fraud were clean opinions. Just over 25% of the companies changed auditors during the fraud period or just prior to the fraud period. Auditors were identified in the AAERs 29% of the time, for negligence or fraud.

48. Fraudulent Financial Reporting: 1987-1997  Key findings: consequences & outcomes Over 50% of the companies went bankrupt following disclosure of the fraud. 21% were delisted by a national stock exchange. A significant number of senior executives were terminated, forced to resign, and/or faced financial penalties. Relatively few individuals admitted guilt or served prison sentences.