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Chapter 3 : 

Chapter 3 Management Fraud and Audit Risk My actions are inexcusable…. I'm sorry for the hurt that has been caused by my cowardly behavior. -- Scott Sullivan, former WorldCom CFO, at his sentencing. "It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently." - - Warren Buffet, billionaire investor

Chapter 3 Objectives: 

Chapter 3 Objectives Define and explain the differences among several kinds of fraud, errors, and illegal acts that might occur in an organization. Explain auditors’ responsibilities with respect to detecting and reporting fraud. List and explain some conditions that can lead to frauds. Explain auditors’ responsibilities with respect to illegal acts. Describe the conceptual audit risk model and explain the meaning and importance of its components in terms of professional judgment and audit planning. Define materiality and explain its relationship to the audit risk model. Describe the content and purpose of audit programs. List and describe eight general types of audit procedures for gathering evidence. Discuss the effectiveness of various audit procedures.

Exhibit 3.1 An Abundance of Frauds: 

Exhibit 3.1 An Abundance of Frauds

Financial Statements: Errors, Frauds and Illegal Acts: 

Financial Statements: Errors, Frauds and Illegal Acts Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements. Management Fraud is intentional misstatements or omissions of amounts or disclosures in financial statements. Direct-effect illegal acts are violations of laws or government regulations by the company or its management or employees that produce direct and material effects on dollar amounts in financial statements. "Illegal acts" (far‑removed) are violations of laws and regulations that are far removed from financial statement effects (for example, violations relating to insider securities trading, occupational health and safety, food and drug administration, environmental protection, and equal employment opportunity).

Auditor and Investigator Responsibilities: 

Auditor and Investigator Responsibilities External Auditors (CPAs) SAS 99: Consideration of Fraud in a Financial Statement Audit Design audit to provide reasonable assurance of detecting fraud that could have a material effect on the financial statements. Perform fraud-related procedures SAS 54: Illegal Acts Focused primarily is on direct-effect illegal acts SAS 61: Communication with Audit Committees Internal Auditors (CIAs) SIAS 3: Deterrence, Detection, Investigation, and Reporting of Fraud Governmental Auditors Focus on laws and regulations (compliance), design audit to detect abuse and illegal acts, report to the appropriate authority Certified Fraud Examiners (CFEs) Assignments begin with predication (probable cause)

Reasons Auditors Fail to Detect Fraud: 

Reasons Auditors Fail to Detect Fraud Over reliance on client representations. Lack of awareness or failure to recognize that an observed condition may indicate a material fraud. Lack of experience. Personal relationships with clients.

Exhibit 3.2 Considering the Risk of Fraud (SAS 99) : 

Exhibit 3.2 Considering the Risk of Fraud (SAS 99) Gather information to identify risks. Identify risks. Assess risks taking into account entity’s programs and controls. Respond to results of assessment. Step 1: Staff discussion Step 2: Identify information necessary to assess fraud risk factors Step 3: a. Identify and b. Assess fraud risk factors Step 4: Respond to risk assessment Step 5: Evaluate audit evidence Step 6: Communicate fraud matters Step 7: Document

Step 1: Discussion Among Engagement Personnel: 

Step 1: Discussion Among Engagement Personnel Required procedure Objectives Gain understanding of Previous experiences with client How a fraud might be perpetrated and concealed in the entity Procedures that might detect fraud Set proper tone Should be continuous

Step 2: Obtain Information to Identify Risks: 

Step 2: Obtain Information to Identify Risks Inquiries Management Others Audit committee Internal auditors Planning analytical procedures Net income to cash flows (total accruals to total assets) Days sales in receivables Gross margin Asset quality index (non current assets- p,p&e to total assets) Sales growth index

Step 3a: Identify Risk Factors Related to Fraudulent Financial Reporting: 

Step 3a: Identify Risk Factors Related to Fraudulent Financial Reporting Management’s characteristics and influence Industry Conditions Operating characteristics and financial stability

Risk Factors: Management’s Characteristics and Influence: 

Risk Factors: Management’s Characteristics and Influence Management has a motivation to engage in fraudulent reporting. Management decisions are dominated by an individual or a small group. Management fails to display an appropriate attitude about internal control. Managers’ attitudes are very aggressive toward financial reporting. Managers place too much emphasis on earnings projections. Nonfinancial management participates excessively in the selection of accounting principles or determination of estimates. The company has a high turnover of senior management. The company has a known history of violations. Managers and employees tend to be evasive when responding to auditors’ inquiries. Managers engage in frequent disputes with auditors.

Risk Factors: Industry conditions: 

Risk Factors: Industry conditions Company profits lag the industry. New requirements are passed that could impair stability or profitability. The company’s market is saturated due to fierce competition. The company’s industry is declining. The company’s industry is changing rapidly.

Risk Factors: Operating Characteristics: 

Risk Factors: Operating Characteristics A weak internal control environment prevails. The company is not able to generate sufficient cash flows to ensure that it is a going concern. There is pressure to obtain capital. The company operates in a tax haven jurisdiction. The company has many difficult accounting measurement and presentation issues. The company has significant transactions or balances that are difficult to audit. The company has significant and unusual related-party transactions. Company accounting personnel are lax or inexperienced in their duties.

Step 3b: Assess Fraud Risks: 

Step 3b: Assess Fraud Risks Type of risk Significance of risk Likelihood of risk Pervasiveness of risk Assess controls and programs

Required Risk Assessments: 

Required Risk Assessments Presume that improper revenue recognition is a fraud risk. Identify risks of management override of controls. Examine journal entries and other adjustments. Review accounting estimates for biases. Evaluate business rationale for significant unusual transactions.

Step 4: Respond to Assessed Risks: 

Step 4: Respond to Assessed Risks Overall effect on audit Assignment of personnel Choice of accounting principles Predictability of auditing procedures Examination of journal entries and other adjustments Retrospective review of prior year accounting estimates Extended procedures

Extended procedures: 

Extended procedures Count the petty cash twice in one day. Investigate suppliers/vendors. Investigate customers. Examine endorsements on canceled checks. Add up the accounts receivable summary. Audit general journal entries. Match payroll to life and medical insurance deductions. Match payroll to social security numbers. Match payroll with addresses. Retrieve customer checks. Use marked coins and currency. Measure deposit lag time. Examine documents. Inquire, ask questions. Covert surveillance. Horizontal and vertical analysis. Net worth analysis. Expenditure analysis.

Step 5: Evaluate Audit Evidence: 

Step 5: Evaluate Audit Evidence Discrepancies in the accounting records. Conflicting or missing evidential matter. Problematic or unusual relationships between the auditor and management. Results from substantive of final review stage analytical procedures. Vague, implausible or inconsistent responses to inquiries.

Step 6: Communicate Fraud Matters: 

Step 6: Communicate Fraud Matters SAS 99—evidence that fraud may exist--appropriate level of management. Sarbanes Oxley—significant deficiencies to board.

Step 7: Document: 

Step 7: Document Discussion of engagement personnel. Procedures to identify and assess risk. Specific risks identified and auditor response. If revenue recognition not a risk—explain why. Results of procedures regarding management override. Other conditions causing auditors to believe additional procedures are required. Communication to management, audit committee, etc.

Exhibit 3-3 Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts : 

Exhibit 3-3 Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts

The AUDIT RISK MODEL (ARM): 

The AUDIT RISK MODEL (ARM) Audit risk (AR) is the risk (likelihood) that the auditor may unknowingly fail to modify the opinion on financial statements that are materially misstated (e.g., an unqualified opinion on misstated financial statements.) The AUDIT RISK MODEL decomposes overall audit risk into three components: inherent risk (IR), control risk (CR), and detection risk (DR): AR = IR x CR x DR

Exhibit 3.4 Inherent, Control and Detection Risk: 

AUDIT RISK The likelihood that an error or fraud will occur, and not get caught by either the internal controls or auditor’s procedures. DETECTION RISK The likelihood that an error or fraud will not be caught by the auditor’s procedures. Financial Statements CONTROL RISK The likelihood that an error or fraud will not get caught by the client’s internal controls. INHERENT RISK The likelihood that, in the absence of internal controls, an error or fraud will enter the accounting information system Exhibit 3.4 Inherent, Control and Detection Risk Accounting Information System Internal Controls Events, Transactions Substantive Procedures

ARM Concepts: 

ARM Concepts The auditor cannot affect inherent risk or control risk. The auditor can only ASSESS them. The auditor can only affect detection risk—generally by examining more evidence. Detection risk is inversely related to control risk and inherent risk. Detection risk is inversely related to competence and reliability of evidence.

Inherent Risk: 

Inherent Risk Inherent Risk (IR) is the likelihood that, in the absence of internal controls, a material misstatement could occur. In other words, it is a measure of the susceptibility of an account to misstatement. Factors affecting account inherent risk include: Dollar size of the account Liquidity Volume of transactions Complexity of the transactions New accounting pronouncements Subjective estimates

Other Factors Affecting Overall Inherent Risk: 

Other Factors Affecting Overall Inherent Risk Competition Economy Nature of Industry Management Style Leverage

Inherent Risk: General Categories of Errors and Frauds : 

Inherent Risk: General Categories of Errors and Frauds Invalid transactions are recorded. Valid transactions are omitted from the accounts. Unauthorized transactions are executed and recorded. Transaction amounts are inaccurate. Transactions are classified in the wrong accounts. Transaction accounting and posting is incorrect. Transactions are recorded in the wrong period.

Control Risk: 

Control Risk Control Risk (CR) is the likelihood that a material misstatement would not be caught by the client’s internal controls. Factors affecting control risk include: The environment in which the company operates (its “control environment”). The existence (or lack thereof) and effectiveness of control procedures. Monitoring activities (audit committee, internal audit function, etc.).

Detection Risk: 

Detection Risk Detection risk (DR) is the risk that a material misstatement would not be caught by audit procedures. Factors affecting detection risk include: Nature, timing, and extent of audit procedures Sampling risk Risk of choosing an unrepresentative sample. Nonsampling risk Risk that the auditor may reach inappropriate conclusions based upon available evidence.

Slide30: 

Detection Risk and the Nature, Timing, and Extent of Audit Procedures

Example of the Audit Risk Model: 

Example of the Audit Risk Model AR =.05 (set by firm) IR =.90 (nature of account) CR =.70 (assessed by auditor) DR =.08 [.05/(.90 X .70)] =.08 Low High Medium High Low

Exhibit 3.8 Matrix Approach to Detection Risk Determination : 

Exhibit 3.8 Matrix Approach to Detection Risk Determination

More Examples: 

More Examples .10 2.0? Low Medium

Materiality: 

Materiality Quantitative Criteria: Absolute size Relative size Cumulative effects Qualitative Criteria Nature of the item or issue Circumstances Uncertainty Materiality refers to an amount (or transaction) that would influence the decisions of users (i.e., an amount (or event) that would make a difference). Materiality Criteria: Ultimately, materiality is a matter of professional judgment.

Exhibit 3.9 Materiality Table: 

Exhibit 3.9 Materiality Table Source: AICPA Audit Sampling Guide, AICPA (New York, New York), 2001.

Audit Programs: 

Audit Programs List of audit procedures to be performed. Each audit program is based, in part, on the output of Audit Risk Model. Generally one for each major cycle or account. Signed off as procedures are performed.

Accounting Cycles: 

Accounting Cycles Groups of related accounts Revenue and collection (Chapter 7) Acquisition and expenditure (Chapter 8) Production (Chapter 9) Financing and investing (Chapter 10)

Approaches to Evidence Gathering: 

Approaches to Evidence Gathering Test of Transactions Few number of transactions High dollar value Test of Balances Large number of transactions Relatively smaller dollar value Auditor must be able to rely on internal controls

General Audit Procedures: 

General Audit Procedures Inspection of records and documents Vouching Tracing Scanning Inspection of tangible assets Observation Inquiry Confirmation Recalculation Reperformance Analytical Procedures

Vouching/Tracing: 

Vouching/Tracing Summary Listing [Sales Journal] Source Documents [Shipping documents] Q: Did all recorded sales actually occur? Q: Were all sales recorded? Vouching (Existence or Occurrence) Tracing (Completeness)