Rationalisation

Question 1

Attitude

Answer 1

ISA 240 identifies various risk factors that can lead to misstatements arising from fraudulent financial reporting and misappropriation of assets. These risk factors can be categorized into opportunities, incentives/pressures, and rationalizations.

Opportunities:
- Ineffective Communication of Ethical Standards: Management’s failure to effectively communicate, implement, support, or enforce the entity’s values or ethical standards.
- Example: Management does not emphasize the importance of ethical behavior, leading to a culture where fraud is more likely to occur.

• Nonfinancial Management’s Involvement: Excessive participation by nonfinancial management in selecting accounting policies or determining significant estimates.
  
  • Example: A marketing manager influencing revenue recognition policies to meet sales targets.
• Excessive Interest in Stock Price: Management’s excessive interest in maintaining or increasing the entity’s stock price or earnings trend.
  
  • Example: Management manipulating financial results to meet market expectations.
• Aggressive Forecasts: Management committing to analysts, creditors, or other third parties to achieve aggressive or unrealistic forecasts.
  
  • Example: Promising unrealistic sales growth to secure financing.
• Failure to Remedy Control Deficiencies: Management failing to address known significant deficiencies in internal control on a timely basis.
  
  • Example: Ignoring repeated audit findings about control weaknesses.
• Low Morale Among Senior Management: Low morale can lead to unethical behavior as a way to cope with dissatisfaction.
  
  • Example: Senior managers engaging in fraudulent activities due to frustration with their compensation or job security.
• No Distinction Between Personal and Business Transactions: Owner-managers not distinguishing between personal and business transactions.
  
  • Example: Using company funds for personal expenses.
• Justifying Inappropriate Accounting: Management justifying marginal or inappropriate accounting practices based on materiality.
  
  • Example: Recording small fraudulent transactions, assuming they won’t be detected.
• Strained Auditor Relationships: Frequent disputes with the current or predecessor auditor.
  
  • Example: Management frequently arguing with auditors over accounting treatments.

Opportunities:
- Disregard for Monitoring or Reducing Risk: Management’s disregard for the need to monitor or reduce the risk of asset misappropriation.
- Example: Not implementing controls to prevent theft.

• Overriding Internal Controls: Management overriding existing controls or failing to take appropriate remedial action on known deficiencies.
  
  • Example: A manager bypassing approval processes to misappropriate funds.
• Employee Dissatisfaction: Behavior indicating displeasure or dissatisfaction with the entity or its treatment of the employee.
  
  • Example: An employee stealing from the company due to perceived unfair treatment.
• Changes in Behavior or Lifestyle: Changes that may indicate assets have been misappropriated.
  
  • Example: An employee suddenly living beyond their means.
• Tolerance of Petty Theft: Allowing small thefts to go unpunished, which can lead to larger frauds.
  
  • Example: Ignoring minor thefts of office supplies.

Scenario 1: Fraudulent Financial Reporting
- Situation: A company faces declining margins and engages in significant related party transactions to inflate revenue.
- Fraudulent Action: Management records fictitious sales to a related party.
- Outcome: Financial statements are misstated, misleading investors.

Scenario 2: Misappropriation of Assets
- Situation: An employee in the warehouse has access to high-value inventory items.
- Fraudulent Action: The employee steals small, high-value items and sells them.
- Outcome: The company suffers inventory losses, and internal controls are compromised.

By understanding these risk factors, auditors can better identify and assess the risks of material misstatement due to fraud, ensuring a thorough and effective audit process. If you have any further questions or need more detailed examples, feel free to ask!