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Chapter 2 The Risk of Fraud and Mechanisms to Address Fraud: Regulation, Corporate Governance, and Audit Quality. Learning Objectives. Define the various types of fraud that affect organizations Define the fraud triangle and describe the three elements of the fraud triangle

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Chapter 2The Risk of Fraud and Mechanisms to Address Fraud: Regulation, Corporate Governance, and Audit Quality

learning objectives
Learning Objectives
  • Define the various types of fraud that affect organizations
  • Define the fraud triangle and describe the three elements of the fraud triangle
  • Describe implications for auditors of recent fraudulent financial reporting cases and the third COSO report on fraud
  • Discuss auditors’ fraud-related responsibilities and users’ related expectations
learning objectives1
Learning Objectives
  • Explain how various requirements in the Sarbanes–Oxley Act of 2002 are designed to help prevent the types frauds perpetrated in the late 1990s and early 2000s
  • Define corporate governance, identify the parties involved, and describe their respective activities
professional judgment in context examples of fraud in organizations
Professional Judgment in Context - Examples of Fraud in Organizations
  • Fraudulent financial reporting can involve:
    • Embezzlement of funds by higher-level management
    • Diversion of funds by creating a separate account
    • Inaccurate financial reporting
    • Presentation of financial related reports that are not a formal part of financial statements
professional judgment in context examples of fraud in organizations1
Professional Judgment in Context - Examples of Fraud in Organizations
  • What are the major types of fraud? What are the major characteristics of fraud that auditors should consider? (LO 1, 2)
  • To what extent should the auditor be responsible for identifying the risk of fraud, and then determining whether material fraud actually exists? How can a quality audit prevent or detect these types of frauds? (LO 4)
professional judgment in context examples of fraud in organizations2
Professional Judgment in Context - Examples of Fraud in Organizations
  • How can society as a whole, and the external auditing profession in particular, act to prevent and detect fraud? (LO 4, 5, 6)
  • What is corporate governance, and how can effective corporate governance prevent these types of frauds? (LO 6)
  • An intentional act involving use of deception that results in a material misstatement of financial statements
  • Two types of misstatements
    • Misappropriation of assets
    • Fraudulent financial reporting
  • Different from errors
    • Errors occur unintentionally
asset misappropriation
Asset Misappropriation
  • Involves theft or misuse of organization’s assets
  • Examples
    • Skimming cash
    • Stealing inventory
    • Payroll fraud
  • A dominant fraud scheme perpetrated against small businesses
    • Perpetrators commonly being employees
asset misappropriation1
Asset Misappropriation

Commonly occurs when employees

Manipulate accounts to cover up cash thefts

Manipulate cash disbursements through fake companies

Steal inventory or other assets and manipulate financial records

fraudulent financial reporting
Fraudulent Financial Reporting
  • The intentional manipulation of reported financial results to misstate the economic condition of the organization
  • Common ways
    • Manipulation, falsification, or alteration of accounting records or supporting documents
    • Misrepresentation or omission of events or transactions
    • Misapplication of accounting principles
incentives or pressures to commit fraud
Incentives or Pressures to Commit Fraud
  • Management compensation schemes
  • Financial pressures for improved earnings or an improved balance sheet
  • Debt covenants
  • Pending retirement or stock option expirations
  • Personal wealth tied to either financial results or survival of company
  • Greed
incentives or pressures to commit fraud1
Incentives or Pressures to Commit Fraud
  • Personal factors
  • Pressure from family, friends, or culture
  • Addictions to gambling or drugs
opportunities to commit fraud
Opportunities to Commit Fraud
  • Significant related-party transactions
  • Company’s industry position
  • Management’s inconsistency involving subjective judgments
  • Complex transactions
  • Complex or difficult to understand transactions
  • Ineffective monitoring of management by the board
  • Complex or unstable organizational structure
  • Weak or nonexistent internal controls
rationalizing the fraud
Rationalizing the Fraud
  • Rationalization involves reconciling unlawful or unethical behavior
  • Rationalization for fraudulent financial reporting
    • “Saving” a company
  • Rationalization for asset misappropriation
    • Mistreatment by the company
    • Sense of entitlement by the individual perpetrating the fraud
Learning Objective 3Describe Implications for Auditors of Recent Fraudulent Financial Reporting Cases and the Third COSO Report on Fraud
implications to keep in mind when conducting an audit
Implications to Keep in Mind when Conducting an Audit
  • Pressure created for top management by the analyst following and earnings expectations
  • Before completing an audit, sufficient time should be allowed to examine major year-end transactions:
    • Especially if there are potential problems with revenue
  • Understanding complex transaction to determine:
    • Their economic substance
    • The parties that have economic obligations
implications to keep in mind when conducting an audit1
Implications to Keep in Mind when Conducting an Audit
  • Understanding and analyzing weaknesses in an organization’s internal controls
    • To determine where and how a fraud may take place
  • Developing audit procedures to address specific opportunities for fraud to take place
auditing in practice professional skepticism
Auditing in Practice - Professional Skepticism
  • Center for Audit Quality (CAQ) describes professional skepticism as follows in its 2010 report on fraud
    • Skepticism involves the validation of information through probing questions, critical assessment of evidence, and attention to inconsistencies
    • Skepticism is meant to create a hostile atmosphere or to imply micromanagement
    • Skepticism increases not only the likelihood that fraud will be detected, but also the perception that fraud will be detected, which reduces the risk that fraud will be attempted
auditing in practice professional skepticism1
Auditing in Practice - Professional Skepticism
  • Defined by international auditing standards
    • An attitude that includes a questioning mind and a critical assessment of audit evidence
    • Requires an ongoing questioning of whether the information and audit evidence obtained suggests that a material misstatement due to fraud may exist
auditing in practice professional skepticism2
Auditing in Practice - Professional Skepticism
  • The Standard states:
    • Auditor’s previous experience with an entity contributes to a better understanding of the entity
    • However, maintenance of professional skepticism is important because there may have been changes in circumstances
    • Auditors should not be satisfied with less-than-persuasive audit evidence based on a belief that management and those charged with governance are honest and have integrity
the third coso report an analysis
The Third COSO Report - An Analysis
  • Identified the major characteristics of companies that had perpetrated fraud
  • Compared fraud and nonfraud companies
the third coso report an analysis1
The Third COSO Report - An Analysis
  • Major findings
    • The amount and incidence of fraud remains high
    • The median size of company perpetrating the fraud rose tenfold
    • Heavy involvement in fraud by the CEO and/or CFO
    • Most common fraud involved revenue recognition
    • One-third of the companies changed auditors during the latter part of the fraud
    • Majority of the frauds took place at companies that were listed on the Over-The-Counter (OTC) market
the third coso report an analysis2
The Third COSO Report - An Analysis
  • Common motivations for fraud among companies
    • Need to meet internal or external earnings expectations
    • Attempt to conceal deteriorating financial conditions
    • Need to increase stock price
    • Need to bolster performance for pending equity or debt financing
    • Desire to increase management compensation based on financial results
the enron fraud what went wrong
The Enron Fraud: What went Wrong?
  • Management accountability
  • Corporate governance
  • Accounting rules
  • Financial analyst community
  • Banking and investment banking
  • External auditing profession and Arthur Andersen
mitigating the risk of fraudulent financial reporting
Mitigating the Risk of Fraudulent Financial Reporting
  • Center for Audit Quality recommends three ways in which individuals involved in the financial reporting process can mitigate risk of fraudulent reporting
    • Need to acknowledge the existence of a strong, highly ethical tone at the top of an organization
    • Need to consistently exercise professional skepticism in evaluating and/or preparing financial reports
    • Need to understand the role of strong communication in the financial reporting process
message to auditors
Message to Auditors
  • Assume greater responsibility for detecting fraud
  • Provide assurance that financial statements are free of material fraud
Learning Objective 5


sarbanes oxley act of 2002
Sarbanes-Oxley Act of 2002
  • Broad legislation mandating new standard setting for audits of public companies and new standards for corporate governance
  • Applies to publicly traded companies
    • Not privately held organizations
corporate governance
Corporate Governance
  • A process by which owners and creditors exert control and require accountability for resources entrusted to organizations
  • Owners elect board of directors to provide:
    • Oversight of organizations’ activities
    • Accountability to stakeholders
exhibit 2 5 overview of corporate governance responsibilities and accountabilities
Exhibit 2.5 - Overview of Corporate Governance Responsibilities and Accountabilities
parties involved in corporate governance
Parties Involved in Corporate Governance
  • Board of directors: The major representative of stockholders, who ensure that the organization is run according to the organization’s charter and that there is proper accountability
  • Audit committee: A subcommittee of the board of directors responsible for monitoring audit activities and serving as a surrogate for the interests of shareholders
parties involved in corporate governance1
Parties Involved in Corporate Governance
  • Board of directors and its audit committee oversee management
    • Expected to protect stockholders’ rights
    • Ensure that controls exist to prevent and detect fraud
  • Stakeholders: Anyone who is influenced, either directly or indirectly, by actions of a company
principles related to boards and management
Principles Related to Boards and Management
  • Objective is to build long-term sustainable growth in shareholder value
  • Responsible for creating a culture of performance with integrity and ethical behavior
  • Effective corporate governance should be integrated with company’s business strategy
principles related to boards and management1
Principles Related to Boards and Management
  • Make efforts to ensure that companies have sound disclosure policies and practices – transparency is very critical
  • Independence and objectivity are necessary attributes of board members
responsibilities of audit committees
Responsibilities of Audit Committees
  • Appointment, compensation, and oversight of work of registered accounting firms
  • Must be independent
  • Establish whistleblowing mechanisms within companies
  • Authority to engage their own independent counsel
  • Companies must provide adequate funding for audit committees