1. Fraud in Financial Statements and Auditor Responsibilities
Chapter 5
Fraud in Financial Statements
and Auditor Responsibilities

2. Questions for Consideration
What are the red flags that are indicators that fraud may exist?
What is the difference between an error, a fraud, and an illegal act and related audit responsibilities?
What the auditor’s responsibilities to detect and report fraud?
What is the role of internal controls and risk assessment in preventing and detecting fraud?

3. What is an Audit?
Audit, an examination of company prepared financial statements in accordance with GAAP
Independent opinion rendered on the examination
SEC requires all public companies to have an audit
PCAOB establishes audit standards for independent auditors and ethics standards for companies listed on stock exchanges
AICPA issues auditing standards for private companies

4. Expectations Gap
Difference between what the public and users of financial statements and accounting profession perceive as the responsibilities of auditors and the purpose of an audit
Investing public perceive audits should detect material misstatements due to error and fraud
Accounting profession perceive that audit provides only reasonable assurance that financial statements are free of all types of material misstatements
Closing the Gap
Management Integrity/Honesty
Organizational Culture
Audit Risks

5. Fraudulent Financial Reporting
Involves either intentional misstatements or omissions of amounts or disclosures in order to deceive financial statement users
Deception – manipulation, falsification or alteration of accounting records or supporting documents
Misrepresentation in, or intentional omission of, events, transactions, or other significant information
Intentional misapplication of accounting principles

6. Nature and Causes of Misstatements
The auditor has responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud or illegal acts.
Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance.

7. Error, Fraud & Illegal Acts
Innocent mistake in math or application of GAAP
Innocent mistake in omission of information
Fraud
Deliberate decision made to deceive others
Fraudulent financial reporting
Misappropriation of assets
Illegal Acts
Violations of laws or regulations
Bribery

8. Procedures upon Discovery of Illegal Acts
Assess the impact of the acts on the financial statements
Consult with legal counsel and other specialists
Report the acts to audit committee
Consider client’s remedial actions
Disciplinary actions
Controls to safeguard against recurrence
Reporting effects of the acts
Consider withdrawing from engagement

9. Private Securities Litigation Reform Act (PSLRA)
Additional requirements upon public companies and their auditors when
The illegal act has a material effect on financial statements
Senior management and board of directors have not taken appropriate remedial action
Failure to take remedial action may warrant departure from a standard audit report (or resignation of auditors)
When illegal act has material effect on the financial statements
Auditors must report act to the client
Client must inform Board of Directors which has one day to inform the SEC
If client does not inform the SEC
Auditors must furnish the report to the SEC within one day
Or resign from the engagement

10. Auditors Responsibilities for Fraud Prevention, Detection, and Reporting
First line of defense against fraud
Effective system of internal controls
Independent internal audit function
Fraud assessment
Internal auditors should have direct and unrestricted access to the audit committee
Description and Characteristics of Fraud
Management Fraud
Misstatements arising from fraudulent financial reporting
Defalcations
Misappropriation of assets

11. Fraud Triangle INCENTIVES/PRESSURES TO COMMIT FRAUD Self-serving
Pressures to meet financial numbers
Financial distress
Personal Problems
OPPORTUNITY
Employees who have access to assets such as cash and inventory
Internal controls to help safeguard assets
Segregation of duties
Reconciliations
Backdating stock options
RATIONALIZATION
Explain away actions as acceptable
Perpetrators are often in denial
It’s a one-time event
A good person may get caught up in the fraud
Rationalization
Company had to make numbers
Fear losing job
I’m entitled since I’m underpaid

12. Tyco: A Case of Corporate Greed
Lavish parties
Decorating NY apartment
Company “loans” to avoid paying taxes
Failed corporate governance
PwC partner On Tyco issued cease and desist order
Failed to follow GAAS
Violated antifraud provisions of securities law

13. Fraud Risk Assessment
Approach each engagement with a healthy dose of skepticism
Identify risk of material misstatement due to fraud
Make inquiries of management and others
Consider any unusual or unexpected relationships: analytical procedures during planning
Consider whether fraud risk factors exist
Consider other information
Consider management override of controls
Consider improper revenue recognition

14. Fraud Risk Assessment
Evaluation of evidence about the potential client before accepting engagement
Communication with predecessor auditor
Reasons for firing or the reasons for no longer servicing client
Management’s integrity
Disagreement with management over accounting principles
Make inquiries about the risks of fraud and how they are addressed
Consider any unusual or unexpected relationships
Consider whether one or more fraud risk factors exist
Consider other information

15. Fraud Considerations in the Audit
Description and characteristics of fraud
Importance of exercising professional skepticism
Discussion among engagement personnel regarding the risks of material misstatement due to fraud
Obtaining the information needed to identify risks of material misstatements due to fraud
Identifying risks that may result in a material misstatement due to fraud
Assessing the identified risks after taking into account an evaluation of the entity’s programs and controls
Responding to the results of the assessment
Evaluating audit evidence
Communicating about fraud to management, the audit commitment, and others
Documenting the auditor’s consideration of fraud

16. Rite Aid Fraud
Improper adjusting entries to reduce cost of goods sold and accounts payable
Management failed to devise and maintain a system of internal controls
KPMG, auditors
Noted failure of management to have internal control system

17. Communications about Possible Fraud
If fraud may exist that causes a material misstatement of financial statements
Brought to the attention of appropriate level of management
Reported even if matter might be considered inconsequential
Whether caused by management or other employees
Reported directly through governance structure
Consider whether fraud has internal control implications

18. Management Representations and Financial Statement Certifications
Management responsible for preventing and detecting fraud
Management can override internal controls and create deceptive accounting
Management representation letters from CEO, CFO, and other appropriate officers (SOX requirements)
Provided access to all known information bearing on fair presentation of financial statements
Confirms that management has performed an assessment of effectiveness of internal control over financial reporting
Concludes that effective internal controls have been maintained
Discloses any deficiencies in the design or operation of internal controls

19. The Contents of the Audit Report
Title – Independent; addressed to BOD/stockholders
Introductory Paragraph – identifies entity, financial statements, time period
Management’s Responsibility
Preparation and fair presentation of financial statements
Design, implementation and maintenance of internal controls
Auditor’s Responsibility
Express an opinion based upon audit
Procedures to obtain evidence
Auditor’s judgment and risk assessments
Consideration of internal controls
Audit evidence is sufficient and appropriate as basis for opinion
Opinion – link to “present fairly” and conformity to GAAP
Optional Paragraph: Report on Other Legal and Regulatory Requirement
Signature, date, auditor’s city and state

20. Unmodified Audit Opinions
Unmodified (clean or standard opinion)
Financial statements “present fairly”
Financial position
Results of operations
Cash flows
Stockholders’ Equity
Optional paragraph
Emphasis-of-matter
Going concern
Consistent application of accounting principles
Litigation uncertainty
Other-matter
Supplemental information

21. Modified Audit Opinions
Modifies the audit when: explain type of modification and why
Based upon evidence financial statements are materially misstated, or
Unable to obtain sufficient appropriate evidence
Qualified
Concludes misstatements, individually or in the aggregate, are material but not pervasive to the financial statements, or
Unable to obtain sufficient appropriate audit evidence but possible effect on financial statements could be material but not pervasive
Adverse
Concludes that misstatements, individually or in the aggregate, are material and pervasive
Disclaimer
Unable to gather sufficient evidence to warrant the expression of an opinion on the statements as a whole
Basis for Modifications
Separate paragraph describe smatter giving rise to modification
Place immediately before the opinion paragraph
Titled “Basis for (Qualified, Adverse, Disclaimer) Opinion

22. Generally Accepted Auditing Standards (GAAS)
AICPA Auditing Standards Board
Privately owned businesses
Public Company Accounting Oversight Board (PCAOB)
Establishes auditing standards for public companies
Required standards, not generally accepted
Establishes independence rules
Establishes quality control standards for registered CPA firms
Conducts peer review for registered firms

23. GAAS General Standards Adequate technical training and proficiency
Independence in mental attitude
Due care in the performance of the audit and preparation of the report
Standards of Field Work
Adequately plan the audit work and supervise assistants
Obtain a sufficient understanding of internal control to adequately plan the audit and determine the nature, timing, and extent of tests to be performed
Gather sufficient competent evidential matter to provide a basis for an opinion
Standards of Reporting
The statements have been in conformity with GAAP
Accounting principles have been consistently applied
Adequate informative disclosures have been made
Expression of an opinion on statements taken as a whole, or indication that an opinion cannot be expressed

24. Auditing Evidence
Consideration of the competency and sufficiency of evidence
Management representations are not a substitution for application of audit procedures
Audit risk and materiality considered together
Determination of nature, timing and extent of procedures
Evaluation of results of procedures
Assess risks of material misstatements due to fraud
Application of professional skepticism
Audit procedures – specific acts performed to gather evidence about specific assertions

25. Limitations of the Audit Report
Reasonable Assurance
Due care
Relation of independence and client relationships
Not an absolute guarantee
Followed GAAS, gathering sufficient competent evidential matter
Failure to follow GAAS: allegation of negligence

26. Limitations of the Audit Report
Materiality
Magnitude of an omission or misstatement of accounting information that the judgment of reasonable person relying on the information would have been changed or influenced by the omission or misstatement
Judging Materiality
May not rely solely on a quantitative threshold as a “rule of thumb” to determine materiality
5% is a common materiality test
Unintended consequence of materiality is that it is subject to manipulation
Full analysis of all relevant considerations including qualitative ones
Consideration of risk of fraud

27. Limitations of the Audit Report
Present Fairly
Auditor’s assessment of fair presentation depends on whether
Accounting principles used have general acceptance
Accounting principles are appropriate
Financial statements are informative
Information presented is classified and summarized in a reasonable manner
Financial statements reflect the underlying transactions and events in a manner that is consistent with materiality and reflects economic substance

28. COSO Internal Control – Integrated Framework
Broadens the definition of internal control and the parties that affect it by linking sound controls to the actions of the BOD, management and other personnel
Identifies five interrelated components of internal control
Control environment Risk assessment
Control activities Information systems
Monitoring of controls

29. Internal Control – Integrated Framework
Internal control as a process
Effected by board of directors, management, and other personnel
Designed to provide reasonable assurance
Effectiveness and efficiency of operations
Reliability of financial reporting
Compliance with laws and regulations

30. COSO Findings in Fraudulent Financial Reporting: 1998 -2007
347 alleged cases of public company fraudulent financial reporting
CEO and/or CFO some level involvement in 89% of the fraud cases
Most common fraud technique
Improper revenue recognition (60%)
Overstatement of existing assets
Capitalization of expenses
60% of fraud firms changed auditors during fraud period

31. Enterprise Risk Management – Integrated Framework
Internal control enhanced with corporate governance and risk management
Aligning risk appetite and strategy
Enhancing risk response decisions
Reducing operational surprises and losses
Identifying and managing multiple and cross-enterprise risks
Seizing opportunities
Improving deployment of capital

32. PCAOB’s Integrated Audit Concept
Integrated audit combines an audit of internal control over financial reporting with the audit of the financial statements
Objectives of the two audits are achieved simultaneously through a single coordinated process
Can help to improve the quality and integrity of both audits

33. PCAOB Standards
Auditing Std No. 4 – audit of whether previously reported material weakness no longer exists
Auditing Std No. 5 – audit of assessment of effectiveness of internal control over financial reporting
Auditing Std No. 6 – auditor’s evaluation of the consistency of the financial statements

34. PCAOB Standards
Auditing Std No. 8 – consideration of audit risk in an audit of financial statement as a part of an integrated audit including internal controls
Auditing Std No. 9 – requirements regarding planning an audit, including assessing matters, appropriate audit strategy, and audit plan
Auditing Std No. 10 –requirements for the supervision of the audit engagement

35. PCAOB Standards
Auditing Std No. 11 – consideration of materiality in planning and performing an audit
Auditing Std No. 12 – requirements regarding the process of identifying and assessing risks of material misstatement of the financial statements
Auditing Std No. 13 – requirement for responding to risks of material misstatements in financial statements

36. PCAOB Standards
Auditing Std No. 14 – requirements regarding the auditor’s evaluation of audit results and determination of whether the auditor has obtained sufficient appropriate audit evidence
Auditing Std No. 15 – requirements for designing and performing audit procedures to obtain sufficient appropriate audit evidence to support the opinion expressed in the auditor’s report

37. Communication with Audit Committees
Auditing Std No. 16 – requirements of communications with audit committees
Understanding of the audit engagement
Significant accounting policies and practices
Critical accounting policies and practices
Critical accounting estimates
Significant unusual transactions

38. Auditing Quality of Financial Reporting
Difficult or contentious matters
Going concern
Uncorrected and corrected misstatements
Departure from standard report
Disagreements with management
Difficulties encountered in performing audit
Form and documentation of communication

39. Restatements of Financial Statements
Downward trend since 2006 peak year
Improved reliability of ICFR implementations
Relaxed approach adopted by SEC
Materiality
Need to file restatements
Drop in severity of restatements
Smaller cut out of profits

40. Causes behind Restatements
Complexity of accounting standards and/or transactions
Weak financial governance and controls
Increased auditor and audit committee conservatism
Broad application of materiality
Earnings management driven by pressure to make the numbers
Lack of transparency
Fraud