Fraud Auditing

Chapter 11
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©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-5

 Learning Objective 1

Define fraud and distinguish between

fraudulent financial reporting and
misappropriation of assets.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 2

 Types of Fraud
Management
Fraud

Fraudulent
Misappropriation
financial
of assets
reporting

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 3

 Learning Objective 2

Describe the fraud triangle and identify

conditions for fraud.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 4

 The Fraud Triangle

Incentives/Pressures

Opportunities Attitudes/Rationalization

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 5

 Why Fraud Occurs

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 6

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 7

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 8

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

 A history of violations of laws is known

 Management has a practice of making

overly aggressive or unrealistic forecasts

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 9

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 10

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 11

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 12

 Learning Objective 3

Understand the auditor’s responsibility for

assessing the risk of fraud and detecting
material misstatements due to fraud.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 13

 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.”

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 14

 Sources of Information Gathered
to Assess Fraud Risks

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 15

 Documenting Fraud Assessment

 Discussion among engagement team

 Procedures performed to assess risk
 Specific risks and audit response
 Reasons supporting conclusions
 Other conditions and analytical
relationships
 Nature of communications

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 16

 Learning Objective 4

Identify corporate governance and other

control environment factors that reduce
fraud risks.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 17

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 18

 Example Elements for a Code of
Conduct
 Organizational code of conduct

General employee conduct

Conflicts of interest

Outside activities, employment, and

directorships

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 19

 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

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 20

 Example Elements for a Code of
Conduct
 Organization records and communications

 Dealing with outside people and

organizations

 Prompt communications

 Privacy and confidentiality

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 21

 Organizational Factors
Contributing to Risk of Fraud

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 22

 Learning Objective 5

Develop responses to identified fraud risks.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 23

 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 fraud risks.

Design and perform procedures to

address the risk of management
override of controls.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 24

 Learning Objective 6

Recognize specific fraud risk areas and

develop procedures to detect fraud.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 25

 Specific Fraud Risk Areas

 Revenue and accounts receivable fraud risks

 Inventory fraud risks

 Purchases and accounts payable fraud risks

 Other areas of fraud risk

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 26

 Effect of Fictitious Receivables
on Accounting Ratios

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 27

 Effect of Fictitious Inventory on
Inventory Turnover

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 28

 Learning Objective 7

Understand interview techniques and other

activities after fraud is suspected.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 29

 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.

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 30

 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.
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 31
 Types of Inquiry Techniques

Informational
Assessment

Listening
Evaluating
responses

Interrogative
Observing
behavioral cues
©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 32
 Observing Verbal Cues

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 33

 Observing Non-Verbal Cues

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 11 - 34

 End of Chapter 11

©2012 Prentice Hall Business Publishing, Auditing 14/e, Arens/Elder/Beasley 5-5