Chapter 9

Auditing for Fraud

Fraud & Auditor Responsibilities:
Historical Evolution
"The detection of material fraud is a reasonable expectation of
users of audited financial statements. Society needs and
expects assurance that financial information has not been
material misstated because of fraud. Unless an independent
audit can provide this assurance, it has little if any value to
society"
This statement by the Public Companies Accounting Oversight
Board represents a dramatic change in auditors'
responsibility for detecting fraudulent financial reporting
Previously, AICPA auditing standards required auditors to plan
and perform an audit to provide reasonable assurance of
detecting material misstatements, including those caused
by fraud
Today, the message is clear: auditors must assume greater
responsibility for detecting fraud
 Comment on the Magnitude of
Fraud
According to a 2002 study by the Association
of Certified Fraud Examiners (ACFE)--
 Six percent of revenues will be lost as a
result of fraud
 Estimated at losses of $600 Billion per year
These estimates cover all types of fraud, but do
not include the losses investors incurred on
major financial reporting frauds such as
Enron or WorldCom
 Costs of Fraud
The 10 Largest Bankruptcies 1980 - Present*

Company Bankruptcy Date Assets in Billions

Worldcom, Inc. 2002 $104
Enron Corp. 2001 $63
Conseco, Inc. 2002 $61
Texaco, Inc. 1987 $36
Financial Corp. of America 1988 $34
Refco Inc. 2005 $33
Global Crossing Ltd. 2002 $30
Pacific Gas and Electric Co. 2001 $30
Calpine Corporation 2005 $27
UAL Corp. 2002 $25

* Source – BankruptcyData.com

Five of the Ten Largest U.S. Bankruptcies since 1980 had significant
financial and reporting frauds
 Define Fraud
Intentional concealment or
misrepresentation of material facts in
order to deceive
Differentiated from errors by the intent to
deceive
Traditionally defined into broad
categories:
Defalcations (misappropriate of assets)
Fraudulent financial reporting
 What is defalcation?
Employee takes assets from the organization for
personal gain
Examples: theft, embezzlement
ACFE divides into frauds due to
 Corruption
 Fraudsters use their influence in a transaction to gain
personal benefit
 Examples: kickbacks, conflict of interest, bribery, economic
extortion
 Asset misappropriation
 Theft or misuse of organization's assets
 Common schemes: skimming revenues, cash schemes,
fraudulent disbursement, inventory theft, payroll fraud
Defalcation may create misleading financial statements
if stolen assets are reported on the statements
 Define Fraudulent Financial
Reporting
Intentional manipulation of financial statements
Typically committed by management
 Has opportunity to override internal controls
 Often evaluated and compensated based on financial results
Usually involves:
 Manipulation, falsification, or alteration of accounting
records or supporting documents
 Misrepresentation or omission of events, transactions, or
significant information
 Intentional misapplication of accounting principles
The most common types are
 Overstate assets and understate expenses
 Overstate revenues and assets
 Understate liabilities
 Review Lessons Learned From
Fraud Cases
Auditors take risk whenever they do not audit the
entire company
 Auditors need to look at economic assumptions
underlying a company’s growth
 Auditors need to assess risk factors and when the
risk of fraud is high, they must demand stronger
evidence
 Computer errors should be viewed as a risk factor
 Dominant clients can be a problem
 Auditors need to know what motivates management
 Auditors should not assume all people are honest
 When fraud risk indicators are discovered, they must
be thoroughly investigated
 Discuss the Second COSO
Report
Report of the Committee of Sponsoring
Organizations of the Treadway Commission
(COSO) identified major characteristics of
companies that had perpetrated fraud:
 Involved smaller companies - under $200
million in revenues
 Board of directors dominated by
management
 Audit committees non-existent or inactive
 Overstated revenues and corresponding
assets in over half the frauds
 Most revenue frauds involved premature
recognition or fictitious revenues
 Discuss the Second COSO
Report (Continued)
 No internal audit department
 Perpetrated over relatively long-terms
(average period 2 years)
 Companies were in loss situations or near
break-even prior to the fraud
 CEO and /or CFO involved in 83% of the
cases
Auditors realized there are signs that fraud
might be taking place and that auditors
would have to identify and investigate these
signs
 Review Auditing Standards on
Fraud
SAS 99, "Fraud Detection in a Financial
Statement Audit" issued in 2002
 Requires auditors to search for risk factors
related to fraud
 If these risk factors are present, auditor
needs to modify audit to
 Actively search for fraud
 Require more substantive audit evidence
 In some cases, assign forensic (fraud) auditors to
the engagement
 Emphasizes the need for professional
skepticism
 Review a Proactive Approach to
Fraud Detection - Planning the Audit
The audit must be planned to detect material
misstatements - whether the misstatements are due
to errors or fraud
The auditor must
 Understand the business
 Understand how changes in the economy might
affect the business
 Understand management's motivations for
committing a fraud
 Identify opportunities for other employees to commit
defalcation
 Analyze changes in company's financial results for
reasonableness
 Identify areas that might suggest fraud
Discuss Proactive Approach to Fraud
Detection - Conducting the Audit
Overview of the process to integrate fraud risk
assessment and fraud procedures into the audit
includes ten major steps:
 Understand the nature of fraud, motivations to
commit fraud, and how fraud may be committed
 Develop and implement an approach based on
professional skepticism
 Brainstorm and share knowledge within the audit
team
 Obtain information useful in identifying and
assessing fraud risk
 Identify specific fraud risks and areas likely to be
affected by fraud
Discuss Proactive Approach to Fraud
Detection - Conducting the Audit
 Evaluate the quality and effectiveness of
company controls in mitigating the risk of
fraud
 Adjust audit procedures to address the risk
of fraud and gather evidence specifically
related to the possibility of fraud
 Evaluate findings; if evidence signals fraud
might exist, consider whether specialists are
needed for the audit team
 Communicate possibility of fraud to
management and audit committee
 Document all steps related to fraud
 What are the motivations to
commit fraud?
Research consistently shows three
factors associated with fraud
These factors are referred to as the fraud
triangle
Incentives or pressures to commit
fraud
Opportunities to commit fraud
Rationalization of the fraud as
acceptable
 Review Motivations to Commit
Fraud – Incentives or Pressures
The pressures to commit fraud include:
Management compensation schemes
Personal wealth ties to financial results
or survival of the company
Other financial pressures to improve
earnings or the balance sheet
Example: to avoid violating debt covenant
Personal factors, including personal
financial needs
 Discuss Motivations to Commit
Fraud – Opportunities
Warning signs indicating opportunities for fraud:
 Weak or non-existent internal controls (no segregation of
duties)
 Complex or unstable organizational structure
 Ineffective monitoring of management, either because board of
directors is not effective, or management is dominant
 Significant accounting estimates made by management
 Significant related party transactions
 Industry dominance, including ability to dictate terms to
suppliers or customers
 Simple transactions made complex through disjointed
recording process
 Complex or difficult to understand transactions
 Management controlled by small number of individuals or a
single member of management/owner
 Comment on Motivations to
Commit Fraud – Rationalizations
The nature of fraud rationalization often differs
depending on the type of fraud
For defalcations, rationalizations often revolve around
personal issues:
 Personal financial problems
 Mistreatment by the company
 Sense of entitlement
 Everyone does it
For fraudulent financial reporting, the rationalizations
may involve personal or organizational issues:
 Compensation based on financial results (personal)
 Ego (personal)
 Necessary for organization to survive
 What is the purpose of audit
team brainstorming?
SAS 99 requires members of the audit team to discuss the risk
of material misstatement due to fraud
This brainstorming is designed to:
 Allow experienced auditors to educate less experienced
auditors
 Set the proper level of professional skepticism for the audit
Topics covered during the brainstorming should include:
 Consider how fraud can be perpetrated and concealed
 Presume fraud in revenue recognition
 Consider incentives, opportunities, and rationalization for
fraud
 Consider industry conditions
 Consider operating characteristics and financial stability
 Audit Procedures
When there is a possibility of fraud, the auditor should
consider that evidence might not be what it seems
SAS 99 suggests the auditor consider the following:
 Greater susceptibility of evidence manipulation
 Greater skepticism of management responses
 Journal entries are important
 New technology provides new ways to commit fraud
 Recognition that collusion may be likely
 Predictability of audit procedures
 Analytical procedures should tie to operational or
industry data
 Obtaining Information about
Fraud Risk
The auditor should specify procedures that
could signal the possibility of fraud including
 Making inquires of management and others
to obtain their views about the risk and fraud
and controls set up to address those risks
 Perform analytical procedures and consider
any unusual relationships
 Review risk factors identified earlier
(pressure, opportunity, rationalization)
 Review management responses to
recommendations for control improvements
and internal audit reports
 What are some analytical
indicators of fraud risk?
Some of the key analytical factors the auditor should
develop include:
 Large revenue increase at the end of the period
 Sales increasing faster than industry sales which
don't seem justified
 Unusually large increase in gross margin
 Large number of sales returns after year-end
 Increase in number of day's sales in receivables
 Increase in number of day's sales in inventory
 Significant increase in debt/equity ratio
 Cash flow or liquidity problems
 Significant changes in non-financial performance
measures
 Identifying Risks of Fraud
The auditor should examine each of the fraud risk
conditions - pressure, opportunity, rationalization
During this examination, the auditor should consider
 The type of fraud that might occur
 The potential significance of the fraud in both
quantitative and qualitative terms
 The likelihood of fraud occurring
 The pervasiveness of the risk that fraud might occur
SAS 99 requires the auditor presume there are risks
with revenue recognition and management override
of internal controls
Relate Internal Control and Fraud
Risk
Internal control weaknesses are a strong indicator of
fraud risk
The auditor will examine a variety of control areas
including:
 Corporate governance
 Management control and influence
 Audit committee
 Corporate culture
 Internal auditing
 Monitoring controls
 Whistle blowing
 Codes of ethics
 Related party transactions
Developing a Revised Audit Plan
Auditor should develop hypotheses about how fraud
could be committed and concealed
The audit team should then develop and implement
audit procedures that are directly responsive to the
fraud risks
Depending on the hypothesized fraud risks the auditor
may change the
 Audit procedures in order to gather additional
corroborative and/or direct evidence
 Timing of audit procedures
 Staffing of the engagement to include more
experience auditors or specialists
Developing a Revised Audit Plan
(Continued)
 Extent of audit procedures; examples include:
 Performing procedures on a surprise or
unannounced basis
 Requiring inventories be counted and observed at
year-end (instead of at an interim date)
 Making oral inquiries of major customers and
suppliers
 Performing analytics using disaggregated data
 Examining details of major sales contracts
 Examining financial viability of customers
 Examining, in detail, reciprocal or similar
transactions between two entities
 Detailed examination of journal entries,
particularly those at year-end
 Discuss Evaluating Audit
Evidence
The auditor's skepticism should be
heightened whenever
There are discrepancies in the
accounting records
The auditor finds conflicting or missing
evidential matter
The relationship with management is
strained
There are significant or unusual
transactions around year-end
 Review Communicating the
Existence of Fraud
Fraud should be communicated to a level at
which effective action can be taken
 The auditor must communicate the existence
of fraud to management, the Board (or its
equivalent), and the audit committee
 If fraud involves top management, the
auditor must assess the actions taken by the
Board
 If sufficient actions are not taken, the auditor
must consider the control environment and
the possible need to resign the engagement
 Review Communicating the
Existence of Fraud
The auditor must determine that the financial
statements have been corrected and the
fraud adequately disclosed
 If the statements are not corrected, the
auditor should issue a qualified or adverse
opinion
In some cases, the auditor may be required to
report the fraud to outside parties, such as to
meet regulatory requirements
For public companies, material fraud reflects a
weakness in internal controls and may need
be reported
 Comment on Audit
Documentation
The audit team should document the full extent
of the process described
That documentation should include:
 Discussion among audit team members
including the assessment of fraud risk and
how such frauds might take place
 Discussion of the factors that affected the
risk assessment
 Audit procedures performed
 Need for corroborating evidence
 Evaluation of audit evidence and
communication to required parties
 Discuss Characteristics of
Financial Reporting Frauds
Historically, there are patterns in financial reporting frauds:
 Complex revenue recognition schemes
 Incorrect billings to the government
 Holding the books open (accelerated revenue
recognition)
 Capitalizing expenses
The implications for audit procedures is clear:
 The auditor must understand complex transactions to
determine their economic substance
 The auditor cannot be pressured to complete the audit
early; there must be sufficient time to examine year-end
transactions
 The auditor must use necessary procedures to gather
sufficient reliable evidence including
 What are the characteristics of
defalcations?
ACFE reports 90% of defalcations involve thefts of
cash; remaining 10% were thefts of inventory and
other assets
Cash misappropriation schemes include:
 Larceny: stealing cash after it has been recorded on
the books
 Skimming: stealing cash before it is recorded on the
books
 Fraudulent disbursements
 Most common: 70% of defalcation schemes
 Billing: set up false vendors and pay for fictitious goods
 Payroll: add fictitious employees to payroll
 Expense reimbursement: submit overstated reimbursement
requests
 Check tampering: alter check, e.g. change payee or amount
 Audit Procedures & Evidence
Considerations
The procedures used by the auditor should reflect the internal
control weaknesses and fraud risk indicators found with the
client
Linking Audit Procedures to Control Deficiencies
 Audit procedures used are based on specific control
deficiencies
 Linkage process from control deficiencies to audit procedures:
 What errors or fraud could occur because of the control
deficiencies
 What account balances would be affected and how
 What audit procedures would provide evidence on whether the
account balance is misstated
 Do the audit procedures provide objective evidence independent
of the parties who have access to the assets
 Examples listed in Exhibit 8.11
Review Linking Audit Procedures to
Fraud Risk Indicators
As with control deficiencies, audit procedures will
depend on the fraud risk indicators and auditor's
preliminary analytical review of account balances
Existence of fraud risk indicators should cause the
auditor to
 Expand audit testing to more detailed sampling
 Review all major sales and other transactions
 Place more emphasis on independent outside
evidence
 Perform more procedures at year-end (instead of
interim testing)
 Examples listed in Exhibits 8.12 and 8.13
 Discuss Using Computers to
Analyze the Possibility of Fraud
Audit software can read a file and perform a number of
procedures to analyze the possibility of fraud:
 Test mechanical accuracy: footing, mathematical
extensions, and logical relationships
 Statistical selection
 Search for duplicate entries
 Analyze unusual patterns in data
 Analysis of logical relationships among data sets
 Identify unusual sources of entries to an account
 Search for missing data
 Responsibilities for Detecting
and Reporting Illegal Acts
Illegal acts are violations of laws or
governmental regulations...by management
or employees acting on behalf of the entity
(AU 317.02)
Illegal acts often have a direct impact on
financial statements
Audit must be designed to identify illegal acts
that have a direct, material effect on the
financial statements; audit procedures
include:
 Reading corporate minutes
 Inquiries of management and legal counsel
Responsibilities for Detecting and
Reporting Illegal Acts (continued)
 Tests of details to support transactions or account
balances
 Large payments to consultants or employees for
unspecified services
 Excessively large sales commissions
 Unexplained governmental payments
 Unauthorized or unnecessarily complex transactions
If illegal acts are discovered, the auditor should
 Consult with the client's legal counsel
 Report the acts to management and the audit
committee
 Make the financial statements present fairly
including proper disclosure
 Define Forensic Accounting
Forensic accounting is an extension of auditing, but
with a number of differences:
 Detailed investigation where fraud has been
identified or is suspected
 Focuses on identifying perpetrators and getting a
confession
 Builds support for legal action against the
perpetrator
 May provide litigation support such as expert
testimony
 Extensive use of interviews
 100% examination of fraud-related documents
 Reconstruction of account balances
 Broader scope than auditing