AUDITING
A RISK-BASED APPROACH TO
CONDUCTING A QUALITY AUDIT
9th Edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
CHAPTER 2
THE RISK OF FRAUD AND MECHANISMS TO
ADDRESS FRAUD: REGULATION, CORPORATE
GOVERNANCE, AND AUDIT QUALITY
Copyright © 2014 South-Western/Cengage Learning
LEARNING OBJECTIVES
1.
2.
3.
4.
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
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LEARNING OBJECTIVES
5.
6.
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
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THE AUDIT OPINION FORMULATION
PROCESS
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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
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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)
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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)
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LEARNING OBJECTIVE 1
DEFINE THE VARIOUS TYPES OF FRAUD THAT
AFFECT ORGANIZATIONS
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FRAUD
• 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
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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
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ASSET MISAPPROPRIATION
Manipulate accounts to cover up cash thefts
Commonly
occurs
when
employees
Manipulate cash disbursements through fake
companies
Steal inventory or other assets and manipulate
financial records
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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
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LEARNING OBJECTIVE 2
DEFINE THE FRAUD TRIANGLE AND DESCRIBE
THE THREE ELEMENTS OF THE FRAUD TRIANGLE
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EXHIBIT 2.2 - THE FRAUD TRIANGLE
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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
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INCENTIVES OR PRESSURES TO
COMMIT FRAUD
• Personal factors
• Pressure from family, friends, or culture
• Addictions to gambling or drugs
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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
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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
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LEARNING OBJECTIVE 3
DESCRIBE IMPLICATIONS FOR AUDITORS OF
RECENT FRAUDULENT FINANCIAL REPORTING
CASES AND THE THIRD COSO REPORT ON FRAUD
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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
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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
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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
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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
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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-thanpersuasive audit evidence based on a belief that
management and those charged with governance are
honest and have integrity
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THE THIRD COSO REPORT - AN
ANALYSIS
• Identified the major characteristics of companies
that had perpetrated fraud
• Compared fraud and nonfraud companies
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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
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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
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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
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LEARNING OBJECTIVE 4
DISCUSS AUDITORS’ FRAUD-RELATED
RESPONSIBILITIES
AND USERS’ RELATED EXPECTATIONS
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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
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MESSAGE TO AUDITORS
• Assume greater responsibility for detecting fraud
• Provide assurance that financial statements are free
of material fraud
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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
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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
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EXHIBIT 2.4 - SIGNIFICANT PROVISIONS I: PUBLIC
COMPANY ACCOUNTING OVERSIGHT BOARD
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EXHIBIT 2.4 - SIGNIFICANT PROVISIONS
II: AUDITOR INDEPENDENCE
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EXHIBIT 2.4 - SIGNIFICANT PROVISIONS
III: CORPORATE RESPONSIBILITY
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EXHIBIT 2.4 - SIGNIFICANT PROVISIONS
IV: ENHANCED FINANCIAL DISCLOSURES
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EXHIBIT 2.4 - SIGNIFICANT PROVISIONS
V: ANALYST CONFLICTS OF INTEREST
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EXHIBIT 2.4 - SIGNIFICANT PROVISIONS VI:
COMMISSION RESOURCES AND AUTHORITY
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EXHIBIT 2.4 - SIGNIFICANT PROVISIONS
VII: STUDIES AND REPORTS
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EXHIBIT 2.4 - SIGNIFICANT PROVISION VIII: CORPORATE
AND CRIMINAL FRAUD ACCOUNTABILITY
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EXHIBIT 2.4 - SIGNIFICANT PROVISION IX: WHITE–
COLLAR CRIME PENALTY ENHANCEMENTS
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EXHIBIT 2.4 - SIGNIFICANT PROVISION X:
CORPORATE TAX RETURNS
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EXHIBIT 2.4 - SIGNIFICANT PROVISION XI:
CORPORATE FRAUD AND ACCOUNTABILITY
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LEARNING OBJECTIVE 6
DEFINE CORPORATE GOVERNANCE, IDENTIFY
THE PARTIES INVOLVED, AND DESCRIBE THEIR
RESPECTIVE ACTIVITIES
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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
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EXHIBIT 2.5 - OVERVIEW OF CORPORATE GOVERNANCE
RESPONSIBILITIES AND ACCOUNTABILITIES
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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
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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
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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
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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
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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
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