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Chapter 4

Chapter 4. Management Fraud and Audit Risk. 1. Errors, Fraud, and Noncompliance. Definitions Errors - unintentional Fraud (irregularities) - intentional Noncompliance with laws and regulations (Illegal acts)- violations of the law Auditor’s responsibilities

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Chapter 4

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  1. Chapter 4 Management Fraud and Audit Risk Chapter 3

  2. 1. Errors, Fraud, and Noncompliance • Definitions Errors - unintentional Fraud (irregularities) - intentional Noncompliance with laws and regulations (Illegal acts)- violations of the law • Auditor’s responsibilities • History Errors & Fraud: SAS 1, SAS 16, SAS 53, SAS 82, SAS 99 Illegal Acts: SAS 54 Chapter 3

  3. 1. Errors, Fraud, andNoncompliance (continued) • Errors and Fraud (AU-C 240) • design and conduct the audit to provide reasonable assurance that material errors and fraud will be discovered, and report the findings to appropriate parties • Noncompliance with laws and regulations (Illegal Acts) (AU-C 250) • direct effect noncompliance — same • indirect effect noncompliance — have general level of awareness and act on those discovered Questions Chapter 3

  4. 1. Errors, Fraud, and Noncompliance (continued) Steps involved in Considering the Risk of Fraud • Staff discussion • Obtain information needed to identify risks • Identify risks • Assess identified risks • Respond to results of assessment • Evaluate audit evidence • Communicate about fraud (SAS 114) • Document consideration of fraud Chapter 6

  5. 2. Fraud Causes of Misstatements Causes ErrorsFraud Misappropriation Fraudulent of Assets Financial Reporting Chapter 3

  6. 2. Fraud (continued) EXHIBIT 3.1 Chapter 3

  7. 2. Fraud (continued) • Fraudulent financial reporting (cooking the books) (management fraud) • falsification of financial statements • falsification or omissions of transactions • Misappropriation of assets (employee fraud) • larceny • embezzlement Chapter 3

  8. 2. Fraud (continued) • Overview of Fraud (outline) • costs • discovery • victims • perpetrators • common characteristics • types Chapter 3

  9. The Fraud Triangle PRESSURE PERCEIVED OPPORTUNITY RATIONALIZATION Summer 2009

  10. 2. Fraud (continued) • Prevalence of fraud • Current frauds • Reasons to study fraud • Fraud related job opportunities • ACFE • CFE Chapter 3

  11. 3. Audit Risk Chapter 3

  12. Top-Down Evaluation of Client’s Risk Risk Based Auditing Chapter 3

  13. 3. Audit Risk • AU-C 320 – Audit Risk • General business risks • Engagement risk • Audit Risk Model • AR = RMM x DR • AR = IR x CR x DR • AR = IR x CR x TD x AP • Audit Risk definition • the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated • the danger that the auditor will fail to detect material misstatements in the financial statements • at financial statement level; at account balance level Chapter 3

  14. 3. Audit Risk (continued) • Risk of Material Misstatement • product of inherent risk and control risk • consider at entity level and account/assertion level • Inherent Risk • the susceptibility of an account balance to error assuming there are no controls • based on auditor’s judgment considering understanding of entity, nature of account (routine, systematic processing, complexity, etc), and fraud considerations • Control Risk • the risk that the ICS will not prevent or detect a material error on a timely basis • based on tests of control’s effectiveness Chapter 3

  15. 3. Audit Risk (continued) • Detection Risk • the risk that the auditor’s procedures will not detect a material error • the product of Tests of Details Risk (TD) and Substantive Analytical Procedures Risk (AP) • Tests of Details Risk • the risk that tests of details will not detect a material error • Substantive Analytical Procedures Risk • the risk that analytical procedures (or other procedures that do not utilize sampling) will not detect a material error Chapter 3

  16. 3. Audit Risk (continued) • Risks defined in negative • Auditor’s control over risks • Relationship between • RMM and DR • DR and amount of substantive testing Chapter 3

  17. 3. Audit Risk (continued) • Subjectively considering Audit Risk • Quantifying Audit Risk • not required • DR = AR / IR x CR • TD = AR / IR x CR x AP Questions Chapter 3

  18. 3. Audit Risk (continued) • General guidelines • Inherent Risk • High > 60% • Moderate 40% - 60% • Low < 40% • Control Risk • Maximum = 100% • High > 70% • Moderate 40% - 70% • Low < 40% • Very Low < 10% Chapter 3

  19. 3. Audit Risk (continued) • Analytical Procedures Risk • High > 50% • Moderate 20% - 50% • Low 10% - 20% • Very Low < 10% Chapter 3

  20. 4. Analytical Procedures • Definition • Uses in an audit • planning stage • as a substantive test (SAP) • final review stage • Required use Chapter 3

  21. 4. Analytical Procedures(Continued) • In planning stage • enhances auditor’s understanding • identifies risk areas • uses highly aggregated data • generally financial data Chapter 3

  22. 4. Analytical Procedures(Continued) • Steps • develop an expectation • define a significant difference • calculate predictions and compare with recorded amount • investigate significant differences • document each step Chapter 3

  23. 4. Analytical Procedures (Continued) • Substantive analytical procedures • based on level of DR • based on auditor judgment • balance sheet data vs. income statement data • often uses non-financial data Chapter 3

  24. 4. Analytical Procedures(Continued) • In final evaluation stage • uses aggregated data • usually financial data • review same data used in planning stage Questions Chapter 3

  25. 5. Review Questions for Discussion • Chapter 4 4.6 4.7 4.8 4.9 4.12 4.14 4.17 Chapter 3

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