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McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
Chapter 3
Management Fraud and Audit Risk
"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently."
- - Warren Buffet, billionaire investor
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
Presentation Outline
I. Errors, Fraud, and Illegal Acts
II. Steps in Considering the Risk of Fraud (SAS 99)
III. The Audit Risk Model
IV. Audit Programs and Procedures
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I. Errors, Fraud, and Illegal Acts
A. ErrorsB. Management Fraud
C. Consideration of Fraud in a Financial Statement Audit
D. Reasons Auditors Fail to Detect FraudE. Auditor Responsibility for Detecting Errors,
Frauds, and Illegal Acts
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A. Errors
Errors are unintentional
misstatements or omissions of amounts or
disclosures in financial statements.
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B. Management Fraud
Management fraud is intentional
misstatements or omissions of amounts
or disclosures in financial statements
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C. Consideration of Fraud in a Financial Statement Audit
SAS 99 requires auditors to understand fraud, assess fraud risks, design audits to provide reasonable assurance of detecting material
management/employee fraud that could have a material effect on the financial statements, and report the findings to management, directors, users of financial statements (sometimes), and
outside agencies (under certain conditions).
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D. Reasons Auditors Fail to Detect Fraud
Over reliance on client representations.Lack of awareness or failure to recognize that an
observed condition may indicate a material fraud.Lack of experience.
Personal relationships with clients.
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E. Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts
Responsible forDetection?
Must Communicate Findings?
Material
Immateri
al
Material
Immaterial
Errors
Yes
No
Yes(Audit
Committee)
No
Fraud
Yes
No
Yes(Audit
Committee)
Yes(One level
above)
Illegal Acts
Yes
(Direct Effect)
No
Yes
(Audit Committee)
Yes(One level
above)
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II. Steps in Considering the Risk of Fraud (SAS 99)
Step 1: Staff discussion
Step 2: Identify information necessary to assess fraud risk factors
Step 3: a. Identify and b. Assess fraud risk factors
Step 4: Respond to risk assessment
Step 5: Evaluate audit evidence
Step 6: Communicate fraud matters
Step 7: Document
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Step 1: Discussion Among Engagement Personnel
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 toneShould be continuous
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Step 2: Obtain Information to Identify Risks
Inquiries:ManagementAudit committeeInternal auditorsOthers
Planning analytical proceduresAnalytical procedures are very useful in identifying
unusual relationships among financial statement accounts that merit additional investigation.
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Step 3a: Identify Risk Factors Related to Fraudulent Financial
Reporting
1) Management’s characteristics and influence
2) Industry Conditions
3) Operating Characteristics and Financial Stability
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1) 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.
Nonfinancial 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.
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2) 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.
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3) Operating CharacteristicsA 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.
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Step 3b: Assess Fraud Risks
Required risk assessments include:Presume that improper revenue recognition is a fraud risk.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.
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Step 4: Respond to Assessed Risks
Assignment of personnel (i.e., level of experience)
Predictability of auditing proceduresExamination of journal entries and other
adjustmentsRetrospective review of prior year accounting
estimates