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Fraud Auditing

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Title: Fraud Auditing


1
Fraud Auditing
2
Fraud Auditing
  • TOPICS
  • Fraud Background and History
  • Changing Landscape of the Profession
  • Requirements of SAS 99
  • Specific Fraud Examples

3
  • The accounting profession was under fire. 
  • Throughout the summer, newspapers were filled
    with new details of a corporate accounting
    scandal.
  • One of the largest, most respected companies in
    the United States had been caught inflating
    earnings and assets through blatant manipulation
    of the accounting rules.
  • Thousands of investors and employees had
    suffered.
  • Congressional hearings were called to examine and
    understand the fraud, and everyone asked, "Where
    were the auditors?" 
  • The accounting profession was under immense
    political pressure from reform-minded lawmakers,
    and the negative publicity surrounding the
    perceived audit failure cast all CPAs in the most
    unfavorable light.

4
Fraud
  • Enron?
  • WorldCom?
  • Perhaps ESM Government Securities?
  • Maybe the infamous ZZZZ Best?
  •  

Fraud
5
Fraud
  • The Year?
  • - 1938
  • The Company?
  • - McKesson-Robbins
  • The Result?
  • - New audit rules requiring confirmation of
    receivables and observation of inventory
  •  

6
History of Fraud
  • The term cooking the books was first used to
    refer to George Hudson, the railway king in
    Britain, who falsified the books of the Eastern
    Counties Railways in the mid 1800s. He was
    exposed as a fraudster and jailed.

7
The Enron Effect
  • Enron was different
  • Size of company
  • Role of Andersen in obstruction
  • Complexity of issues involved
  • WorldCom was the follow-up punch
  • Large, yet comparatively plain vanilla fraud of
    improperly capitalized fixed assets
  • Other frauds suggest problems werent limited to
    Andersen

8
A Changed Landscape
  • Sarbanes-Oxley termed the most significant
    securities legislation since 33 and 34
    Securities Acts
  • Public Company Accounting Oversight Board created
  • Establish auditing standards for auditors of
    public companies
  • Establish and enforce quality control standards
  • Required reporting on internal control over
    financial reporting
  • Further restrictions on nonaudit services for
    public company audit clients

9
Forensic Accounting The Hot New Career
  • Forensic accountants must have the skills of
    both a private investigator and an accountant
  • US News World Report labels forensic accounting
    one of the 20 hot job tracks of the future.

10
Fraud is on the Increase
of Companies Reporting
Theft of Assets
Fraudulent Financial Reportng
Source KPMG Fraud Survey
11
How Are Frauds Detected?
Source KPMG Fraud Survey
12
The Fraud Triangle
  • Incentives/Pressures

Opportunities
Attitudes/Rationalization
13
Auditor Responsibility
  • An auditor is responsible to detect material
    misstatements in the financial statements,
    whether due to
  • Errors
  • Fraud
  • This responsibility is unchanged, but guidance to
    auditors has

14
SAS 99 on Fraud
  • SAS 99 is effective for audits beginning on or
    after December 15, 2002
  • Supercedes SAS 82 which was issued in 1997
  • Recognition of need for better guidance and
    linkage between fraud risks and audit tests
  • Selected key components of SAS 99
  • Emphasis on professional skepticism by auditors
  • Brainstorming by staff to identify fraud risks
  • Developing specific procedures to respond to
    fraud risk
  • Revenue recognition generally recognized as a
    specific fraud risk

15
Information to Assess Fraud Risks
Analytical Procedures
Fraud Risk Factors
Inquiries
Other Information
Brainstorming
Identified Fraud Risks
16
SAS 99 on Fraud
  • Focus on the fraud triangle by major fraud
    types
  • Misappropriation of assets
  • Fraudulent financial reporting
  • Auditors primary concern is fraudulent reporting
  • Cannot ignore misappropriation of assets
  • Material in some cases
  • Often accompanies fraudulent financial reporting
  • Source of expectation gap
  • Misappropriations are best prevented by
    appropriate controls

17
  • Multiple Choice 11-21 (b)
  •  
  • As a result of analytical procedures, the auditor
    determines that the gross profit percentage has
    increased from 30 in the preceding year to 40
    in the current year. The auditor should
  • Document managements plans for maintaining this
    trend.
  • Evaluate managements performance in causing the
    improvement in gross profit.
  • Require footnote disclosure.
  • Consider the possibility of fraud or other
    misstatements in the financial statements.

18
Responding to the Risk of Fraud
  •  
  • Design and perform audit procedures to address
    identified risks.
  • Change the overall conduct of the audit to
    respond to identified fraud risks.
  • Perform procedures to address the risk of
    management override of controls.

19
Responding to the Risk of Fraud
  •  Design and perform audit procedures to address
    identified risks.
  • In most cases, it is not sufficient to test more.
    Instead, the auditor must test differently to
    address fraud risks.
  • Key point
  • Auditor responds to increases in IR and CR by
    testing more.
  • Auditor responds to fraud risk with different
    procedures and approaches.

20
Revenue Recognition
  • Revenue recognition is the hot financial
    reporting issue
  • Report from COSO indicates that improper revenue
    recognition is found in over half of major case
    of fraudulent financial reporting
  • SAS 99 indicates auditors should normally assess
    risk of fraud due to improper revenue recognition

21
Accelerated Revenue Channel Stuffing
  • Companies often try to accelerate the timing of
    revenues by shipping unwanted goods to customers
  • Sunbeam and infamous Chainsaw Al Dunlap
    barbeque grills were sold out of season
  • Bausch Lomb Shipped several months supply of
    contacts to suppliers with unconditional right of
    return
  • What tests would indicate these problems?

22
Accelerated Revenue Leases
  • Xerox is a recent high-profile case
  • Leases had three components the value of the
    equipment, servicing over the life of the lease,
    and financing
  • Equipment revenue recorded at the beginning of
    the lease
  • Servicing and financing recognized over the life
    of the lease contract
  • Xerox shifted servicing and financing revenue to
    the value of the equipment to recognize more
    revenue immediately

23
Inventory Fraud
  • From McKesson Robbins to the infamous Salad
    Oil scandal to Crazy Eddie, many frauds have
    involved fictitious inventory
  • Cost of Goods Sold calculation
  • Beginning inventory
  • Purchases
  • - Ending Inventory
  • Cost of Good sold
  • What happens if the company overstates inventory?
  • How would you know if inventory didnt exist?

24
Fixed Assets
  • Expanded Accounting Equation
  • Assets Liabilities Equity Revenues
    Expenses
  • What happens when a company records an expense as
    an asset?
  • How can an accountant detect this?
  • Prominent recent examples included WorldCom and
    HealthSouth

25
Disclosure in Extractive Industries
  • Value of company is largely related to value of
    unrecorded oil or mineral reserves
  • Shell Oil has just been charged with overstating
    its oil reserves
  • Bre-X case involved fictitious gold deposits in
    Indonesia
  • Value based on samples that were salted with
    gold
  • One of the perpetrators allegedly committed
    suicide by jumping from a helicopter

26
  • Multiple Choice 11-22 (a)
  •  
  • Cash receipts from sales on account have been
    misappropriated. Which of the following acts
    would conceal this defalcation and be least
    likely to be detected by the auditor?
  • Understating the sales journal.
  • Overstating the accounts receivable control
    account.
  • Overstating the accounts receivable subsidiary
    ledger.
  • Understating the cash receipts journal.
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