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Fraud Auditing

Chapter 11

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Learning Objective 1
Define fraud and distinguish
between fraudulent financial
reporting and misappropriation
of assets.

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Types of Fraud

Fraudulent financial reporting

Misappropriation of assets

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Learning Objective 2
Describe the fraud triangle and
identify conditions for fraud.

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The Fraud Triangle

Incentives/Pressures

Opportunities Attitudes/Rationalization

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Examples of Risk Factors
for Fraudulent Reporting
Incentives/Pressures:
Financial stability or profitability is threatened by
economic, industry, or entity operating conditions

Excessive pressure exists for management to


meet debt requirements

Personal net worth is materially threatened

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Examples of Risk Factors
for Fraudulent Reporting
Opportunities:
There are significant accounting estimates that
are difficult to verify

There is ineffective oversight over financial


reporting

High turnover or ineffective accounting, internal


audit, or information technology staff exists

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Examples of Risk Factors
for Fraudulent Reporting
Attitudes/Rationalization:
Inappropriate or inefficient communication
and support of the entitys values is evident

A history of violations of laws is known

Management has a practice of making


overly aggressive or unrealistic forecasts

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Examples of Risk Factors
for Misappropriation of Assets
Incentives/Pressures:
Personal financial obligations create pressure
to misappropriate assets

Adverse relationships between management


and employees motivate employees to
misappropriate assets

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Examples of Risk Factors
for Misappropriation of Assets
Opportunities:
There is a presence of large amounts of cash
on hand or inventory items

There is an inadequate internal control over


assets

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Examples of Risk Factors
for Misappropriation of Assets
Attitudes/Rationalization:
Disregard for the need to monitor or reduce
risk of misappropriating assets exists

There is a disregard for internal controls

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Learning Objective 3
Understand the auditors
responsibility for assessing
the risk of fraud and detecting
material misstatements due to
fraud.

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Assessing the Risk of Fraud

SAS 99 provides guidance to auditors


in assessing the risk of fraud.

SAS 1 states that, in exercising professional


skepticism, an auditor neither assumes that
management is dishonest nor assumes
unquestioned honesty.

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Sources of Information Gathered
to Assess Fraud Risks
Communication Inquiries of Risk Analytical Other
among audit team management factors procedures information

Identified risks of material misstatements due to fraud

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Documenting Fraud
Assessment
Discussion
Procedures
Specific risks
Reasons
Other conditions and analytical relationships
Nature of communications

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Learning Objective 4
Identify corporate governance
and other control environment
factors that reduce fraud risks.

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Corporate Governance Oversight
to Reduce Fraud Risks
1. Culture of honesty and high ethics

2. Management's responsibility
to evaluate risks of fraud

3. Audit committee oversight

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Example Elements for a Code
of Conduct
Organizational code of conduct

General employee conduct

Conflicts of interest

Outside activities, employment, and directorships

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Example Elements for a Code
of Conduct
Relationships with clients and suppliers

Gifts, entertainment, and favors

Kickbacks and secret commissions

Organization funds and other assets

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Example Elements for a Code
of Conduct
Organization records and communications

Dealing with outside people and organizations

Prompt communications

Privacy and confidentiality

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Organizational Factors
Contributing to Risk of Fraud
Collusion between 48
employees and 31
third parties 33
Inadequate 39
internal 58
controls 59
Management 31
override of 36
internal controls 36

2003 1998 1994


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Organizational Factors
Contributing to Risk of Fraud
Collusion between 15
employees and 19
management 23
Lack of control 12
over management 11
by directors 6
Ineffective or 10
nonexistent ethics or 8
compliance program 7

2003 1998 1994


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Learning Objective 5
Develop responses to identified
fraud risks.

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Responding to the Risk of Fraud

Change the overall conduct of the audit


to respond to identified fraud risks.

Design and perform audit procedures


to address identified risks.

Design and perform procedures to


address the risk of management
override of controls.

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Learning Objective 6
Recognize specific fraud risk
areas and develop procedures
to detect fraud.

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Initial Detection Method for Million Dollar
Schemes
42.3%
Tip
46.2%
22.8%
By Accident
Type of Detection

20.0%
18.6%
Internal Audit
19.4%

Internal Controls 16.7% $1,000,000+


23.3%
15.8% All Cases
External Audit
9.1%
6.0%
Notified By Police
3.2%

0% 10% 20% 30% 40% 50%


Note: The sum of percentages in this chart exceeds 100 percent because in some cases respondents identified more than one detection method.
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Specific Fraud Risk Areas

Revenue and accounts receivable fraud risks

Inventory fraud risks

Purchases and accounts payable fraud risks

Other areas of fraud risk

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Learning Objective 7
Understand interview techniques
and other activities after fraud
is suspected.

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Responding to Misstatements That
May Be the Result of Fraud

When fraud is suspected, the auditor gathers


additional information to determine whether
fraud actually exists.

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Types of Inquiry Techniques

Informational inquiry

Assessment inquiry

Interrogative inquiry

Evaluating responses

Listening techniques

Observing behavioral cues

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End of Chapter 11

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