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Chapter 8. Auditing for Fraud . Fraud & Auditor Responsibilities: Historical Evolution.

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chapter 8

Chapter 8

Auditing for Fraud

fraud auditor responsibilities historical evolution
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
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

fraud defined
Fraud - Defined

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
  • Fraudulent financial reporting
defalcation
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

fraudulent financial reporting defined
Fraudulent Financial Reporting - Defined

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
lessons learned from fraud cases
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
the second coso report
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
the second coso report continued
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

auditing standards on fraud
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
a proactive approach to fraud detection planning the audit
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
proactive approach to fraud detection conducting the audit
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
proactive approach to fraud detection conducting the audit1
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
the motivations to commit fraud
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
motivations to commit fraud 1 incentives or pressures
Motivations to Commit Fraud – 1. 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
motivations to commit fraud 2 opportunities
Motivations to Commit Fraud – 2. Opportunities

Warning signs indicating opportunities for fraud:

  • Weak or non-existent internal controls
  • 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
motivations to commit fraud 3 rationalizations
Motivations to Commit Fraud – 3. 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
audit team brainstorming
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
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
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
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
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
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
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
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
evaluating audit evidence
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
communicating the existence of fraud
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, 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
communicating the existence of fraud cont d
Communicating the Existence of Fraud (Cont’d)

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

audit documentation
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
characteristics of financial reporting frauds
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
characteristics of defalcations
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
Audit Procedures & Evidence Considerations

The procedures used by the auditor should reflect

  • the internal control weaknesses and
  • fraud risk indicators found with the client
1 linking audit procedures to control deficiencies
1. 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
2 linking audit procedures to fraud risk indicators
2. 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
  • 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
using computers to analyze the possibility of fraud
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
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
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
forensic accounting
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