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Fraud Auditing

Chapter 11
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Learning Objective 1
Define fraud and distinguish
between fraudulent financial
reporting and misappropriation
of assets.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Types of Fraud
Fraudulent financial reporting
Misappropriation of assets

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Learning Objective 2

Describe the fraud triangle and


identify conditions for fraud.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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The Fraud Triangle


Incentives/Pressures

Opportunities

Attitudes/Rationalization

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Examples of Risks Factors for


Fraudulent Reporting
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.
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Examples of Risks Factors for


Fraudulent Reporting
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.
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Examples of Risks Factors for


Fraudulent Reporting
Inappropriate or inefficient communication
and support of the entitys values is evident.
A history of violations of laws is known.
Management has a practice of making
overly aggressive or unrealistic forecasts.
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Examples of Risks Factors for


Misappropriation of Assets
Personal financial obligations create pressure to
misappropriate assets.
Adverse relationships between management
and employees motivate employees to
misappropriate assets.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Examples of Risks Factors for


Misappropriation of Assets
There is a presence of large amounts of cash
on hand or inventory items.
There is an inadequate internal control over
assets.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Examples of Risks Factors for


Misappropriation of Assets
Disregard for the need to monitor or reduce
risk of misappropriating assets exists.
There is a disregard for internal controls.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Learning Objective 3
Understand the auditors
responsibility for assessing
the risk of fraud and detecting
material misstatements due to
fraud.
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Assessing the Risk of Fraud


SAS 99 provides guidance to auditors
in assessing the risk of fraud.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Professional Skepticism

SAS 1 states that, in exercising professional


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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Sources of Information Gathered


to Assess Fraud Risks
Communication
among audit team

Inquiries of
management

Risk
factors

Analytical
procedures

Other
information

Identified risks of material misstatements due to fraud


2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Documenting Fraud Assessment


Discussion

Procedures

Specific risks

Reasons

Results

Other conditions

Nature of communications

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Learning Objective 4

Identify corporate governance


and other control environment
factors that reduce fraud risks.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Corporate Governance Oversight


to Reduce Fraud Risks
1. Create and maintain a culture of honesty
and high ethics.
2. Evaluate fraud risks and implement programs
and controls to mitigate identified fraud risks.
3. Develop an appropriate fraud oversight process.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Organizational Factors
Contributing to Risk of Fraud
Collusion between
employees and
third parties
Inadequate
internal
controls
Management
override of
internal controls
2003

1998

48
31
33
39
58
59
31
36
36
1994

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Organizational Factors
Contributing to Risk of Fraud
Collusion between
employees and
management
Lack of control
over management
be directors
Ineffective or
nonexistent ethics or
compliance program
2003

1998

15
19
23
12
11
6
10
8
7
1994

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Learning Objective 5

Develop responses to identified


fraud risks.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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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.
2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Learning Objective 6

Recognize specific fraud risk


areas and develop procedures
to detect fraud.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Rates of Fraud Occurrence


Theft of assets
Check fraud
Expense account
abuse
Credit card fraud
Payroll fraud
2003

49
22
40
26
36
13
20
13
12
3

1998

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Rates of Fraud Occurrence


Conflict of interest
Inventory theft
Kickbacks
Financial reporting
fraud

2003

12
9
11
11
9
6
7
3

1998

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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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

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Learning Objective 7

Understand interview techniques


and other activities after fraud
is suspected.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Methods of Uncovering Fraud


77%
51%
52%
65%
43%
47%
63%
58%
51%

Internal controls
Internal audit
Notification
by employee
2003

1998

1994

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Methods of Uncovering Fraud


54%
37%
28%
41%
35%
26%
34%
41%
34%

Accident
Anonymous tip
Notification
by customer
2003

1998

1994

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Methods of Uncovering Fraud


Notification by
regulatory or law
enforcement agency

19%
16%
8%
16%
11%
15%
12%
4%
5%

Notification
by vendor
External audit
2003

1998

1994

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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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.

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Types of Inquiry Techniques

Informational inquiry
Assessment inquiry
Interrogative inquiry

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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Types of Inquiry Techniques

Evaluating responses
Listening techniques
Observing behavioral cues

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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End of Chapter 11

2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder

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