Ch 4 Management of Fraud and Audit Risk PP

Business Risk
failure to meet objectives
– Objectives—overall plans
– Strategies—methods to meet objectives
Information Risk
—financial statements will be misstated.
Auditor’s Risk Responsibilities
Audit Risk
Management Fraud Risk
Audit Risk
—auditor will give unqualified opinion on misstated financial statements
Management Fraud Risk
—management intentionally misstates financial statements
Fraudulent financial reporting
are unintentional misstatements or omissions of amounts or disclosures in financial statements.
Auditors’ primary responsibility
is to design procedures to provide reasonable assurance that frauds that materially misstate the financial statements are detected.
Other Definitions Related to Fraud
– Employee fraud
– Larceny (misappropriation of assets)
– Defalcation
– Embezzlement
General Categories of Errors and Frauds
– Invalid transactions are recorded.
– Valid transactions are omitted from the accounts.
– Unauthorized transactions are executed and recorded.
– Transaction amounts are inaccurate.
– Transactions are classified in the wrong accounts.
– Transaction accounting and posting is incorrect.
– Transactions are recorded in the wrong period.
Risk Factors Related to Fraudulent Financial Reporting
– Management’s characteristics and influence
– Industry conditions
– Operating characteristics and financial stability
Fraud Risk Factors: Management’s Characteristics and Influence
– Management has a motivation to engage in fraudulent reporting.
– Management decisions are dominated by an individual or a small group.
– Management fails to display an appropriate attitude about internal control.
– Managers’ attitudes are very aggressive toward financial reporting.
– Managers place too much emphasis on earnings projections.
– Non-financial management participates excessively in the selection of accounting principles or determination of estimates.
– The company has a high turnover of senior management.
– The company has a known history of violations.
– Managers and employees tend to be evasive when responding to auditors’ inquiries.
– Managers engage in frequent disputes with auditors
Fraud Risk Factors: Industry conditions
– Company profits lag the industry.
– New requirements are passed that could impair stability or profitability.
– The company’s market is saturated due to fierce competition.
– The company’s industry is declining.
– The company’s industry is changing rapidly.
Fraud Risk Factors: Operating Characteristics
– A weak internal control environment prevails.
– The company is not able to generate sufficient cash flows to ensure that it is a going concern.
– There is pressure to obtain capital.
– The company operates in a tax haven jurisdiction.
– The company has many difficult accounting measurement and presentation issues.
– The company has significant transactions or balances that are difficult to audit.
– The company has significant and unusual related-party transactions.
– Company accounting personnel are lax or inexperienced in their duties.
Audit risk (AR)
is the risk (likelihood) that the auditor may unknowingly fail to modify the opinion on financial statements that are materially misstated (e.g., an unqualified
decomposes overall audit risk into three components: inherent risk (IR), control risk (CR), and detection risk (DR):
– AR = IR x CR x DR
– (IR x CR = Risk of Material Misstatement (RMM))
Audit risk =
IR x CR x DR
Inherent Risk: Factors affecting account inherent risk include:
– Dollar size of the account
– Liquidity
– Volume of transactions
– Complexity of the transactions
– New accounting pronouncements
– Subjective estimates
Control Risk (CR)
is the likelihood that a material misstatement would not be caught by the client’s internal controls.
Factors affecting control risk include:
– The environment in which the company operates (its “control environment”).
– The existence (or lack thereof) and effectiveness of control activities.
– Monitoring activities (audit committee, internal audit function, etc.).
Detection risk (DR)
is the risk that a material misstatement would not be caught by audit procedures.
Factors affecting detection risk include:
– Nature, timing, and extent of audit procedures
– Sampling risk
– Non-sampling risk
Sampling Risk
Risk of choosing an unrepresentative sample.
Non-Sampling Risk
Risk that the auditor may reach inappropriate conclusions based upon available evidence
Factors Affecting Overall Inherent Risk
– Company and its environment
– Nature of Company (Related parties)
– Accounting Principles and Disclosures
– Objectives and Strategies
– Measurement and Analysis of Financial Performance
Information Sources
– General Business Sources
– Company Sources (Minutes)
– Client acceptance, Planning, Past audits, and Other Engagements
Preliminary Analytic Procedures
– Attention directing – Identify potential problem areas
– An organized approach- A standard starting place to start examining the financial statements
– Describe the financial activities – Identify unusual changes in relationships in the data
– Ask relevant questions
1.What could be wrong?
2. What legitimate reasons are there for these results?
– Cash flow analysis
Analytic Procedure Steps
1. Develop an expectation.
2. Define a significant difference.
3. Calculate predictions and compare them with the recorded amount.
4. Investigate significant differences.
5. Document each of the above steps.
Analytic Procedures: Stages of Use
– Preliminary planning– required
– Substantive testing — optional
– Final review — required
Audit team discussions objectives
Gain understanding of:
– Previous experiences with client
– How a fraud might be perpetrated and concealed in the entity
– Procedures that might detect fraud
set proper tone for engagement
– Management
– Audit committee
– Internal auditors
– Risk of Fraud
Assess Fraud Risks
– Type of risk
– Significance of risk
– Likelihood of risk
– Pervasiveness of risk
– Assess controls and programs
Required Risk Assessments
– Presume that improper revenue recognition is a fraud risk.
– Identify risks of management override of controls.
– Identify Significant Risks
Identify risks of management override of controls.
– Examine journal entries and other adjustments.
– Review accounting estimates for biases.
– Evaluate business rationale for significant unusual transactions.
Respond to Significant Risks
– Assignment of personnel
– Choice of accounting principles
– Predictability of auditing procedures
– Retrospective review of prior year accounting estimates
Evaluate Audit Evidence
– Discrepancies in the accounting records.
– Conflicting or missing evidential matter.
– Problematic or unusual relationships between the auditor and management.
– Results from substantive of final review stage analytical procedures.
– Vague, implausible or inconsistent responses to inquiries.
Communicate Fraud Matters
– Evidence that fraud may exist must be communicated to appropriate level of management.
– Sarbanes Oxley: Significant deficiencies must be communicated to those charged with governance.
– Any fraud committed by management (no matter how small) is material.
Document Fraud Matters
– Discussion of engagement personnel.
– Procedures to identify and assess risk.
– Specific risks identified and auditor response.
– If revenue recognition not a risk—explain why.
– Results of procedures regarding management override.
– Other conditions causing auditors to believe additional procedures are required.
– Communication to management, audit committee, etc.
Direct-effect noncompliance
produce direct and material effects on the financial statements . The law or regulation can be identified with a specific account or disclosure (e.g., income tax .evasion).
– Auditor’s responsibility–design procedures to provide reasonable assurance
Indirect-effect noncompliance
are not related to specific accounts or disclosures on the financial statements (e.g., violations relating to insider securities trading, occupational health and safety, food and drug administration, environmental protection, and equal employment opportunity).
-Auditor’s responsibility—Follow up on suspected violations material to the financial statements
Red Flags of Potential Noncompliance
– Unauthorized transactions.
– Government investigations.
– Regulatory reports of violations.
– Payments to consultants, affiliates, or employees for unspecified services.
– Excessive sales commissions and agents’ fees.
– Unusually large cash payments.
– Unexplained payments to government officials.
– Failure to file tax returns or to pay duties and fees.