1. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 11 - 1 Fraud Auditing Chapter 11

2. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 2 Learning Objective 1 Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.

3. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 3 Types of Fraud  Fraudulent financial reporting  Misappropriation of assets

4. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 4 Learning Objective 2 Describe the fraud triangle and identify conditions for fraud.

5. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 5 The Fraud Triangle Incentives/Pressures OpportunitiesAttitudes/Rationalization

6. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 6 Examples of Risks Factors for Fraudulent Reporting 1. Incentives/Pressures Financial stability or profitability is threatened by economic, industry, or entity operating conditions. Excessive pressure exists for management to meet debt requirements / EPS / budgets – Waste Mgt Personal net worth of mgt is materially threatened. Stock price obsession - Worldcom

7. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 7 Examples of Risks Factors for Fraudulent Reporting 2. Opportunities There are significant accounting estimates that are difficult to verify – Waste Mgt. There is ineffective oversight over financial reporting – less collusion needed: Enron. Ineffective internal audit, internal controls, or information technology staff exists: ERP systems CA and bolt on applications

8. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 8 Examples of Risks Factors for Fraudulent Reporting 3. Attitudes/Rationalization Inappropriate or inefficient communication and support of the entity’s values is evident. SOX – code of ethics – Tone from the top. A history of violations of laws is known. Management has a practice of making overly aggressive or unrealistic forecasts. W & K’s Broken Window Theory

9. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 9 Learning Objective 3 Understand the auditor’s responsibility for assessing the risk of fraud and detecting material misstatements due to fraud.

10. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 10 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.”

11. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 11 Sources of Information Gathered to Assess Fraud Risk Communication among audit team Inquiries of management Risk factors Analytical procedures Other information Identified risks of material misstatements due to fraud

12. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 12 Learning Objective 4 What does the latest research tell us?????

13. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 13 Research 1.Auditors are typically good at FR assessment 2.Auditors could use NFMs to better assess FR 3.Auditors typically bad at responding to FR – testing 4. Brainstorming (???) is “good”, Group Support Systems may improve bstorming, and bstorming improves “nature” reaction – let’s bstorm about potential “nature” reactions.

14. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 14 A/P - More reliable expectations, more detailed level Confirmations - Add sales agreement info or have oral discussions with customers CAATs – search for unusual entries, names, related parties Inquiry - Talk to nonfinancial personnel More physical observation / external evidence vs. tracing to IT/system data FV – specialist estimate and compare vs. auditing mgt’s estimate Changing Nature

15. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 15 Tell me about the avg bstorm session Partner/CFE led (60%), not all members (27%), fraud specialist (31%-only led 4/56), IT/Tax (69/63%), hierarchical participation, use of checklist (72%), held late (35%), no wrap-up in PY (84%), average total time (1.5 hours), more than one session (50%).

16. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 16 Partner/CFE led (60%), not all members (27%), fraud specialist (31%-only led 4/56), IT/Tax (69/63%), hierarchical participation, use of checklist (72%), held late (35%), no wrap-up in PY (84%), average total time (1.5 hours), more than one session (50%). Distribution of Bstorming Quality

17. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 17 Distribution of FR Assessments

18. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 18 Does Bstorming Quality Matter?? FR FactorsFRAssessment FR Responses Brainstorming Quality Best practices – ptr led, IT auditor present, held early, MC, PC, Discussion of FR factors and responses

19. ©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens//Elder/Beasley 11 - 19 Other Findings from Research 1. Red Flags – Insiders on BOD, High Accruals, Stock Options (evidence is mixed), highly leveraged, younger Companies, M&A activity, and Rev Growth 2. Investors hold SEC and External auditors most accountable for detecting fraud 3. Auditor litigation all about overstated Rev and Assets fraudulent financial reporting 4. Fraud Experiences – 1989: avg.5 frauds for career 2007: avg 71% at least one, 21% at least 2, why?