Chapter 11

1. Chapter 11 FRAUD

2. FRAUD • Types of Fraud • fraudulent financial reporting-Management Fraud • misappropriation of assets-theft-employee fraud • companies deliberately understate income-management fraud • “cookie jar reserves” = smoothing earnings-shift earnings between periods • earnings management- deliberate actions to meet earning objectives • income smoothing is one kind of earnings management

3. FRAUD • Most common fraud, record revenue prematurely • Or create fictitious revenue • Or overstate assets (capitalize expenses)

4. FRAUD • Fraud Triangle • Conditions: • Incentives/Pressures • Opportunities • Attitudes/Rationalization

5. Fraudulent Financial Reporting • Incentives: • decline in financial prospects • to meet forecasts or debt covenants • inflate stock price • Opportunities Judgments and estimates – value of inventory turnover in Accountants Audit Committee oversight lacking • Attitudes • CEO or CFO disregard financial reporting process

6. Employee Fraud • Incentive: • financial obligations • drug abuse • gambling • dissatisfied employees • Opportunities • Cash-small assets • Lack of separation of duties • Attitudes • Management has lack of concern over internal controls • Management cheats customers

7. Assess Risk of Fraud • Auditor has responsibility to plan and perform audit to obtain reasonable assurance that material misstatements are detected. • Professional Skepticism • Questioning Mind • Critical Evaluation of Audit Evidence • Sources of Information • Communications among audit team • How F/S susceptible • How management could perpetuate financial report • How assets could be stolen • How would auditor respond?

8. Assess Risk of Fraud • Inquiries of management • What fraud if any occurred • What risk of fraud exists • What risk exists in internal controls • Interview internal audit • Interview audit committee • Risk Factors/ Pressures • Analytical procedures during planning (revenue accounts)

9. Documenting Fraud • Document discussion of audit team • document procedures performed to assess risk of fraud • risks found • document reason there is no risk on improper revenue recognition

10. Documenting Fraud • document results of procedures to detect management • override of controls • document other conditions requiring additional audit • work • document nature of communications with management, audit committee and internal auditors

11. Corporate governance • Antifraud Program • Culture of Honesty • Tone at the top • Positive environment (whistleblower protection) • Hire and promote appropriate people • Training for employees • Confirmation of receiving code of ethics • Discipline and accountability

12. Corporate governance • Evaluate risk- implement controls • Identify risk • Mitigating risk (lock box) • Monitoring controls (internal audit) • Audit Committee Oversight • Management override of controls • Internal and external audit • Whistle blowers policy

13. Auditor responding to risk • Change conduct of audit • More experience personnel • Subjective measurements or complex transactions • Revenue recognition • Unpredictability • Procedures for risk • Different for each area of audit (each cycle) • Management Override of Controls • Examine JE’s • Review estimates • Review business rationale for unusual transactions

14. Auditor responding to risk • Update risk assessment • Discrepancies • Conflicting evidence • Problematic relationships (auditor management) • Analytical procedures • Responses to inquiries

15. Specific fraud risk areas • 1. Revenue and A/R • Fictitious revenue i.e., fictitious insurance policies, • fictitious construction, fictitious sales entries • Premature revenue recognition • Bill and hold sale (invoice before ship) • Side agreements • Manipulation of adjustments to revenue • Sales returns and allowances not recorded • Allowance for doubtful accounts • (alter age of receivables) • Warning signs of revenue fraud: Analytical shows • gross profit margin higher and A/R turnover lower. • Documentary discrepancies and less detail in documents.

16. Specific fraud risk areas • Misappropriation of receipts (theft of cash) • failure to record sale and cash stolen (test shipping documents to uncover) • theft of receipts after sale recorded Record return to cover up Write off account to cover up Lapping to cover up

17. Inventory fraud • Fraudulent Financial Reporting Fictitious inventory, client transfers inventory to and from locations • Warning signs Analytical gross margin high and low inventory turnover

18. Purchases and A/P • Deliberate understatement of A/P • payments to fictitious vendors • kickbacks • Fraudulent financial reporting • recording A/P in subsequent period • complex arrangements with vendors (advertising credits) • Misappropriation: Fictitious vendors, stealing checks

19. Fixed Assets • Capitalize repairs • theft (laptops)

20. Payroll Expenses • In manufacturing overstate inventory by inflating labor costs • Theft, fictitious employees or overstatement of individual payroll hours.

21. Responsibilities when fraud suspected • Inquiry – watch verbal and nonverbal responses in interviews • Informational inquiry for facts • Assessment inquiry to corroborate or contradict • Interrogative inquiry, deceptive or omitting information

22. When auditor determines there may be fraud • first investigate and determine if material fraud • Then discuss with management a level higher than that perpetrator