Chapter 8: Risk of Fraud & Illegal Acts

Question 1

What are the three ways fraudulent financial reporting can be accomplished?

Answer 1

• Manipulating, falsifying, or altering accounting records or supporting documents from which the financial statements are prepared.
• Misrepresenting, or intentionally omitting from, the financial statements events, transactions, or other significant information.
• Intentionally misapplying accounting principles relating to amounts, classification, manner of presentation, or disclosure.

Question 2

What four elements characterize an act of occupational fraud?

Answer 2

Four elements seem to characterize the incidence of occupational fraud. Such an act:
■ Is clandestine (that is, secretive and suspicious).
■ Violates the perpetrator’s fiduciary duties to the victim organization.
■ Is committed for the purpose of direct or indirect financial benefit to the perpetrator.
■ Costs the employing organization assets, revenues, or reserves

Question 3

What are the three elements that may be called the “root causes of fraud”?

Answer 3

• perceived opportunity
• perceived pressure or incentive
• rationalization

Question 4

What are the five key principles for managing fraud risk?

Answer 4

The five key principles are:
■ Establish a fraud risk management policy.
■ Perform a comprehensive fraud risk assessment.
■ Select, develop, and deploy preventive and detective fraud control activities.
■ Establish a fraud reporting process and a coordinated approach to investigation and corrective
action.
■ Manage the fraud risk management process, report results, and improve the process.

Question 5

What are the three key steps in a fraud risk assessment?

Answer 5

The three key steps in a fraud risk assessment are:

1. Brainstorming and fraud risk identification.
2. Assessment of fraud risk likelihood and impact.
3. Based on risk prioritization, developing a fraud risk response.

Question 6

Predication is a technical term that refers to:

a. The ability of internal auditors to predict fraud successfully.
b. The ability of a fraud examiner to commence an investigation if a form of evidence exists that fraud has occurred.
c. The activities of fraud perpetrators in concealing their tracks so that fraud is covered up and may not be discovered.
d. Management’s analysis of fraud risks so they can put in place effective anti-fraud programs and controls.

Answer 6

B is the best answer. Predication, sometimes called “credication,” refers to the existence of reason to
believe that the allegation of fraud has a strong enough basis to require the formal launching of an
investigation. Fraud examiners would not typically consent to commencing an investigation without
predication (per the ACFE).

Question 7

What fraud schemes were reported to be most common in the ACFE’s 2016 Report to the Nations?

a. Corruption.
b. Fraudulent billing.
c. Misappropriation of assets by employees.
d. Inappropriately reporting revenues in published financial results.

Answer 7

C is the best answer. The 2016 Report to the Nations identified asset misappropriations, which
occurred in 83 percent of all cases and resulted in a median loss of $125,000, as the most common
fraud scheme

Question 8

Which of the following is not a typical “rationalization” of a fraud perpetrator?

a. It’s in the organization’s best interest.
b. The company owes me because I’m underpaid.
c. I want to get back at my boss (revenge).
d. I’m smarter than the rest of them.

Answer 8

D is the best answer. While fraud perpetrators may feel they are smarter than most others, this is not a
rationalization for committing fraud. Each of the others is considered a rationalization for fraud.

Question 9

Which of the following is not something all levels of employees should do?

a. Understand their role within the internal control framework.
b. Have a basic understanding of fraud and be aware of the red flags.
c. Report suspicions of incidences of fraud.
d. Investigate suspicious activities that they believe may be fraudulent.

Answer 9

D is the best answer. The Fraud Guide cites the first three as responsibilities of all employees. Investigating suspicious activities should be conducted by those who are properly trained to do so.

Question 10

An organization that manufactures and sells computers is trying to boost sales between now and the end of the year. It decides to offer its sales representatives a bonus based on the number of units they deliver to customers before the end of the year. The price of all computers is determined by the vice president of sales and cannot be changed by sales representatives. Which of the following presents the greatest reason a sales representative may commit fraud with this incentive program?

a. Sales representative may sell units that have a lower margin than other units.
b. Customers have the right to return a laptop for up to 90 days after purchase.
c. The units delivered may be defective.
d. The customers may not pay for the computers timely.

Answer 10

B is the best answer. In this situation, a sales representative may deliver more units than the customer wants, and tell them they can return the units up to 90 days later. This may allow the sales representative to inflate his or her bonus. The other three answers also may be concerns for the company, but they are business risks and not necessarily fraud risks.

Question 11

How should an organization handle an anonymous accusation from an employee that a supervisor in the organization has manipulated time reports?

a. Assign a staff internal auditor to review all time reports for the past six months in the supervisor’s area.
b. Make a record of the accusation but do nothing, as anonymous accusations are typically not true.
c. Assess the facts provided by the anonymous party against pre-established criteria to determine whether a formal investigation is warranted.
d. Turn the issue over to the HR department because this type of anonymous accusation is usually just a human resource issue.

Answer 11

C is the best answer. Before conducting an investigation, it is best to understand all of the available facts against relevant criteria to determine whether an investigation, or some other form of follow-up, is warranted. Even if an investigation is warranted, a staff internal auditor probably does not have the experience to provide the support necessary to take action. Doing nothing is not acceptable as the accusations may be true, and lack of responsiveness sends a negative message to the organization about the tone at the top. The human resources department may need to be involved at some point, but it does not have the experience to assess whether this accusation justifies an investigation

Question 12

Which of the following is an example of misappropriation of assets?

a. A small amount of petty cash is stolen.
b. A journal entry is modified to improve reported financial results.
c. A foreign official is bribed by the chief operating officer (COO) to facilitate approval of a new product.
d. A duplicate bill is sent to a customer in hopes that they will pay it twice.

Answer 12

A is the best answer. Regardless of the amount, any asset of the organization that is directed for a use
other than what was intended is a misappropriation of assets. The other answers may represent fraud,
but they do not represent a misappropriation of assets.

Question 13

Which of the following is not an example of a fraud prevention program element?

a. Background investigations of new employees.
b. Exit interviews of departing employees.
c. Establishing authority limits related to purchasing commitments.
d. Analyzing cash disbursements to determine whether any duplicate payments have been made.

Answer 13

B is the best answer. The other answers represent elements that can play an important role in prevent-ing fraud, while answer B would be considered a detective control.

Question 14

Which of the following types of companies would most likely need the strongest anti-fraud controls?

a. A manufacturer of popular athletic shoes.
b. A grocery store.
c. A bank.
d. An internet-based electronics retailer.

Answer 14

C is the best answer. While all of these organizations are vulnerable to fraud, banks deal in cash, which is valuable to almost all individuals and subject to potentially the largest losses from fraud. Instructors may want to take the opportunity to discuss other outcomes of fraud, such as inadequate protection of customers’ privacy. While C is still the best answer, it will provide students with greater insights into how one must consider the assets involved, the value of the assets, and the potential amounts that can be misappropriated.

Question 15

A payroll clerk increased the hourly pay rate of a friend and shared the resulting overpayment with the friend. Which of the following controls would have best served to prevent this fraud?

a. Requiring that all changes to pay records be recorded on a standard form.
b. Limiting the ability to make changes in payroll system personnel information to authorized HR department supervisors.
c. Periodically reconciling pay rates per personnel records with those of the payroll system.
d. Monitoring payroll costs by department supervisors monthly.

Answer 15

B is the best answer. Such a control would serve to prevent an unauthorized change to critical payroll data, such as the pay rate. Some students may question why C is not an acceptable answer. This control may help detect unauthorized changes, but it will not prevent such changes. A and D are valid payroll controls, but they would not prevent unauthorized changes.

Question 16

The internal audit function’s responsibilities with respect to fraud are limited to:

a. The organization’s operational and compliance activities only because financial reporting matters are the responsibility of the independent outside auditor.
b. Monitoring any calls received through the organization’s whistleblower hotline but not necessarily conducting a follow-up investigation.
c. Being aware of fraud indicators, including those relating to financial reporting fraud, but not necessarily possessing the expertise of a fraud investigation specialist.
d. Ensuring that all employees have received adequate fraud awareness training.

Answer 16

C is the best answer. This description of the internal auditor’s responsibilities is consistent with The IIA’s International Standards for the Professional Practice of Internal Auditing. For instance, IIA Standard 1210.A2 states, “Internal auditors must have sufficient knowledge to evaluate the risk of fraud and the manner in which it is managed by the organization, but are not expected to have the expertise of a person whose primary responsibility is detecting and investigating fraud.”

Question 17

From an organization’s standpoint, because internal auditors are seen to be “internal control experts,” they also are:

a. Fraud risk management process owners, and hence, the first and most important line of defense against fraudulent financial reporting or asset misappropriation.
b. The best resource for audit committees, management, and others to consult in-house when setting up anti-fraud programs and controls, even if they may not have any fraud investigation experience.
c. The best candidates to lead an investigation of a fraud incident involving the potential violation of laws and regulations.
d. The primary decision-maker in terms of determining punishment or other consequences for fraud perpetrators.

Answer 17

B is the best answer. The internal audit function is viewed as in-house “internal control experts” and should be consulted by senior management and the audit committee about the design and implemen-tation of effective anti-fraud programs and controls. Management owns the fraud risk management process and is the most important line of defense against fraud. The legal function would be the best lead for an investigation of fraud involving potential violation of laws and regulations. Determining punishment is a role of management, not the internal audit function.

Question 18

According to research in personality psychology, the three “dark triad personalities” do not mention:

a. Sociopaths.
b. Psychopaths.
c. Narcissists.
d. Machiavellians.

Answer 18

A is the best answer. The other answers are mentioned as “dark triad personalities.”

Question 19

The 17 principles in the updated COSO 2013 Internal Control – Integrated Framework include one devoted specifically to addressing fraud risk:

a. True.
b. False.

Answer 19

A is the best answer. The 17 principles in the updated COSO 2013 Internal Control - Integrated Frame-work include one principle devoted specifically to addressing fraud risk.

Question 20

The Cressey Fraud Triangle does not include, as one of its vertices:

a. Pressure.
b. Opportunity.
c. Rationalization.
d. Fraudster personality.

Answer 20

D is the best answer. The three vertices of the Cressey Fraud Triangle are pressure, opportunity, and rationalization.