Arens AAS17 sm 09 - Answers to Audit and Assurance Services PDF

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Chapter 9 Assessing and Responding to Fraud Risks 

Concept Checks

P. 281 1. The three conditions of fraud referred to as the “fraud triangle” are (1) Incentives/Pressures; (2) Opportunities; and (3) Attitudes/Rationalization. Incentives/Pressures are incentives of management or other employees to commit fraud. Opportunities are circumstances that allow management or employees to commit fraud. Attitudes/Rationalization are indications that an attitude, character, or set of ethical values exist that allow 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, including how and where the company might be susceptible to material misstatements due to fraud. Responses to auditor inquiries of management about their views of the risks of fraud and about existing programs and controls to address specific identified fraud risks. Specific risk factors for fraudulent financial reporting and misappropriations of assets. Analytical procedures results obtained during planning that indicate possible implausible or unexpected analytical relationships. Knowledge obtained thro ugh other procedures such as client acceptance and retention decisions, interim review of financial statements, and consideration of inherent or control risks.

P. 294 1. The three auditor responses to fraud are: (1) change the overall conduct of the audit to respond to identified fraud risks; (2) design and perform audit procedures to address identified risks; and (3) perform procedures to address 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 as bill-and-hold sales and channel stuffing; and (3) manipulation of adjustments to revenue such as sales returns and allowance and other contra accounts. Copy right © 2020 Pearson Education Ltd.

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Review Questions

9-1 Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users. Two examples of fraudulent financial reporting are accelerating the timing of recording sales revenue to increase reported sales and earnings, and recording expenses as fixed assets to increase earnings. 9-2 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 company controlled by the clerk, and a sales clerk fai ling to record a sale and pocketing the cash receipts. 9-3 The following are examples of risk factors for fraudulent financial reporting for each of the three fraud conditions:  



Incentives/Pressures – The company is under pressure to meet debt covenants or obtain additional financing. Opportunities – Ineffective oversight of financial reporting by the board of directors allows management to exercise discretion over reporting. Attitudes/Rationalization – Management is overly aggressive. For example, the company may issue aggressive earnings forecasts, or make extensive acquisitions using company stock.

9-4 Three conditions for fraud arising from fraudulent financial reporting and misappropriations of assets are described in the auditing standards. These three conditions are referred to as the fraud triangle: 1. Incentives/Pressures means management or other employees have incentives or pressures to commit fraud. 2. Opportunities mean circumstances provide opportunities for management or employees to commit fraud. 3. Attitudes/Rationalization means an attitude, character, or set of ethical values exists that allows 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. 9-5 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 be susceptible to material misstatement due to fraud. This should include consideration of known external and internal factors affecting the entity that might create an incentive or pressure for management to commit fraud.  provide the opportunity for fraud to be perpetrated.

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9-5 (continued) indicate a culture or environment that enables management to rationalize fraudulent acts. How management could perpetrate and conceal fraudulent fina ncial reporting. How assets of the entity could be misappropriated. How the auditor might respond to the susceptibility of material misstatements due to fraud. 

2. 3. 4.

9-6 Auditors evaluate all the sources of information gathered to assess the risk of material misstatement due to fraud as part of audit planning. Auditors assess fraud risk at both the overall financial statement level and at the assertion level for classes of transactions, account balances, and presentation and disclosure. While the assessment of fraud is conducted as part of audit planning, the auditor’s assessment of fraud risk should be on going throughout the audit, given the auditor may learn new information when performing further audit procedures that provide new insights about the risk of material misstatement. Auditors should evaluate the types of revenue and revenue transactions, and the assertions related to these transactions, which may increase fraud risk. The auditor must document that conclusion in the working papers. The auditor should also obtain an understanding of internal control related to such risks, including an evaluation of whether the controls are suitably designed and implemented. 9-7 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 to corroborate management responses, which would help the auditor distinguish intentional from unintentional misstatements. Critically assessing the evidence means the auditor evaluates each piece of evidence s eparately, but also evaluates all of the evidence gathered as a whole. For example, if all of management’s estimates are biased in the direction of increasing net income, the auditor would be more likely to conclude the misstatements are intentional. 9-8 Management is responsible for implementing corporate governance and control procedures to minimize the risk of fraud, which can be reduced through a combination of prevention, deterrence, and detection measures. As collusion and false documentation make de tection of fraud a challenge, it is often more effective and economical for companies to focus on fraud prevention and deterrence. By implementing antifraud programs and controls, management can prevent fraud by reducing opportuni ty. By communicating fraud detection and punishment policies, management can deter employees from committing fraud. Guidance developed by the AICPA identi fies three elements to prevent, deter, and detect fraud: 1. Culture of honesty and high ethics; 2. Management's responsibility to evaluate risks of fraud; 3. Audit committee oversight. Copy right © 2020 Pearson Education Ltd.

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9-9 Management has primary responsibility to design and implement antifraud programs and controls to prevent, deter, and detect fraud. The audit committee has primary responsibility to oversee the organi zation’s financial reporting and internal control processes and to provide oversight of management ’ s fraud risk assessment process and antifraud programs and controls. 9-10 The auditor can choose among several overall responses to increased fraud ri sk. The auditor may begin by first discussing the auditor’s findings about fraud risk with management to obtain management’s views of the potential for fraud and the existing controls designed to prevent or detect misstatements. The auditor should consider whether antifraud programs and controls mitigate the identified risks of material misstatement due to fraud. If the risk of material misstatement due to fraud is increased, the auditor may decide to assign more experienced personnel to the engagement, inc luding fraud specialists, and greater emphasis may be placed on the importance of increased professional skepticism. The auditor may place greater emphasis on management’s choice of accounting principles with special attention given to those that involve s ubjective measurements or complex transactions. Auditing standards also require auditors to incorporate unpredictability in the audit strategy. 9-11 Auditors are required to take three actions to address potential management override of controls: (1) examine journal entries and other adjustments for evidence of possible misstatements due to fraud; (2) review accounting estimates for biases; and (3) evaluate the business rationale for significant unusual transactions.

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9-12 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 recognition, auditi ng standards require the auditor to presume fraud risk is present in revenue recognition in all audits. In light of this presumption, auditors should evaluate the types of revenue and revenue transactions, and the assertions related to these transactions, which may increase fraud risk. 9-13 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” is designed to ensure that every customer is given a receipt and all sales are entered into the register to establish accountability for the sale. 9-14 Throughout an audit, the auditor continually evaluates whether evidence gathered and other observations made, indicate material misstatement due to fraud. 1. Use of Inquiry: Inquiry can be an effecti ve audit evidence gathering technique, and specific inquiries about the risk of fraud are required by auditing standards. 2. Evaluating Responses to Inquiry: For inquiry to be effective, an auditor needs to be skilled at listening and evaluating responses to questions. 3. Listening Techniques: It is critical for the auditor to use effective listening skills throughout the inquiry process to maintain a questioning mindset. 4. Observing Behavioral Cues: An auditor who is skilled in using inquiry evaluates verbal and nonverbal cues when listening to the interviewee. 9-15 When making inquiries of a deceitful individual, three examples of verbal cues are frequent rephrasing of the question, filler terms such as “well” or “to tell the truth,” and forgetfulness or acknowledgements of nervousness. Three examples of nonverbal cues by the individual are creating physical barriers by blocking their mouth, leaning away from the auditor, and signs of stress such as sweating or fidgeting. 9-16 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 the implications for other aspects of the audit. When the auditor determines that fraud may be present, auditing standards require the auditor to discuss the matter and audit approach for further investigation with an appropriate level of management that is at least one level above those involved, and with senior management and the audit committee, even if the matter might be consi dered inconsequential. For public company auditors, the discovery of fraud of any 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 Copy right © 2020 Pearson Education Ltd.

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public company auditor decides the fraud is a material weakness, the auditor’ s report on internal control over financial reporting will contain an adverse opinion. 9-17 Auditing standards require that auditors document the following matters related to the auditor’s consideration of material misstatements due to fraud: 

Significant decisions made during the discussion among engagement team personnel in planning the audit about the susceptibility of the entity’s financial statements to material fraud, including how and when the discussion occurred and who participated.

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Procedures performed to obtain information necessary to identify and assess the risks of material fraud.

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Specific risks of material fraud that were identified at both the overall financial statement level and the assertion level and a description of the auditor’s responses to those risks.

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Reasons supporting a conclusion that there is not a significant risk of material improper revenue recognition.

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Results of the procedures performed to address the risk of management override of controls.

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Other conditions and analytical relationships indicating that additional auditing procedures or other responses were required, and the actions taken by the auditor.

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The nature of communications about fraud made to management, the audit committee, or others.

Discussion Questions and Problems 9-18

INFORM ATION

a. FRAUD RISK

b. FRAUD CONDITION

1.

High financial stability or profitability is threatened by economic, industry, or entity operating conditions.

Yes

Ince ntives/ Pressures

2.

There is an excessive pressure for management to meet high debt repayment or other debt covenant requirements.

Yes

Ince ntives/ Pressures

3.

Management or the board of directors’ personal net worth is materially threatened very hard by the entity’s financial performance.

Yes

Ince ntives/ Pressures

4.

Significant accounting estimates involve subjective judgments or uncertainties that are ve ry difficult to verify.

Yes

Opportunities

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5.

Board of director or audit committee oversights over financial reporting very ineffectively.

Yes

Opportunities

6.

There is very high turnover or ineffective accounting, internal audit, or information technology staff.

Yes

Opportunities

7.

There is very inappropriate or ineffective communication and support of the entity’s values.

Yes

Attitudes/ Rationalization

8.

There are many known history of violations of securities laws or other laws and re gulations.

Yes

Attitudes/ Rationalization

9.

Management’s practice makes overly very aggressive or unrealistic forecasts to analysts, creditors, and other third pa rties.

Yes

Attitudes/ Rationalization

9-19

a.

b.

c.

d.

e.

The purpose of the audit team’s brainstorming session is for the audit team to exchange ideas about how and where they believe the entity’s financial statements might be susceptible to material misstatement due to fraud, how management could perpetrate and conceal fraudulent financial reporting, and how assets of the entity could be misappropriated. 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 audit specialists, such as tax or IT specialists who work on the audit engagement. The meeting should be held during planning so that the audit plan can be adjusted to address the identified risks, and emphasize professional skepticism throughout the engagement. 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 familiar with engagement specifics, they do provide a fresh perspective of possible ways management might engage in fra ud. More importantly, they will benefit from hearing the exchange of ideas from other members of the audit team. That should help heighten their professional skepticism as they perform the audit. The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by fraud or error. Thus, the auditor’s detection responsibility for fraud is no different from the auditor’s detection responsibility for errors. Auditing standards require that the audit documentation include significant decisions made during the discussion among engagement team personnel in planning the audit about the susceptibility of the entity’s financial statements to material fraud, Copy right © 2020 Pearson Education Ltd.

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including how and when the discussion occurred and who participated. 9-20

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 Cash should be deposited at least once each deposited. Cash should not be day. left undeposited for a week. 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 an...