Fraud Risk Factors

Question 1

Factors

Answer 1

ISA 240 outlines three key fraud risk factors that can lead to misstatements arising from fraudulent financial reporting and misappropriation of assets:

1. Incentive or Pressure to Commit Fraud:
   
   • Example: Management might be under pressure to meet unrealistic earnings targets to trigger bonuses or avoid breaching loan covenants. This pressure can come from both internal and external sources.
2. Opportunity to Commit Fraud:
   
   • Example: An individual might perceive an opportunity to commit fraud if they believe they can override internal controls due to their position of trust or knowledge of specific control weaknesses.
3. Rationalisation for Committing Fraud:
   
   • Example: An individual might rationalize fraudulent behavior if they feel wronged or entitled. For instance, someone who didn’t receive a bonus they expected might justify theft as taking what they believe is owed to them.

Scenario 1: Incentive or Pressure
- Situation: A company’s CEO is under pressure to meet quarterly earnings targets to maintain the company’s stock price.
- Fraudulent Action: The CEO instructs the accounting department to recognize revenue prematurely by recording sales that have not yet been completed.
- Outcome: This leads to an overstatement of revenue and earnings in the financial statements.

Scenario 2: Opportunity
- Situation: A trusted employee in the finance department has access to both the company’s bank accounts and the accounting records.
- Fraudulent Action: The employee exploits this access to transfer funds to a personal account and manipulates the records to conceal the theft.
- Outcome: This results in a misappropriation of assets and inaccurate financial statements.

Scenario 3: Rationalisation
- Situation: An employee feels they are underpaid and believes they deserve more compensation.
- Fraudulent Action: The employee starts submitting false expense reports to claim reimbursement for non-existent expenses.
- Outcome: This leads to fraudulent financial reporting and a loss of company funds.

Auditors need to be vigilant in identifying these fraud risk factors during their audit procedures. This includes:
- Assessing Incentives and Pressures: Understanding the financial and non-financial pressures on management and employees.
- Evaluating Opportunities: Reviewing the effectiveness of internal controls and identifying any weaknesses that could be exploited.
- Understanding Rationalisations: Being aware of attitudes and behaviors that might indicate a propensity to commit fraud.

By recognizing these risk factors, auditors can better design their audit procedures to detect and prevent fraud, ensuring the integrity of the financial statements. If you have any further questions or need more detailed examples, feel free to ask!