FRAUD AUDITING
Chapter 11
LEARNING OBJECTIVES
❑Define fraud and distinguish between fraudulent financial reporting and misappropriation of assets.
❑Describe the fraud triangle and identify conditions for fraud.
❑Understand the auditor’s responsibility for assessing the risk of fraud and detecting material
misstatements due to fraud.
❑Identify corporate governance and other control environment factors that reduce fraud risks.
❑Develop responses to identified fraud risks.
❑Recognize specific fraud risk areas and develop procedures to detect fraud.
❑Understand interview techniques and other activities after fraud is suspected.
WHAT IS THE FRAUD?
❑An Intentional Misstatement Of Financial Statements.
❑The Two Main Categories Are:
A. Fraudulent Financial Reporting
B. Misappropriation Of Assets
FRAUDULENT FINANCIAL
REPORTING
❑an intentional misstatement or omission of amounts or disclosures with the
intent to deceive users.
❑Most cases of fraudulent financial reporting involve an attempt to overstate
income—either by an overstatement of assets and income or by the omission
of liabilities and expenses.
❑Such practices are called income smoothing and earnings management
INCOME SMOOTHING AND
EARNINGS MANAGEMENT
▪ Earnings Management involves deliberate actions taken by management to
meet earnings objectives.
▪ Income Smoothing is a form of earnings management in which revenues and
expenses are shifted between periods to reduce fluctuations in earnings.
▪ One technique to smooth income is to reduce the value of inventory and other assets of an
acquired company at the time of acquisition, resulting in higher earnings when the assets are
later sold.
MISAPPROPRIATION OF ASSETS
❑Misappropriation of assets is a fraud that involves theft of an
entity’s assets. In many cases, but not all, the amounts involved
are not material to the financial statements. However, theft is
often a management concern because small thefts can easily
increase in size over time.
❑Misappropriation of assets is normally perpetrated at lower levels of the
organization
WHY FRAUD OCCURS
CONDITIONS FOR FRAUD
(FRAUD TRIANGLE)
1.Incentives/Pressures. Management or other employees
have incentives or pressures to commit fraud.
2.Opportunities. Circumstances provide opportunities for
management or employees to commit fraud.
3.Attitudes/Rationalization. An attitude, character, or set
of ethical values exists that allows management or
employees to commit a dishonest act, or they are in an
environment that imposes sufficient pressure that causes
them to rationalize committing a dishonest act.
This model replaced the capability - identified in the
Capability is an individual Diamond Model, for competence and added the
quality to commit deception, arrogance factor.
which drives them to find an Arrogance is the belief that one's rights or status are
opportunity and make use of it. superior to those of others and that one is above the
company's institutional policies or supervision.
Someone is likely to commit fraud if he is highly
arrogant and has a strong company position.
ASSESSING THE RISK OF FRAUD
▪ Auditing standards provide guidance to Auditors in assessing the
risk of fraud.
▪ Auditing standards state that, in exercising Professional
skepticism, an auditor “neither assumes that management is
dishonest nor assumes unquestioned honesty.”
▪ Auditing standards emphasize consideration of a client's
susceptibility to fraud regardless of the auditor’s beliefs about the
likelihood of fraud and management’s honesty and integrity.
SOURCES OF INFORMATION GATHERED TO
ASSESS FRAUD RISK
➢ SAS 99 requires the audit team to conduct discussions to share insights
from more experienced audit team members and to “brainstorm” ideas
that address the following:
• How and where they believe the entity's financial statements
might be susceptible.
• How management could perpetrate and conceal fraud.
• How anyone might misappropriate assets.
• How the auditor might respond to the susceptibility of material
misstatements due to fraud.
➢ SAS 99 also requires the auditor to make specific inquiries about fraud
in every audit.
➢ SAS 99 requires the auditor to evaluate whether fraud risk factors
indicate incentives or pressures to perpetrate fraud.
➢ Auditors must perform analytical procedures during the planning and
completion phases of the audit to help identify unusual transactions.
