Fraud Auditing

1. Fraud Auditing

2. Fraud Auditing TOPICS • Fraud Background and History • Changing Landscape of the Profession • Requirements of SAS 99 • Specific Fraud Examples

3. The accounting profession was under fire.  Throughout the summer, newspapers were filled with new details of a corporate accounting scandal. One of the largest, most respected companies in the United States had been caught inflating earnings and assets through blatant manipulation of the accounting rules. Thousands of investors and employees had suffered. Congressional hearings were called to examine and understand the fraud, and everyone asked, "Where were the auditors?"  The accounting profession was under immense political pressure from reform-minded lawmakers, and the negative publicity surrounding the perceived audit failure cast all CPAs in the most unfavorable light.

4. Fraud Enron? WorldCom? Perhaps ESM Government Securities? Maybe the infamous ZZZZ Best? Fraud

5. Fraud • The Year? - 1938 • The Company? - McKesson-Robbins • The Result? - New audit rules requiring confirmation of receivables and observation of inventory

6. History of Fraud The term “cooking the books” was first used to refer to George Hudson, the “railway king” in Britain, who falsified the books of the Eastern Counties Railways in the mid 1800s. He was exposed as a fraudster and jailed.

7. The Enron Effect • Enron was different • Size of company • Role of Andersen in obstruction • Complexity of issues involved • WorldCom was the follow-up punch • Large, yet comparatively “plain vanilla” fraud of improperly capitalized fixed assets • Other frauds suggest problems weren’t limited to Andersen

8. A Changed Landscape • Sarbanes-Oxley termed the most significant securities legislation since ’33 and ’34 Securities Acts • Public Company Accounting Oversight Board created • Establish auditing standards for auditors of public companies • Establish and enforce quality control standards • Required reporting on internal control over financial reporting • Further restrictions on nonaudit services for public company audit clients

9. Forensic Accounting: The Hot New Career “Forensic accountants must have the skills of both a private investigator and an accountant” US News & World Report labels forensic accounting one of the “20 hot job tracks of the future.”

10. Fraud is on the Increase % of Companies Reporting Theft of Assets Fraudulent Financial Reportng Source: KPMG Fraud Survey

11. How Are Frauds Detected? Source: KPMG Fraud Survey

12. The Fraud Triangle Incentives/Pressures Opportunities Attitudes/Rationalization

13. Auditor Responsibility • An auditor is responsible to detect material misstatements in the financial statements, whether due to • Errors • Fraud • This responsibility is unchanged, but guidance to auditors has

14. SAS 99 on Fraud • SAS 99 is effective for audits beginning on or after December 15, 2002 • Supercedes SAS 82 which was issued in 1997 • Recognition of need for better guidance and linkage between fraud risks and audit tests • Selected key components of SAS 99 • Emphasis on professional skepticism by auditors • Brainstorming by staff to identify fraud risks • Developing specific procedures to respond to fraud risk • Revenue recognition generally recognized as a specific fraud risk

15. Information to Assess Fraud Risks Analytical Procedures Fraud Risk Factors Inquiries Other Information Brainstorming Identified Fraud Risks

16. SAS 99 on Fraud • Focus on the “fraud triangle” by major fraud types • Misappropriation of assets • Fraudulent financial reporting • Auditors’ primary concern is fraudulent reporting • Cannot ignore misappropriation of assets • Material in some cases • Often accompanies fraudulent financial reporting • Source of expectation gap • Misappropriations are best prevented by appropriate controls

17. Multiple Choice 11-21 (b) As a result of analytical procedures, the auditor determines that the gross profit percentage has increased from 30% in the preceding year to 40% in the current year. The auditor should • Document management’s plans for maintaining this trend. • Evaluate management’s performance in causing the improvement in gross profit. • Require footnote disclosure. • Consider the possibility of fraud or other misstatements in the financial statements.

18. Responding to the Risk of Fraud • Design and perform audit procedures to address identified risks. • Change the overall conduct of the audit to respond to identified fraud risks. • Perform procedures to address the risk of management override of controls.

19. Responding to the Risk of Fraud Design and perform audit procedures to address identified risks. • In most cases, it is not sufficient to test more. Instead, the auditor must test differently to address fraud risks. Key point: Auditor responds to increases in IR and CR by testing more. Auditor responds to fraud risk with different procedures and approaches.

20. Revenue Recognition • Revenue recognition is the hot financial reporting issue • Report from COSO indicates that improper revenue recognition is found in over half of major case of fraudulent financial reporting • SAS 99 indicates auditors should normally assess risk of fraud due to improper revenue recognition

21. Accelerated Revenue – Channel Stuffing • Companies often try to accelerate the timing of revenues by shipping unwanted goods to customers • Sunbeam and infamous “Chainsaw Al” Dunlap – barbeque grills were sold out of season • Bausch & Lomb – Shipped several months supply of contacts to suppliers with unconditional right of return • What tests would indicate these problems?

22. Accelerated Revenue – Leases • Xerox is a recent high-profile case • Leases had three components: the value of the equipment, servicing over the life of the lease, and financing • Equipment revenue recorded at the beginning of the lease • Servicing and financing recognized over the life of the lease contract • Xerox shifted servicing and financing revenue to the value of the equipment to recognize more revenue immediately

23. Inventory Fraud • From McKesson – Robbins to the infamous Salad Oil scandal to Crazy Eddie, many frauds have involved fictitious inventory • Cost of Goods Sold calculation Beginning inventory + Purchases - Ending Inventory = Cost of Good sold What happens if the company overstates inventory? How would you know if inventory didn’t exist?

24. Fixed Assets • Expanded Accounting Equation Assets = Liabilities + Equity + Revenues – Expenses What happens when a company records an expense as an asset? How can an accountant detect this? • Prominent recent examples included WorldCom and HealthSouth

25. Disclosure in Extractive Industries • Value of company is largely related to value of unrecorded oil or mineral reserves • Shell Oil has just been charged with overstating its oil reserves • Bre-X case involved fictitious gold deposits in Indonesia • Value based on samples that were “salted” with gold • One of the perpetrators allegedly committed suicide by jumping from a helicopter

26. Multiple Choice 11-22 (a) Cash receipts from sales on account have been misappropriated. Which of the following acts would conceal this defalcation and be least likely to be detected by the auditor? • Understating the sales journal. • Overstating the accounts receivable control account. • Overstating the accounts receivable subsidiary ledger. • Understating the cash receipts journal.