Fraud Auditing

Chapter 11

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 1

 Learning Objective 1

Define fraud and distinguish

between fraudulent financial
reporting and misappropriation
of assets.

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 Types of Fraud
 Fraudulent financial reporting

 Misappropriation of assets

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 Learning Objective 2

Describe the fraud triangle and

identify conditions for fraud.

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 The Fraud Triangle
Incentives/Pressures

Opportunities Attitudes/Rationalization

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 Examples of Risk Factors
for Fraudulent Reporting
Incentives/Pressures:
 Financial stability or profitability is threatened by
economic, industry, or entity operating conditions

 Excessive pressure exists for management to

meet debt requirements

 Personal net worth is materially threatened

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 6

 Examples of Risk Factors
for Fraudulent Reporting
Opportunities:
 There are significant accounting estimates that
are difficult to verify

 There is ineffective oversight over financial

reporting

 High turnover or ineffective accounting internal

audit, or information technology staff exists

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 Examples of Risk Factors
for Fraudulent Reporting
Attitudes/Rationalization:
 Inappropriate or inefficient communication
and support of the entity’s values is evident

 A history of violations of laws is known

 Management has a practice of making

overly aggressive or unrealistic forecasts

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 Examples of Risk Factors
for Misappropriation of Assets
Incentives/Pressures:
 Personal financial obligations create pressure
to misappropriate assets

 Adverse relationships between management

and employees motivate employees to
misappropriate assets

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 Examples of Risk Factors
for Misappropriation of Assets
Opportunities:
 There is a presence of large amounts of cash
on hand or inventory items

 There is an inadequate internal control over

assets

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 10

 Examples of Risk Factors
for Misappropriation of Assets
Attitudes/Rationalization:
 Disregard for the need to monitor or reduce
risk of misappropriating assets exists

 There is a disregard for internal controls

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 Learning Objective 3

Understand the auditor’s

responsibility for assessing
the risk of fraud and detecting
material misstatements due to
fraud.

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 Assessing the Risk of Fraud

SAS 99 provides guidance to auditors

in assessing the risk of fraud.

SAS 1 states that, in exercising professional

skepticism, an auditor “neither assumes that
management is dishonest nor assumes
unquestioned honesty.”

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 Sources of Information Gathered
to Assess Fraud Risks
Communication Inquiries of Risk Analytical Other
among audit team management factors procedures information

Identified risks of material misstatements due to fraud

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 Documenting Fraud
Assessment
 Discussion
 Procedures
 Specific risks
 Reasons
 Other conditions
 Results
 Nature of communications
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 Learning Objective 4

Identify corporate governance

and other control environment
factors that reduce fraud risks.

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 Corporate Governance Oversight
to Reduce Fraud Risks
1. Culture of honesty and high ethics

2. Management's responsibility
to evaluate risks of fraud

3. Audit committee oversight

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 Example Elements for a Code
of Conduct
 Organizational code of conduct

 General employee conduct

 Conflicts of interest

 Outside activities, employment, and directorships

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 Example Elements for a Code
of Conduct
 Relationships with clients and suppliers

 Gifts, entertainment, and favors

 Kickbacks and secret commissions

 Organization funds and other assets

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 Example Elements for a Code
of Conduct
 Organization records and communications

 Dealing with outside people and organizations

 Prompt communications

 Privacy and confidentiality

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 Organizational Factors
Contributing to Risk of Fraud
Collusion between 48
employees and 31
third parties 33
Inadequate 39
internal 58
controls 59
Management 31
override of 36
internal controls 36

2003 1998 1994

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 Organizational Factors
Contributing to Risk of Fraud
Collusion between 15
employees and 19
management 23
Lack of control 12
over management 11
by directors 6
Ineffective or 10
nonexistent ethics or 8
compliance program 7

2003 1998 1994

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 Learning Objective 5

Develop responses to identified

fraud risks.

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 Responding to the Risk of
Fraud
Change the overall conduct of the audit
to respond to identified fraud risks.

Design and perform audit procedures

to address identified risks.

Design and perform procedures to

address the risk of management
override of controls.

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 Learning Objective 6

Recognize specific fraud risk

areas and develop procedures
to detect fraud.

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 Rates of Fraud Occurrence
Theft of assets 49
22
Check fraud 40
26
Expense account 36
abuse 13

Credit card fraud 20

13

Payroll fraud 12
3
2003 1998
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 Rates of Fraud Occurrence
Conflict of interest 12
9
Inventory theft 11
11
Kickbacks 9
6
Financial reporting 7
fraud 3

2003 1998
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 Specific Fraud Risk Areas

 Revenue and accounts receivable fraud risks

 Inventory fraud risks

 Purchases and accounts payable fraud risks

 Other areas of fraud risk

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 Learning Objective 7

Understand interview techniques

and other activities after fraud
is suspected.

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 Methods of Uncovering Fraud
(Percentages) 2003 1998 1994
Internal controls 77 51 52
Internal audit 65 43 47
Notification by employee 63 58 51
Accident 54 37 28
Anonymous tip 41 35 26
Notification by customer 34 41 34
Notification by regulatory or 19 16 8
law enforcement agency
Notification by vendor 16 11 15
External audit 12 4 5
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 30
 Responding to Misstatements That
May Be the Result of Fraud
When fraud is suspected, the auditor gathers
additional information to determine whether
fraud actually exists.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 31

 Types of Inquiry Techniques
 Informational inquiry

 Assessment inquiry

 Interrogative inquiry

 Evaluating responses

 Listening techniques

 Observing behavioral cues

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 End of Chapter 11

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 11 - 33