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11 - 1©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Fraud AuditingFraud Auditing
Chapter 11Chapter 11
11 - 2©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 1Learning Objective 1
Define fraud and distinguishDefine fraud and distinguish
between fraudulent financialbetween fraudulent financial
reporting and misappropriationreporting and misappropriation
of assets.of assets.
11 - 3©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Types of FraudTypes of Fraud
Fraudulent financial reportingFraudulent financial reporting
Misappropriation of assetsMisappropriation of assets
11 - 4©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 2Learning Objective 2
Describe the fraud triangle andDescribe the fraud triangle and
identify conditions for fraud.identify conditions for fraud.
11 - 5©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
The Fraud TriangleThe Fraud Triangle
Incentives/PressuresIncentives/Pressures
OpportunitiesOpportunities Attitudes/RationalizationAttitudes/Rationalization
11 - 6©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Examples of Risks Factors for Examples of Risks Factors for Fraudulent ReportingFraudulent Reporting
Financial stability or profitability is threatened byFinancial stability or profitability is threatened byeconomic, industry, or entity operating conditions.economic, industry, or entity operating conditions.
Excessive pressure exists for management toExcessive pressure exists for management tomeet debt requirements.meet debt requirements.
Personal net worth is materially threatened.Personal net worth is materially threatened.
11 - 7©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Examples of Risks Factors for Examples of Risks Factors for Fraudulent ReportingFraudulent Reporting
There are significant accounting estimates thatThere are significant accounting estimates thatare difficult to verify.are difficult to verify.
There is ineffective oversight over financialThere is ineffective oversight over financialreporting.reporting.
High turnover or ineffective accounting internalHigh turnover or ineffective accounting internalaudit, or information technology staff exists.audit, or information technology staff exists.
11 - 8©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Examples of Risks Factors for Examples of Risks Factors for Fraudulent ReportingFraudulent Reporting
Inappropriate or inefficient communicationInappropriate or inefficient communicationand support of the entity’s values is evident.and support of the entity’s values is evident.
A history of violations of laws is known.A history of violations of laws is known.
Management has a practice of makingManagement has a practice of makingoverly aggressive or unrealistic forecasts.overly aggressive or unrealistic forecasts.
11 - 9©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Examples of Risks Factors for Examples of Risks Factors for Misappropriation of AssetsMisappropriation of Assets
Personal financial obligations create pressure toPersonal financial obligations create pressure tomisappropriate assets.misappropriate assets.
Adverse relationships between managementAdverse relationships between managementand employees motivate employees toand employees motivate employees tomisappropriate assets.misappropriate assets.
11 - 10©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Examples of Risks Factors for Examples of Risks Factors for Misappropriation of AssetsMisappropriation of Assets
There is a presence of large amounts of cashThere is a presence of large amounts of cashon hand or inventory items.on hand or inventory items.
There is an inadequate internal control overThere is an inadequate internal control overassets.assets.
11 - 11©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Examples of Risks Factors for Examples of Risks Factors for Misappropriation of AssetsMisappropriation of Assets
Disregard for the need to monitor or reduceDisregard for the need to monitor or reducerisk of misappropriating assets exists.risk of misappropriating assets exists.
There is a disregard for internal controls.There is a disregard for internal controls.
11 - 12©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 3Learning Objective 3
Understand the auditor’sUnderstand the auditor’s
responsibility for assessingresponsibility for assessing
the risk of fraud and detectingthe risk of fraud and detecting
material misstatements due tomaterial misstatements due to
fraud.fraud.
11 - 13©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Assessing the Risk of FraudAssessing the Risk of Fraud
SAS 99 provides guidance to auditorsSAS 99 provides guidance to auditorsin assessing the risk of fraud.in assessing the risk of fraud.
11 - 14©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Professional SkepticismProfessional Skepticism
SAS 1 states that, in exercising professionalSAS 1 states that, in exercising professionalskepticism, an auditor “skepticism, an auditor “neither assumes thatneither assumes thatmanagement is dishonest nor assumesmanagement is dishonest nor assumesunquestionedunquestioned honestyhonesty..””
11 - 15©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Sources of Information Gathered Sources of Information Gathered to Assess Fraud Risksto Assess Fraud Risks
CommunicationCommunicationamong audit teamamong audit team
Inquiries ofInquiries ofmanagementmanagement
RiskRiskfactorsfactors
AnalyticalAnalyticalproceduresprocedures
OtherOtherinformationinformation
Identified risks of material misstatements due to fraudIdentified risks of material misstatements due to fraud
11 - 16©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Documenting Fraud AssessmentDocumenting Fraud Assessment
DiscussionDiscussion
Specific risksSpecific risks
ProceduresProcedures
ReasonsReasons
ResultsResults Other conditionsOther conditions
Nature of communicationsNature of communications
11 - 17©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 4Learning Objective 4
Identify corporate governanceIdentify corporate governance
and other control environmentand other control environment
factors that reduce fraud risks.factors that reduce fraud risks.
11 - 18©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Corporate Governance OversightCorporate Governance Oversightto Reduce Fraud Risksto Reduce Fraud Risks
1. Create and maintain a culture of honesty1. Create and maintain a culture of honesty and high ethics.and high ethics.
2. Evaluate fraud risks and implement programs2. Evaluate fraud risks and implement programs and controls to mitigate identified fraud risks.and controls to mitigate identified fraud risks.
3. Develop an appropriate fraud oversight process.3. Develop an appropriate fraud oversight process.
11 - 19©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Example Elements for a Code of Example Elements for a Code of ConductConduct
Organizational code of conductOrganizational code of conduct
General employee conductGeneral employee conduct
Conflicts of interestConflicts of interest
Outside activities, employment, and directorshipsOutside activities, employment, and directorships
11 - 20©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Example Elements for a Code of Example Elements for a Code of ConductConduct
Relationships with clients and suppliersRelationships with clients and suppliers
Gifts, entertainment, and favorsGifts, entertainment, and favors
Kickbacks and secret commissionsKickbacks and secret commissions
Organization funds and other assetsOrganization funds and other assets
11 - 21©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Example Elements for a Code of Example Elements for a Code of ConductConduct
Organization records and communicationsOrganization records and communications
Dealing with outside people and organizationsDealing with outside people and organizations
Prompt communicationsPrompt communications
Privacy and confidentialityPrivacy and confidentiality
11 - 22©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Organizational Factors Organizational Factors Contributing to Risk of FraudContributing to Risk of Fraud
20032003 19981998 19941994
Collusion betweenCollusion betweenemployees andemployees and
third partiesthird parties
InadequateInadequateinternalinternalcontrolscontrols
ManagementManagementoverride ofoverride of
internal controlsinternal controls
484831313333
393958585959
313136363636
11 - 23©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Organizational Factors Organizational Factors Contributing to Risk of FraudContributing to Risk of Fraud
Collusion betweenCollusion betweenemployees andemployees and
managementmanagement
Lack of controlLack of controlover managementover management
be directorsbe directors
Ineffective orIneffective ornonexistent ethics ornonexistent ethics orcompliance programcompliance program
151519192323
12121111 66
1010 88 77
20032003 19981998 19941994
11 - 24©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 5Learning Objective 5
Develop responses to identifiedDevelop responses to identified
fraud risks.fraud risks.
11 - 25©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Responding to the Risk of FraudResponding to the Risk of Fraud
Change the overall conduct of the auditChange the overall conduct of the auditto respond to identified fraud risks.to respond to identified fraud risks.
Design and perform audit proceduresDesign and perform audit proceduresto address identified risks.to address identified risks.
Design and perform procedures toDesign and perform procedures toaddress the risk of managementaddress the risk of managementoverride of controls.override of controls.
11 - 26©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 6Learning Objective 6
Recognize specific fraud riskRecognize specific fraud risk
areas and develop proceduresareas and develop procedures
to detect fraud.to detect fraud.
11 - 27©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Rates of Fraud OccurrenceRates of Fraud Occurrence
20032003 19981998
Theft of assetsTheft of assets 49492222
Check fraudCheck fraud 40402626
Expense accountExpense accountabuseabuse
36361313
Credit card fraudCredit card fraud 20201313
Payroll fraudPayroll fraud 1212 33
11 - 28©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Rates of Fraud OccurrenceRates of Fraud Occurrence
20032003 19981998
Conflict of interestConflict of interest 1212 99
Inventory theftInventory theft 11111111
KickbacksKickbacks 99 66
Financial reportingFinancial reportingfraudfraud
77 33
11 - 29©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Specific Fraud Risk AreasSpecific Fraud Risk Areas
Inventory fraud risksInventory fraud risks
Revenue and accounts receivable fraud risksRevenue and accounts receivable fraud risks
Purchases and accounts payable fraud risksPurchases and accounts payable fraud risks
Other areas of fraud riskOther areas of fraud risk
11 - 30©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Learning Objective 7Learning Objective 7
Understand interview techniquesUnderstand interview techniques
and other activities after fraudand other activities after fraud
is suspected.is suspected.
11 - 31©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Methods of Uncovering FraudMethods of Uncovering Fraud
20032003 19981998 19941994
Internal controlsInternal controls
Internal auditInternal audit
NotificationNotificationby employeeby employee
77%77%51%51%52%52%
65%65%43%43%47%47%
63%63%58%58%51%51%
11 - 32©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Methods of Uncovering FraudMethods of Uncovering Fraud
20032003 19981998 19941994
AccidentAccident
Anonymous tipAnonymous tip
NotificationNotificationby customerby customer
54%54%37%37%28%28%
41%41%35%35%26%26%
34%34%41%41%34%34%
11 - 33©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Methods of Uncovering FraudMethods of Uncovering Fraud
20032003 19981998 19941994
Notification byNotification byregulatory or lawregulatory or law
enforcement agencyenforcement agency
NotificationNotificationby vendorby vendor
External auditExternal audit
19%19%16%16% 8%8%
16%16%11%11%15%15%
12%12% 4%4% 5%5%
11 - 34©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Responding to Misstatements that Responding to Misstatements that May be the Result of FraudMay be the Result of Fraud
When fraud is suspected,When fraud is suspected,the auditor gathersthe auditor gathersadditional informationadditional informationto determine whetherto determine whetherfraud actually exists.fraud actually exists.
11 - 35©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Types of Inquiry TechniquesTypes of Inquiry Techniques
Informational inquiryInformational inquiry
Assessment inquiryAssessment inquiry
Interrogative inquiryInterrogative inquiry
11 - 36©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
Types of Inquiry TechniquesTypes of Inquiry Techniques
Evaluating responsesEvaluating responses
Listening techniquesListening techniques
Observing behavioral cuesObserving behavioral cues
11 - 37©2006 Prentice Hall Business Publishing, ©2006 Prentice Hall Business Publishing, Auditing 11/e,Auditing 11/e, Arens/Beasley/Elder Arens/Beasley/Elder
End of Chapter 11End of Chapter 11