Detecting Fraud Flashcards
Fraud
An intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception that results in a misstatement in the financial statements.
Fraud Risk Factors
Events or conditions that indicate (a) an incentive or pressure to perpetrate fraud; (b) provide an opportunity to commit fraud; or (c) indicate attitudes or rationalizations to justify a fraudulent action.
There are two different types of misstatements that are relevant to the auditor’s consideration of fraud:
1) Fraudulent Financial Reporting
2) Misappropriation of assets
Fraudulent Financial Reporting
This type of fraud involves misstatements that are intended to deceive financial statement users (e.g., the intent is to inflate the entity’s stock price). Fraudulent financial reporting often involves management override of controls, recording fictitious journal entries, concealing facts, and altering underlying records to achieve the deception. This scenario is typically associated with a conspiracy involving multiple members of senior management to deceive the auditors, as well as financial statement users.
Misappropriation of assets
This type of fraud involves theft of assets causing the financial statements to be misstated owing to false entries intended to conceal the theft. Misappropriation of assets often involves embezzlement of receipts, stealing physical assets or intellectual property, and diverting the entity’s assets for personal use. This scenario is typically associated with an individual bad actor operating individually to perpetrate and conceal the theft.
The Auditor’s Basic Responsibility Relates to Planning
In general, the auditor is required to design (plan) the audit to provide “reasonable assurance” of detecting misstatements that are material to the financial statements. In particular, the auditor should specifically assess the risk of material misstatement due to fraud (in addition to error), and design the audit procedures to be responsive to that risk assessment. That risk assessment should be performed at both the financial statement level and the assertion level.
Inquiry and Analytical Procedures
To obtain information needed to identify the risks of material fraud the auditor emphasizes “inquiry” and “analytical procedures.” (The auditor’s important inquiries should be documented in the Management Representations Letter at the end of fieldwork!)
Inquiry
The auditor should question management personnel about their knowledge of fraud, suspected fraud, or allegations of fraud; inquire about specific controls that management has implemented to mitigate fraud risks; and inquire about management’s communications with those charged with governance about fraud-related issues. The auditor may also choose to question others (e.g., audit committee, internal auditors, operating personnel, in-house legal counsel, etc.) about fraud-related issues.
Analytical Procedures
The auditor should perform analytical procedures involving revenue accounts, in particular. In general, the auditor should consider whether any unexpected results associated with analytical procedures might have been intentional.
Fraud Risk Factors
The auditing standards identify three characteristics generally associated with fraud: (1) incentive/pressure; (2) opportunity; and (3) attitude/rationalization. These three categories of risk factors are sometimes referred to as the fraud triangle.
Incentive/pressure
Reasons that management might be motivated to commit fraudulent financial reporting.
Opportunities
Circumstances that might give management a way to commit fraudulent financial reporting.
Attitude/rationalization
Attitudes, behaviors, or justifications of management that might be associated with fraudulent financial reporting:
1) Lack of commitment to establishing and enforcing ethical standards
2) Previous violations of securities laws (or other regulations)
3) Excessive focus by management on the entity’s stock price
4) Management’s failure to correct reportable conditions
5) Pattern of justifying inappropriate accounting as immaterial
6) Management has a strained relationship with the predecessor or current auditor
Misappropriation of Assets—Example risk factors the auditor should consider:
1) Incentive/pressure—An employee or member of management might be motivated to commit the misappropriation for a variety of reasons, such as the following: employees who have access to cash (or other assets susceptible to theft), may have personal financial problems, or they may have adverse relationships with the entity under audit, (perhaps in response to anticipated future layoffs or recent decreases to their benefits or compensation levels).
2) Opportunities—Circumstances that might give someone a way to commit the misappropriation include the following:
a. When assets are inherently vulnerable to theft— For example, there are large amounts of liquid assets on hand, or inventory items are small, but valuable.
b. Inadequate internal control over assets— For example, there is inadequate segregation separation of duties, inadequate documentation or reconciliation for assets, or inadequate management understanding related to information technology.
3) Attitudes/rationalizations—The individual perpetrating the misappropriation might possess attitudes or justifications that might be associated with that rationalize the improper behaviors and avoid any feelings of remorse for this misconduct. Generally, the auditor cannot normally observe these attitudes, but should consider the implications of such matters when they are discovered.
What assurance does the auditor provide that errors, irregularities (fraud), and direct effect illegal acts that are material to the financial statements will be detected?
The auditor is required to plan the audit to provide REASONABLE assurance that errors, fraud, and direct effect illegal acts, which materially misstate the financial statements, will be detected.
