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10-1
Chapter 10
Assessing and Responding to Fraud Risks
Concept Checks
P. 311
1. The three conditions of fraud referred to as the “fraud triangle” are (1)
Incentives/Pressures; (2) Opportunities; and (3) Attitudes/Rationalization.
management or employees to commit a dishonest act or they are in an
environment that imposes sufficient pressure that causes them to rationalize
committing a dishonest act.
2. Sources used to gather information about fraud risks include:
Information obtained from communications among audit team
members about their knowledge of the company and its industry,
Responses to auditor inquiries of management about their views of
Specific risk factors for fraudulent financial reporting and
Analytical procedures results obtained during planning that indicate
Knowledge obtained through other procedures such as client
P. 323
1. The three auditor responses to fraud are: (1) change the overall conduct of
the risk of management override of controls.
2. Three main techniques used to manipulate revenue include: (1) recording of
fictitious revenue; (2) premature revenue recognition including techniques such
10-2
Review Questions
fixed assets to increase earnings.
10-2 Misappropriation of assets is fraud that involves theft of an entity’s assets.
Two examples are an accounts payable clerk issuing payments to a fictitious
debt covenants or obtain additional financing.
Opportunities – Ineffective oversight of financial reporting by the
Attitudes/Rationalization – Management is overly aggressive. For
10-4 The following are examples of risk factors for misappropriation of
assets for each of the three fraud conditions:
Incentives/Pressures - The individual is unable to meet personal
financial obligations.
Attitudes/Rationalization – Management has disregarded the
10-5 Auditing standards require the audit team 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 entity’s financial statements might
create an incentive or pressure for management to commit
fraud.
rationalize fraudulent acts.
10-3
10-5 (continued)
reporting.
3. How assets of the entity could be misappropriated.
4. How the auditor might respond to the susceptibility of material
misstatements due to fraud.
10-6 Auditors must inquire whether management has knowledge of any fraud
or suspected fraud within the company. Auditing standards also require auditors
to inquire of the audit committee about its views of the risks of fraud and whether
10-7 Professional skepticism suggests the auditor should neither assume that
management is dishonest, nor assume unquestioned honesty, and an auditor
should remain professionally skeptical throughout the entire audit process. A
questioning mind will encourage the auditor to gather more persuasive evidence
10-8 The corporate code of conduct establishes the “tone at the top” of the
importance of honesty and integrity and can also provide more specific guidance
10-9 Management and the board of directors are responsible for setting the “tone
at the top” for ethical behavior in the company. It is important for management
10-4
10-11 The auditor can choose among several overall responses to increased
fraud risk. The auditor may begin by first discussing the auditor’s findings about
greater emphasis may be placed on the importance of increased professional
skepticism. The auditor may place greater emphasis on management’s choice of
10-13 Revenue and related accounts receivable and cash accounts are
especially susceptible to manipulation and theft. Research finds that a majority of
financial statement fraud instances involve revenues and accounts receivable. As
a result of the frequency of financial reporting frauds involving revenue
10-14 The handling of cash by individuals operating cash registers is particularly
susceptible to theft. The notice “your meal is free if we fail to give you a receipt”
example, the auditor may attempt to corroborate the information obtained from
management by making assessment inquiries of individuals in accounts
receivable and shipping. Interrogative inquiry is used to determine if the
10-5
10-16 When making inquiries of a deceitful individual, three examples of verbal
sweating or fidgeting.
10-17 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. Auditing standards also require the auditor to consider
magnitude by senior management is at least a significant deficiency and may be
a material weakness in internal control over financial reporting. This includes
fraud by senior management that results in even immaterial misstatements. If the
discussion occurred and who participated.
Procedures performed to obtain information necessary to identify and
assess the risks of material fraud.
Specific risks of material fraud that were identified at both the overall
Results of the procedures performed to address the risk of management
override of controls.
taken by the auditor.
The nature of communications about fraud made to management, the
audit committee, or others.
10-6
Multiple Choice Questions From CPA Examinations
10-19 a. (1) b. (2) c. (4)
10-22 a. (3) b. (3) c. (4)
Discussion Questions and Problems
10-23
INFORMATION
a.
FRAUD
RISK
b.
FRAUD
CONDITION
1.
Significant operations are located and
conducted across international borders in
jurisdictions where differing business
environments and cultures exist.
Yes
Opportunities
2.
There are recurring attempts by management to
justify marginal or inappropriate accounting on
the basis of materiality.
Yes
Attitudes/
Rationalization
3.
The company’s controller works very hard,
including evenings and weekends, and has not
taken a vacation in two years.
Yes
Opportunities
4.
The company’s board of directors includes
a majority of directors who are independent
of management.
No
N/A
5.
Assets and revenues are based on significant
estimates that involve subjective judgments
and uncertainties that are hard to corroborate.
Yes
Opportunities
10-7
10-23 (continued)
INFORMATION
a.
FRAUD
RISK
b.
FRAUD
CONDITION
6.
The company is marginally able to meet
exchange listing and debt covenant
requirements.
Yes
Incentives/
Pressures
7.
The company’s financial performance is
threatened by a high degree of competition
and market saturation.
Yes
Incentives/
Pressures
8.
New accounting pronouncements have
resulted in explanatory paragraphs for
consistency for the company and other firms
in the industry.
No
N/A
9.
The company has experienced low turnover in
management and its internal audit function.
No
N/A
10-24 a. The purpose of the audit team’s brainstorming session is for the
audit team to exchange ideas about how and where they believe
b. The brainstorming meeting should ordinarily involve the key members
of the audit team, ranging from audit staff members to partners on
the engagement. This meeting would include audit team members
located in other offices who work on the engagement as well as
c. The two staff members on the engagement are just as responsible
for engaging in the exchange of ideas as other members of the
engagement team. While the two new staff accountants may not be
10-8
10-24 (continued)
d. The auditor has a responsibility to plan and perform the audit to
obtain reasonable assurance about whether the financial statements
participated.
10-25 a.
WEAKNESSES IN PROCESSES
RECOMMENDATION
1. There is no basis for
establishing the number of
paying patrons.
Prenumbered admission tickets should be issued
upon payment of the admission fee.
2. There is no segregation of
duties between persons
responsible for collecting
admission fees and persons
responsible for authorizing
admission.
One clerk (hereafter referred to as the cash
receipts clerk) should collect admission fees
and issue prenumbered tickets. The other clerk
(hereafter referred to as the admission clerk)
should authorize admission upon receipt of the
ticket or proof of membership.
3. An independent count of
paying patrons is not made.
The admission clerk should retain a portion of
the prenumbered admission ticket (admission
ticket stub).
4. There is no proof of accuracy
of amounts collected by the
clerks.
Admission ticket stubs should be reconciled with
cash collected by the treasurer each day.
5. Cash receipts records are not
promptly prepared.
The cash receipts should be recorded by the
cash receipts clerk daily on a permanent record
that will serve as the first record of
accountability.
6. Cash receipts are not promptly
deposited. Cash should not be
left undeposited for a week.
Cash should be deposited at least once each
day.
10-9
10-25 (continued)
WEAKNESSES IN PROCESSES
RECOMMENDATION
7. There is no proof of the
accuracy of amounts
deposited.
Authenticated deposit slips should be compared
with daily cash receipts records. Discrepancies
should be promptly investigated and resolved.
In addition, the treasurer should establish a
policy that includes a review of cash receipts.
8. There is no record of the
internal accountability for
cash.
The treasurer should issue a signed receipt for
all proceeds received from the cash receipts
clerk. These receipts should be maintained and
should be periodically checked against cash
receipts and deposit records.
receipts.
c. The weaknesses have less of an effect on the likelihood of fraudulent
financial reporting than they do for misappropriation of assets. The
10-26 a. This fraud is an example of both asset misappropriation and
purchases from her husband or others. Behavioral red flags in the
office may have included being too controlling and not delegating
10-10
10-26 (continued)
c. It would be unusual for a manufacturing company to have several
cashier’s checks rather than using their primary bank account pre-
numbered checks. The auditors can use audit software to search
for recurring payments to vendors who are not on the company’s
approved vendor list, or can also search for cash disbursements
of the company.
d. Koss Corporation could have had more monitoring controls in
place to oversee the activities of the principal accounting officer.
The company also could have had a policy requiring employees
e. The auditors could have changed their audit approach from year-
to-year so that it was not as predictable. The auditors could have
fraud or failed to exercise due professional care. For example,
assume a fraud is covered up by incorrectly footing a bank
reconciliation, but the auditor failed to independently verify the
accuracy of the bank reconciliation. In that case, the auditor would
