Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e
Solutions for Chapter 2
True/False Questions
2-1 F
2-2 F
2-4 F
2-6 T
2-8 T
2-10 T
2-12 F
Multiple Choice Questions
2-13 B
2-14 B
2-16 E
2-18 C
2-20 D
2-22 D
2-24 B
Review and Short Case Questions
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Fraud is an intentional act involving the use of deception that results in a misstatement of the
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Three common ways that fraudulent financial reporting can be perpetrated include:
• Manipulation, falsification or alteration of accounting records or supporting documents
• Misrepresentation or omission of events, transactions, or other significant information
• Intentional misapplication of accounting principles
Common types of fraudulent financial reporting include:
• Improper revenue recognition
• Improper deferral of costs and expenses
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The reporter’s statement makes sense. Asset misappropriations are much easier to accomplish in
small organizations that don’t have sophisticated systems of internal control. Fraudulent financial
reporting is more likely to occur in large organizations because management often has ownership
of or rights to vast amounts of the company’s stock. As the stock price goes up, management’s
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a. A Ponzi scheme occurs when the deposits of current investors are used to pay returns on
the deposits of previous investors; no real investment is happening.
b. The key elements of the Bernie Madoff fraud include:
• Fabricated “gains” of almost $65 billion
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• Accomplished the scheme by keeping all the fraudulent transactions off the real financial
statements of the company
c. The Bernie Madoff fraud is primarily a case of asset misappropriation. However, it is
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a. Management perpetrated the fraud by filling inside containers with water in the larger
containers filled with oil. Further, they transferred the oil from tank to tank in the order in which
they knew the auditors would proceed through the location.
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Incentives relate to the rationale for the fraud, e.g., need for money, desire to enhance stock
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Common incentives for fraudulent financial reporting include:
• Management compensation schemes
• Other financial pressures for either improved earnings or an improved balance sheet
• Debt covenants
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Factors, or red flags, that would be strong indicators of opportunity to commit fraud include:
• inadequate segregation of duties
2-4
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The ability to rationalize is important. Unless fraudsters are outright criminals, they will often be
able to come up with an excuse for their behavior. “Accounting rules don’t specifically disallow
it” or “the company owes me” are potential rationales. Other common rationalizations include:
• Unfair financial treatment (perceived) in relationship to other company employees
• “It is only temporary”, or “it’s a loan from the company”
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a. incentive
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Refer to Exhibit 2.3 for brief descriptions.
a. Enron: fraudulent financial reporting
b. WorldCom: fraudulent financial reporting
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2-36
a. Professional skepticism is an attitude that includes a questioning mind and a critical
assessment of audit evidence; requires an ongoing questioning of whether the information and
audit evidence obtained suggests that a material misstatement due to fraud may exist.
b. Professional skepticism is helpful in detecting fraud because without it the external
auditor will be easily convinced of alternative explanations to the fraud that management will
provide to conceal the fraud.
Publicly available evidence exists that might help you assess whether an individual warrants
increased skepticism. Information can include: tax liens, credit scores, and legal filings.
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a. If a company has good products, it would be expected that it should have comparable
2-6
b. The company is doing better than its competitors and it appears to have achieved these
better results through cost control. While cost control might be a valid explanation, the auditor
should consider other potential explanations such as inappropriately capitalizing expenses,
inappropriately recognizing revenue, etc.
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Some of the key findings of the COSO study included:
• The amount and incidence of fraud remains high.
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a. The various failures and environmental characteristics during the time of the Enron fraud
include:
• Weak management accountability.
• Weak corporate governance.
• Accounting became more rule-oriented and complex.
b. In terms of the fraud triangle,
• Incentives: management was very concerned about managing stock prices through
keeping debt off the balance sheet; the underlying business model of the company was
not working; the company had strayed too far away from its “utility” roots and employees
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were taking significant risks in the financial markets that did not yield expected profits,
thereby creating strong incentives for top management to conduct the fraud.
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Auditing standards historically have reflected a belief that it is not reasonable for auditors to
detect cleverly implemented frauds. However, it is increasingly clear that the general public, as
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The three ways in which individuals involved in the financial reporting process, including the
external auditor, can mitigate the risk of fraudulent financial reporting include:
• Acknowledging that there needs to exist a strong, highly ethical tone at the top of an
organization that permeates the corporate culture, including an effective fraud risk
management program.
Will these actions be effective? This should promote a lively debate among students if this
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2-8
information that is learned through the inspection process can be used as a basis for modifying
and enhancing auditing standards.
b. These sections improve auditor independence by separating consulting and auditing by
the same audit firm. The partner rotation requirement ensures that a “fresh set of eyes” will be
responsible for oversight on the engagement.
c. The “cooling off” period helps to avoid conflicts of interest between top members of the
engagement team and the client. By requiring a cooling off period, an auditor will not be unduly
influenced (or appear to be unduly influenced) by the possibility of high-level employment with
the client.
e. The certification requirements help address the risk of fraud by forcing the CEO and CFO
to take internal controls and high quality financial reporting seriously. By forcing them to sign,
they will likely require individuals below them to provide assurance that those departments or
organizational units are each committed to internal controls and high quality financial reporting
as well. Of course, a signature is just a signature! So, the likelihood that a CFO who is
committing fraud will certify falsely is probably 100%. Thus, this mechanism is not without
practical flaws.
f. It addresses off-balance sheet transactions and special purpose entities, which were the
main mechanisms used to conduct the Enron fraud.
h. One member of the audit committee needs to be a financial expert to ensure that there is
the knowledge necessary on the audit committee to critically evaluate management’s financial
reporting and internal control choices. Without that knowledge, the committee may be unduly
influenced by management’s preferences.
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2-43
2-44
The major parties involved in corporate governance, and their role/activities are as follows:
Party
Overview of Responsibilities
Stockholders
Broad Role: Provide effective oversight through election of board
members, through approval of major initiatives (such as buying or
• Approving major changes, such as mergers
• Approving corporate strategy
• Overseeing accountability activities
Management
stakeholder, and regulatory requirements
• Implementing an effective ethical environment
Broad Role: Manage the organization effectively; provide accurate
and timely accountability to shareholders and other
the Board of
Directors
statements and public reports on internal control
Specific activities include:
• Selecting the external audit firm
• Approving any nonaudit work performed by the audit firm
• Selecting and/or approving the appointment of the Chief
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• Discussing audit findings with internal and external auditors,
and advising the board (and management) on specific actions that
should be taken
• Interpreting previously issued standards
public companies and their auditors
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These principles include:
• The board’s fundamental objective should be to build long-term sustainable growth in
shareholder value for the corporation.
• Successful corporate governance depends upon successful management of the company, as
management has the primary responsibility for creating a culture of performance with
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a. Independent directors are more likely to stand up to management and report fraud than
those directors that are not independent.
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d. Having a written charter and an annual performance evaluation ensures that the
committee responsibilities are appropriate, and that the responsibilities are actually accomplished
(or shareholders are alerted if they are not accomplished). Accomplishing such activities acts as a
deterrent to fraud.
e. By having an independent compensation committee, top management will be less able to
inappropriately influence compensation decisions for themselves.
i. These requirements encourage a high quality set of corporate governance behaviors,
which taken together act as a deterrent to fraud.
j. By making the ethics issue a prominent disclosure, it encourages management and other
individuals within the organization to take it more seriously. It acts to encourage a high quality
“tone at the top”.
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a. This requirement forces audit committees to take internal controls seriously, and to
consider any potential independence impairments for the external auditor. Both internal controls
and high quality external auditing are critical for the prevention and/or detection of fraud.
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b. This requires the audit committee to be engaged and informed about financial accounting
at the company; being engaged and informed enhances the ability of the audit committee to
detect fraud.
c. Analyst interactions and the pressure to meet their expectations provide incentives for
fraud. By requiring that the audit committee discuss the earnings release process, audit
committees have more control over what and how management engages with analysts, and that
control should assist in deterring fraud.
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a. The audit committee must be comprised of “outside” independent directors, one of whom
must be a financial expert. The audit committee now has the authority to hire and fire the
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c. The audit committee is basically in a position of mediator, but not problem solver. One
member must be a financial expert, but all members must be well versed in the field. This
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Factors
a. The company is in the
b. The CEO’s and CFO’s
compensation is based on three
c. The audit committee meets
semi-annually. It is chaired by a
President of the Chamber of
Commerce and the other is a
retired executive from a
successful local manufacturing
Factors
d. The company has an internal
auditor who reports directly to
the CFO, and makes an annual
report to the audit committee.
organization to reduce costs and
centralize authority (most of it in
him).