Chapter 2 [The Auditor’s Responsibilities Regarding Fraud and Mechanisms to Address Fraud: Regulation and Corporate Governance]

Question 1

A fraud that involves the theft or misuse of an organization’s assets. Common examples include skimming cash, stealing inventory, and payroll fraud.

Answer 1

Asset misappropriation

Question 2

A subcommittee of the board of directors responsible for
monitoring audit activities and serving as a surrogate for the interests of shareholders; it should be composed of outside members of the board, that is, members who are independent of the organization.

Answer 2

Audit committee

Question 3

The major representative of stockholders to help ensure
that the organization is run according to the organization’s charter and that there is proper accountability.

Answer 3

Board of directors

Question 4

A joint initiative among five private-sector organizations to combat corporate fraud by guiding executive management and those involved in governance in terms of business ethics, internal control, enterprise risk management, fraud, and financial reporting.

Answer 4

Committee of Sponsoring Organizations of the Treadway Commission

Question 5

A one-year period of time during which registered accounting firms may not perform audits whose CEO, CFO, controller, chief accounting officer or other equivalent position was employed by the accounting firm.

Answer 5

Cooling-off period

Question 6

A process by which the owners and creditors of an
organization exert control and require accountability for the resources entrusted to the organization. The owners (stockholders) elect a board of directors to provide oversight of the organization’s activities and accountability to stakeholders.

Answer 6

Corporate governance

Question 7

Each of the parties with responsibilities in terms of corporate governance has complementary roles and specific responsibilities; no one party is completely responsible.

Answer 7

Corporate governance mosaic

Question 8

The independent, private-sector, not-for-profit organization that establishes financial accounting and reporting standards for public and private companies and not-for-profit organizations that follow Generally Accepted Accounting Principles (GAAP).

Answer 8

Financial Accounting Standards Board (FASB)

Question 9

The intentional manipulation of reported financial results to misstate the economic condition of the organization.

Answer 9

Fraudulent financial reporting

Question 10

An intentional act involving the use of deception that results in a material misstatement of the financial statements.

Answer 10

Fraud

Question 11

A formal discussion among the audit engagement team members about the possibility of fraud, including a fraud risk assessment.

Answer 11

Fraud brainstorming

Question 12

A model that recognizes that incentives, opportunities, and
rationalization are elements typically associated with fraud.

Answer 12

Fraud triangle

Question 13

_____ refers to generally accepted accounting principles for financial reporting. Throughout the book we recognize that the criteria may be developed by either the FASB or the
IASB. _____ has general acceptance and provides criteria by which to assess the fairness of a financial statement presentation.

Answer 13

Generally Accepted Accounting Principles (GAAP)

Question 14

The underlying reason for a fraudster to commit fraud.

Answer 14

Incentive

Question 15

An independent, private-sector body that develops and approves International Financial Reporting Standards (IFRSs). The _____ was formed in 2001 and replaced the International Accounting Standards Committee.

Answer 15

International Accounting Standards Board (IASB)

Question 16

A set of accounting standards developed by an independent, not-for-profit organization called the International Accounting Standards Board (IASB).

Answer 16

International Financial Reporting Standards (IFRS)

Question 17

The internal control weakness that enables the fraudster to commit and conceal the fraud.

Answer 17

Opportunity

Question 18

This type of fraud occurs when the deposits of current investors are used to pay returns on the deposits of previous investors; no real investment is happening.

Answer 18

Ponzi scheme

Question 19

An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.

Answer 19

Professional skepticism

Question 20

The mental process that fraudsters employ to ‘live with themselves’ as they try to convince themselves that what they are doing is not wrong or is in some way justifiable.

Answer 20

Rationalization

Question 21

Risk factors suggesting a heightened risk of fraud.

Answer 21

Red flags

Question 22

Broad legislation mandating new standard setting for audits of public companies and new standards for corporate governance.

Answer 22

Sarbanes-Oaxley Act of 2002

Question 23

Anyone who is influenced, either directly or indirectly, by the actions of a company; ________________ extend beyond the shareholders of a company

Answer 23

Stakeholders

Question 24

These are adjusting journal entries that are not automatically recorded using the company’s book-keeping software; rather, these entries are manually entered by an individual outside of the regular course of producing the financial statements.

Answer 24

Top-side journal entries

Question 25

The Great Salad Oil Swindle of 1963 is an asset misappropriation fraud.

T or F?

Answer 25

FALSE

Question 26

The Koss Corporation fraud is a fraudulent financial reporting fraud.

T or F?

Answer 26

FALSE

Question 27

What is the primary difference between fraud and error in financial statement reporting?

a. The materiality of the misstatement.
b. The intent to deceive.
c. The level of management involved.
d. The type of transaction effected.

Answer 27

B

Question 28

Which of the following examples best represents an example of fraudulent financial reporting?

a. The transfer agent issues 40,000 shares of the
company’s stock to a friend without authorization by the board of directors.
b. The controller of the company inappropriately records January sales in December so that year-end results will meet analysts’ expectations.
c. The in-house attorney receives payments from the French government for negotiating the development of a new plant in Paris.
d. The accounts receivable clerk covers up the theft of cash receipts by writing off older receivables without authorization.

Answer 28

D

Question 29

The three elements of the fraud triangle include incentive, opportunity, and rationalization.

T or F?

Answer 29

TRUE

Question 30

Management compensation schemes that heavily emphasize stock-based compensation primarily affect the opportunity to commit fraud.

T or F?

Answer 30

FALSE

Question 31

Which of the following factors creates an opportunity for fraud to be committed in an organization?

a. Management demands financial success.
b. Poor internal control.
c. Commitments tied to debt covenants.
d. Management is aggressive in its application of
accounting rules.

Answer 31

B

Question 32

Which of the following is a common rationalization for fraudulent financial reporting?

a. This is a one-time transaction and it will allow the company to get through the current financial crisis, but I’ll never do it again.
b. I am only borrowing the money; I will pay it back next year.
c. Executives at other companies are getting paid more than I am, so I deserve the money.
d. The accounting rules don’t make sense for our company, and they make our financial results look weaker than is necessary. Therefore, we have good reason to record revenue using a non-GAAP method.
e. Both (a) and (d).

Answer 32

E

Question 33

In the Enron fraud, one of the ways that management covered up the fraud was to shift debt off the balance sheet to SPEs.

T or F?

Answer 33

TRUE

Question 34

Professional skepticism related to detecting possible fraud involves the validation of information through probing questions, critical assessment of evidence, and attention to inconsistencies.

T or F?

Answer 34

TRUE

Question 35

Which of the following types of transactions did WorldCom management engage in as part of that company’s fraudulent financial reporting scheme?
a. Recorded barter transactions as sales.
b. Used restructuring reserves from prior acquisitions to decrease expenses.
c. Capitalizing line costs rather than expensing them.
d. All of the above.
e. None of the above.

Answer 35

D

Question 36

Which of the following is an implication resulting from the results of the COSO studies?

a. The most common frauds involve outright theft of assets.
b. The individuals most often responsible for fraud include low-level accounting personnel, such as accounts payable clerks.
c. The majority of frauds take place at smaller companies listed on the OTC market rather than at larger companies listed on the NYSE.
d. All of the above.
e. None of the above.

Answer 36

C

Question 37

Which of the following statements is true regarding the deterrence and detection of fraud in financial reporting?

a. Preventing and detecting fraud is the job of the external auditor alone.
b. An effective fraud risk management program can be expected to prevent virtually all frauds, especially those perpetrated by top management.
c. Communication among those involved in the financial reporting process is critical.
d. All of the above.
e. None of the above.

Answer 37

C

Question 38

Which of the following statements is true?

a. Unless an independent audit can provide reasonable assurance that financial information has not been materially misstated because of fraud, it has little, if any, value to society.
b. Repeated revelations of accounting scandals and audit failures related to undetected frauds have seriously damaged public confidence in external auditors.
c. A strong ethical tone at the top of an organization that permeates corporate culture is essential in mitigating the risk of fraud.
d. All of the above.
e. None of the above.

Answer 38

D

Question 39

The AICPA wrote the Sarbanes-Oxley Act of 2002 to address problems revealed in frauds that were committed in the late 1980s.

T or F?

Answer 39

FALSE

Question 40

An important change resulting from the Sarbanes-Oxley Act is that auditors are no longer allowed to provide most consulting services for their public company audit clients.

Answer 40

TRUE

Question 41

The Sarbanes-Oxley Act enacted which of the following provisions relevant to auditors and the audit opinion formulation process?

a. The PCAOB was established, and it has the power to conduct inspections of public company audits.
b. The lead audit partner and reviewing partner must rotate off the audit of a publicly traded company at least every 10 years.
c. In the annual report, management must acknowledge that they are required to have the company’s internal audit function attest to the accuracy of the annual reports.
d. All of the above.
e. None of the above.

Answer 41

A

Question 42

Which of the following statements is true regarding the PCAOB?

a. The PCAOB is a nonprofit corporation, not an agency of the U.S. government.
b. The PCAOB will have five financially literate members who are prominent individuals of integrity and reputation with a commitment to the interests of investors
and the public.
c. The PCAOB has authority to set standards related to public company audit reports and to conduct inspections of registered external audit firms.
d. All of the above.
e. None of the above.

Answer 42

D

Question 43

Corporate governance is the process by which the owners and creditors of an organization exert control over and require accountability for the resources entrusted to the organization.

T or F?

Answer 43

TRUE

Question 44

The term corporate governance mosaic refers to the fact that each of the parties involved in corporate governance has complementary roles and specific responsibilities; no one party is completely responsible.

Answer 44

TRUE

Question 45

Audit committee activities and responsibilities include which of the following?

a. Selecting the external audit firm.
b. Approving corporate strategy.
c. Reviewing management performance and determining compensation.
d. All of the above.
e. None of the above.

Answer 45

A

Question 46

Which of the following audit committee responsibilities has the NYSE mandated?

a. Obtaining a report each year by the internal auditor that addresses the company’s internal control procedures, any quality-control or regulatory problems,
and any relationships that might threaten the independence of the internal auditor.
b. Discussing in its meetings the company’s earnings press releases as well as financial information and earnings guidance provided to analysts.
c. Reviewing with the internal auditor any audit
problems or difficulties that they have had with
management.
d. All of the above.
e. None of the above.

Answer 46

B