Auditing
A Risk-Based Approach To Conducting A Quality Audit
10th edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
CHAPTER 2
THE AUDITOR’S RESPONSIBILITIES REGARDING FRAUD
AND MECHANISMS TO ADDRESS FRAUD: REGULATION
AND CORPORATE GOVERNANCE
Copyright © 2016 South-Western/Cengage Learning
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
Define the various types of fraud that affect organizations
Define the fraud triangle and describe its three elements
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
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
Copyright © 2016 South-Western/Cengage Learning
2-2
THE AUDIT OPINION FORMULATION
PROCESS
Copyright © 2016 South-Western/Cengage Learning
2-3
LEARNING OBJECTIVE 1
DEFINE THE VARIOUS TYPES OF FRAUD THAT
AFFECT ORGANIZATIONS
Copyright © 2016 South-Western/Cengage Learning
FRAUD
• An intentional act involving use of deception that
results in a misstatement of financial statements
• Two types of misstatements
• Misappropriation of assets
• Fraudulent financial reporting
• Different from errors
• Errors occur unintentionally
Copyright © 2016 South-Western/Cengage Learning
2-5
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 are commonly employees
Copyright © 2016 South-Western/Cengage Learning
2-6
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
Copyright © 2016 South-Western/Cengage Learning
2-7
LEARNING OBJECTIVE 2
DEFINE THE FRAUD TRIANGLE AND DESCRIBE
ITS THREE ELEMENTS
Copyright © 2016 South-Western/Cengage Learning
EXHIBIT 2.2 - THE FRAUD TRIANGLE
Copyright © 2016 South-Western/Cengage Learning
2-9
INCENTIVES 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
Addictions to gambling or drugs
Copyright © 2016 South-Western/Cengage Learning
2-10
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
Copyright © 2016 South-Western/Cengage Learning
2-11
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
Copyright © 2016 South-Western/Cengage Learning
2-12
LEARNING OBJECTIVE 3
DESCRIBE IMPLICATIONS FOR AUDITORS OF
RECENT FRAUDULENT FINANCIAL REPORTING
CASES AND THE THIRD COSO REPORT ON FRAUD
Copyright © 2016 South-Western/Cengage Learning
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 transactions to determine:
• Their economic substance
• The parties that have economic obligations
• Understanding and analyzing weaknesses in an organization’s
internal controls
Copyright © 2016 South-Western/Cengage Learning
2-14
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
Copyright © 2016 South-Western/Cengage Learning
2-15
LEARNING OBJECTIVE 4
DISCUSS AUDITORS’ FRAUD-RELATED
RESPONSIBILITIES
AND USERS’ RELATED EXPECTATIONS
Copyright © 2016 South-Western/Cengage Learning
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
Copyright © 2016 South-Western/Cengage Learning
2-17
MESSAGE TO AUDITORS
• Assume greater responsibility for detecting fraud
• Provide assurance that financial statements are free
of material fraud
Copyright © 2016 South-Western/Cengage Learning
2-18
LEARNING OBJECTIVE 5
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
Copyright © 2016 South-Western/Cengage Learning
SARBANES-OXLEY ACT OF 2002
• Broad legislation mandating standard setting for
audits of public companies and standards for
corporate governance
• Applies to publicly traded companies
• Not privately held organizations
• Read Exhibit 2.4 carefully to understand the sections
of SOX and the various features of the legislation
Copyright © 2016 South-Western/Cengage Learning
2-20
LEARNING OBJECTIVE 6
DEFINE CORPORATE GOVERNANCE, IDENTIFY
THE PARTIES INVOLVED, AND DESCRIBE THEIR
RESPECTIVE ACTIVITIES
Copyright © 2016 South-Western/Cengage Learning
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
Copyright © 2016 South-Western/Cengage Learning
2-22
EXHIBIT 2.5 - OVERVIEW OF CORPORATE GOVERNANCE
RESPONSIBILITIES AND ACCOUNTABILITIES
Copyright © 2016 South-Western/Cengage Learning
2-23
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
Copyright © 2016 South-Western/Cengage Learning
2-24
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
Copyright © 2016 South-Western/Cengage Learning
2-25
RESPONSIBILITIES OF AUDIT
COMMITTEES
• Appointment, compensation, and oversight of work
of audit firms
• Must be independent
• Establish whistleblowing mechanisms within
companies
• Authority to engage their own independent counsel
• Companies must provide adequate funding for audit
committees
Copyright © 2016 South-Western/Cengage Learning
2-26