1. Copyright © 2007 Pearson Education Canada 1 Chapter 10: Fraud Auditing

2. Copyright © 2007 Pearson Education Canada 10-2 Chapter 10 objectives  What are two different types of fraud and when are they most likely to exist?  What is the auditor’s responsibility with respect to fraud?  How do good corporate governance and control environment practices reduce fraud risks?  What should an auditor do when there are identified fraud risks?

3. Copyright © 2007 Pearson Education Canada 10-3 What is fraud?  Fraud is a broad legal concept  In the context of auditing: an intentional misrepresentation of a fact in the books of accounts and in the financial statements  Two types: – Fraudulent financial reporting – Misappropriation of assets

4. Copyright © 2007 Pearson Education Canada 10-4 Fraudulent financial reporting (usually perpetrated by management)  This is the intentional misstatement or omission of amounts or disclosure in financial statements to deceive users  Earnings management: The purpose of the misstatement is to help management achieve earnings targets (e.g. to obtain higher bonuses)  Income smoothing: Revenues and expenses are shifted across accounting periods to reduce fluctuations in earnings

5. Copyright © 2007 Pearson Education Canada 10-5 Misappropriation of assets  Fraud that involves theft of an entity’s assets  Usually perpetrated at lower levels of the organization’s hierarchy, i.e. by non- management employees

6. Copyright © 2007 Pearson Education Canada 10-6 Conditions for fraud

7. Copyright © 2007 Pearson Education Canada 10-7 Risk factors for fraudulent financial reporting  Provide examples of the following risk factors for fraudulent financial reporting based upon the fraud triangle: – Incentives – Opportunities – Attitudes/rationalizations

8. Copyright © 2007 Pearson Education Canada 10-8 Risk factors for misappropriation of assets  Provide examples of the following risk factors for misappropriation of assets based upon the fraud triangle: – Incentives – Opportunities – Attitudes/rationalizations

9. Copyright © 2007 Pearson Education Canada 10-9 The auditor needs to maintain ‘‘professional skepticism ’’  Professional skepticism is needed as the auditor gathers information during the audit  Professional skepticism means ‘‘staying alert for evidence that contradicts or brings into question the reliability of documents or management’’  Two components: questioning mind and critical evaluation of audit evidence

10. Copyright © 2007 Pearson Education Canada 10-10 Sources of information gathered to assess fraud risks

11. Copyright © 2007 Pearson Education Canada 10-11 How corporate governance oversight reduces fraud risks  Creates and maintains a culture of honesty and high ethics  Evaluates fraud risks and implements programs and controls to mitigate identified fraud risks  Develops an appropriate fraud oversight process

12. Copyright © 2007 Pearson Education Canada 10-12 Creating and maintaining a culture of honesty and high ethics  Setting the tone at the top (management behaviours demonstrating honesty and integrity) are an example to employees  Creation of a positive workplace environment (improved employee morale reduces the likelihood of employee fraud)  Hiring and promoting appropriate employees (effective screening policies to reduce the likelihood of hiring and promoting individuals with low levels of honesty)

13. Copyright © 2007 Pearson Education Canada 10-13 Creating and maintaining a culture of honesty and high ethics (cont’d)  Training (about company’s expectations of employees’ ethical conduct)  Confirmation (annually of responsibilities for complying with the code of conduct; see Table 10-3 for example elements for a code of conduct)  Discipline (employees held accountable for failing to follow the company’s code of conduct)  Other declarations (e.g. confidentiality policy, independence policy, electronic communications and computer software policies)

14. Copyright © 2007 Pearson Education Canada 10-14 Management’s responsibility to evaluate risks of fraud  Identifying and measuring fraud risks: – Realize that almost any employee is capable of committing a dishonest act under the right circumstances – Assess fraud risks and establish corporate governance programs and controls to prevent, deter, and detect fraud – Conduct a fraud risk assessment (perhaps with assistance of internal audit department)

15. Copyright © 2007 Pearson Education Canada 10-15 Management’s responsibility to evaluate risks of fraud (cont’d)  Mitigating fraud risks: – Design and implement programs and controls to mitigate fraud risks – Change business activities and processes prone to fraud in order to reduce incentives and opportunities

16. Copyright © 2007 Pearson Education Canada 10-16 Management’s responsibility to evaluate risks of fraud (cont’d)  Monitoring fraud prevention programs and controls: – For high fraud risk areas, periodically evaluate whether antifraud programs and controls have been implemented and are operating effectively – Internal audit activities can both detect and deter fraud

17. Copyright © 2007 Pearson Education Canada 10-17 Audit committee oversight  Audit committee has primary responsibility to overseen the organization’s financial reporting and internal control procedures  Needs to consider the potential for management override  Audit committee may need to investigate financial reporting issues

18. Copyright © 2007 Pearson Education Canada 10-18 Auditor’s responses to the risk of fraud  1. Change the overall conduct of the audit to respond to identified fraud risks – Assign more experienced personnel to the audit (or a forensic specialist) – Carefully consider management’s choices of accounting principles – Incorporate unpredictability into the audit plan – Gather information from an increased number of sources

19. Copyright © 2007 Pearson Education Canada 10-19 Auditor’s responses to the risk of fraud (cont’d)  2. Design and perform audit procedures to address fraud risks: – Depend upon the type of fraud risk factors or conditions identified, the account balance, class of transactions, or assertions affected – Procedures tend to be corroborative – May involve examining all of the transactions in a class rather than just a sample

20. Copyright © 2007 Pearson Education Canada 10-20 Auditor’s responses to the risk of fraud (cont’d)  3. Design and perform procedures to address management override of controls – This risk exists in almost all audits and GAAS requires three specific procedures: – (1) Examine journal entries and adjustments for evidence of possible misstatements due to fraud – (2) Review accounting estimates for biases – (3) Evaluate the business rationale for significant unusual transactions

21. Copyright © 2007 Pearson Education Canada 10-21 Practice problem 10-29 (pp. 312-13)  Assessment of fraud risk factors and compliance with GAAS during the conduct of an audit

22. Copyright © 2007 Pearson Education Canada 10-22 Ongoing risk assessment requires auditor alertness  During fieldwork, the auditor should be alert for: – Discrepancies in the accounting records – Conflicting or missing evidence – Problematic or unusual relationship between the auditor and management – Other issues, e.g. accounting policies inconsistent with industry norms

23. Copyright © 2007 Pearson Education Canada 10-23 Revenue and accounts receivable fraud risks  Fraudulent financial reporting: revenue can be overstated by: – Fictitious revenues – Premature revenue recognition – Manipulation of adjustments to revenues  Potential detection methods: – Analytical revenue (overstatement of gross margin, lower accounts receivable turnover) – Documentation discrepancies

24. Copyright © 2007 Pearson Education Canada 10-24 Revenue and accounts receivable fraud risks (cont’d)  Misappropriation of assets could occur by means of taking revenue receipts by: – Failing to record a sale – Stealing cash after the sale is recorded  Potential detection methods: – Careful review of sales returns or allowances, of customer write-offs, and matching of payments to sales amounts (to detect lapping)

25. Copyright © 2007 Pearson Education Canada 10-25 Practice question 10-25 (p. 311)  Examine a situation with respect to theft of cash  How could the theft have been prevented?

26. Copyright © 2007 Pearson Education Canada 10-26 Inventory fraud risks:  Fraudulent financial reporting: inventory can be overstated by: – Including fictitious inventory – Deliberate pricing errors (increasing inventory)  Potential detection methods: – Analytical review (understatement of cost of goods sold and overstatement of gross margin)

27. Copyright © 2007 Pearson Education Canada 10-27 Purchases and accounts payable fraud risks  Fraudulent financial reporting: accounts payable can be understated by: – Not recording accounts payable until the subsequent period – Recording fictitious reductions to accounts payable  Potential detection methods: – Review of subsequent transactions – Tracing transactions to supporting documentation

28. Copyright © 2007 Pearson Education Canada 10-28 Purchases and accounts payable fraud risks (cont’d)  Misappropriation of assets could occur by means of: – Payments to fictitious vendors for goods not received – Kickbacks or other illegal arrangements with suppliers  Potential detection methods: – Review supporting receiving documentation – Examine supplier approval process

29. Copyright © 2007 Pearson Education Canada 10-29 Practice problem 10-26 (p. 311)  Duplicate payments for an accounts payable account  How could this theft have been detected or prevented?

30. Copyright © 2007 Pearson Education Canada 10-30 Auditor responsibilities when fraud is suspected or detected  Conduct audit procedures to confirm or dispel  Inform the appropriate level of management (above the suspected level of fraud); inform audit committee when management fraud is suspected