Instructor's Solutions Manual for Auditing, C11e (Arens/Elder/Beasley/Splettstoesser-Hogeterp)

11-10 The actions that the auditor should take when considering fraud risks at the manufacturing company (with reference to Table 11-4) are. This is a partial list. Refer to Table 11-4 for more detail. 1. Preplanning: include managements responsibility for fraud in the engagement letter, and carefully consider managements biases. For example, if the company has had difficulties obtaining contracts or has high debt, it may have a bias to overstate earnings. 2. Client risk profile: Analytical review should be used to highlight unusual relationships. Consider management characteristics and the potential for management override or manipulation of contacts. 3. Audit plan: Identify and document internal controls that could prevent or detect fraud and asses risks of fraud. Consider these controls and risks at the individual assertion level, and discuss with other team members. 4. Design further audit procedures: Adjust the audit programs to include any additional audit steps needed to consider risks of fraud. 5. Tests of controls: Include in the audit program tests of controls for those controls to be relied upon that mitigate the risks of fraud. 6. Substantive tests: Where there are weaknesses or significant risks of fraud, conduct the audit to quantify potential errors. 7. Ongoing evaluation: Incorporate results of audit tests and look for inconsistencies or unusual results. 8. Reporting: Communicate with audit committee and management the results of the audit and the impact upon the fraud risk management processes. 11-11 Auditors use several sources to gather information about fraud risks, including: Information obtained from communications among audit team members about their knowledge of the company and its industry, including how and where the company might be susceptible to material misstatements due to fraud. Responses to auditor inquiries of management about their views of the risks of fraud and about existing programs and controls to address specific identified fraud risks. Specific risk factors for fraudulent financial reporting and misappropriations of assets. Analytical procedures results obtained during planning that indicate possible implausible or unexpected analytical relationships. Knowledge obtained through other procedures such as client acceptance and retention decisions, interim review of financial statements, and consideration of inherent or control risks. 11-12 The audit team is required to conduct discussions to share insights from more experienced audit team members and to brainstorm ideas that address the following: 1. How and where they believe the entitys financial statements might be susceptible to material misstatement due to fraud. This should include consideration of known external and internal factors affecting the entity that might: create an incentive or pressure for management to commit fraud

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2. 3. 4. fraud.

provide the opportunity for fraud to be perpetrated indicate a culture or environment that enables management to rationalize fraudulent acts How management could perpetrate and conceal fraudulent financial reporting. How assets of the entity could be misappropriated. How the auditor might respond to the susceptibility of material misstatements due to

11-13 Auditors must inquire whether management has knowledge of any fraud or suspected fraud within the company. They should also inquire of the audit committee about its views of the risks of fraud and whether the audit committee has knowledge of any fraud or suspected fraud. If the entity has an internal audit function, the auditor should inquire about internal audits views of fraud risks and whether they have performed any procedures to identify or detect fraud during the year. The auditor is also required to make inquiries of others within the entity whose duties lie outside the normal financial reporting lines or responsibility about the existence or suspicion of fraud. 11-14 The auditor is required to document several matters with respect to the fraud risk assessment for the company: The decisions reached during the discussion among engagement team personnel in planning the audit about the susceptibility of the entitys financial statements to material fraud. The assessed risk of material misstatement due to fraud, both overall and at the assertion level. The response to the assessed risks of material fraud that were identified, including the impact on the nature, timing, and extent of audit procedures. Results of the procedures performed to address the risk of management override of controls. The nature of communications about fraud made to management, the audit committee, or others. Reasons supporting a conclusion that there is not a significant risk of material improper revenue recognition. The student could include examples that were specific to real estate, such as ensuring that prices were fairly set, that agent relationships were properly clarified, or other valid examples.

11-15 The three auditor responses to fraud are: (1) to change the overall conduct of the audit to respond to identified fraud risks; (2) design and perform audit procedures to address identified risks; and (3) perform procedures to address the risk of management override of controls. 11-16 Auditors are required to take three actions to address potential management override of controls: (1) examine journal entries and other adjustments for evidence of possible

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misstatements due to fraud; (2) review accounting estimates for biases; and (3) evaluate the business rationale for significant unusual transactions. 11-17 Three main techniques used to manipulate revenue include: (1) recording of fictitious revenue; (2) premature revenue recognition including techniques such as bill-and-hold sales and channel stuffing; and (3) manipulation of adjustments to revenue such as sales returns and allowances and other contra accounts. 11-18 Cash register receipts are particularly susceptible to theft. The notice your meal is free if we fail to give you a receipt is designed to ensure that every customer is given a receipt and all sales are rung on the register, establishing accountability for the sale. 11-19 The two types of inquiry are informational and assessment. Auditors use informational inquiry to obtain information about facts and details that the auditor does not have. For example, if the auditor suspects financial statement fraud involving improper revenue recognition, the auditor may inquire of management as to revenue recognition policies. The auditor uses assessment inquiry to corroborate or contradict prior information. In the previous example, the auditor may attempt to corroborate the information obtained from management by making assessment inquiries of individuals in accounts receivable and shipping. 11-20 If the auditor believes that senior management may be involved in fraud, the auditor should discuss the matter directly with the audit committee. In addition, as a minimum, the auditor should communicate the following matters: questions the auditor might have regarding the honesty and integrity of management any fraud involving management, no matter how trivial fraud involving employees who play a significant role in the entitys financial reporting and internal controls process matters, while not material now, that may cause the financial statements to be materially misstated in the future 11-21 When the auditor suspects that fraud may be present, auditing standards require the auditor to obtain additional evidence to determine whether material fraud has occurred. The auditor is also required to consider the implications for other aspects of the audit. When the auditor determines that fraud may be present, the auditor is required to discuss the matter and audit approach for further investigation with an appropriate level of management that is at least one level above those involved, and with senior management and the audit committee, even if the matter might be considered inconsequential. Discussion Questions and Problems 11-22 Information Management has a strong interest in employing Fraud Condition Incentives/Pressures
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Chapter 11: Fraud Auditing

2.

3. 4.

5.

6.

inappropriate means to minimize reported earnings for tax-motivated reasons. Assets and revenues are based on significant estimates that involve subjective judgments and uncertainties that are hard to corroborate. The company is marginally able to meet exchange listing and debt covenant requirements. Significant operations are located and conducted across international borders in jurisdictions where differing business environments and cultures exist. There are recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality. The companys financial performance is threatened by a high degree of competition and market saturation.

Opportunities

Incentives/Pressures Opportunities

Attitudes/Rationalization

Incentives/Pressures

11-23 a. Management fraud is often called fraudulent financial reporting, and is the intentional misstatement or omission of amounts or disclosures by management with the intent to deceive users. In contrast, defalcations, which are also called misappropriation of assets, involve theft of an entitys assets, and normally involve employees and others below the management level. b. The auditors responsibility to detect management fraud is the same as for other errors that affect the financial statements. The auditor should design the audit to detect errors and fraud that are material to the financial statements. c. The auditor should evaluate the potential for management fraud using the fraud triangle of incentives/pressures, opportunities, and attitudes/rationalization: Incentives/pressures: Auditors should evaluate incentives and pressures that management or other employees may have to misstate financial statements, including: o declines in the financial stability or profitability of the company due to economic, industry or company operating conditions o pressure to meet debt repayment or debt covenant terms o net worth of managers or directors is materially threatened by financial performance Opportunities: Circumstances provide an opportunity for management to misstate financial statements, such as: o Financial statements include significant accounting estimates that are difficult to verify o Ineffective board of director or audit committee oversight o High turnover in accounting personnel or ineffective accounting, internal audit, or information systems personnel Attitudes/rationalization: An attitude, character, or set of values exist that allows management to rationalize committing a dishonest act, for example:

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o inappropriate or ineffective communication of entity values o history of violations of securities laws or other laws and regulations o aggressive or unrealistic management goals or forecasts. d. There are potentially many factors that should heighten an auditors concern about the existence of management fraud. The factors (1) of an intended public placement of securities, and (2) management compensation dependent on operating results are both factors that affect incentives to manipulate financial statements. The auditor should be alert for other incentives, such as the existence of debt covenants or planned use of stock to acquire another company that may provide incentives to manipulate the financial statements. The third factor of weak internal control reflects both an opportunity for misstatement of financial statements, and an attitude that allows rationalization of actions to misstate the financial statements. As additional examples, the auditor should be alert to the potential to use accounting estimates or discretion over the timing of revenues to misstate financial statements. The auditor should also consider the attitude of management, and whether they are overly aggressive or have previously violated securities laws or other regulations. In addition to the risk factors from the fraud triangle, the auditor should consider other signals of the potential existence of management fraud. These signals may include unusual changes in ratios or other performance measures, as well as unusual or inconsistent results of enquiries of management and communication among the audit team.

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11-24 1. a. b.

c.

There may be unrecorded cash disbursement transactions. Because the transactions relate to cash disbursements, the cash account will be affected. The accounts payable account may be misstated if the disbursement is the payment on an account. If the disbursement is for the direct payment of an expense or is related to the purchase of assets, then expense or asset accounts will be affected. Payments on other liability accounts would impact those liability accounts. Existing transactions are recorded (completeness).

2. a. Management may have manipulated key assumptions so that pension expense and pension liability amounts would be lower. b. Pension expense and pension liability accounts are likely to be affected. c. Amounts included are stated at the correct values (accuracy). 3. a. b. c. There may be fictitious accounts receivable accounts included in the master file. Accounts receivable and sales are likely to be affected by fictitious receivables. Amounts included exist (existence).

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