Fraud Auditing

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Fraud Auditing
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Fraud Auditing

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

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• 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.

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Fraud

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

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

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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.

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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

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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

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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.

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Fraud is on the Increase
of Companies Reporting
Theft of Assets
Fraudulent Financial Reportng
Source KPMG Fraud Survey
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How Are Frauds Detected?
Source KPMG Fraud Survey
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The Fraud Triangle

• Incentives/Pressures

Opportunities
Attitudes/Rationalization
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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

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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

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Information to Assess Fraud Risks
Analytical Procedures
Fraud Risk Factors
Inquiries
Other Information
Brainstorming
Identified Fraud Risks
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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

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• 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.

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Responding to the Risk of Fraud

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• 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.

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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.

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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

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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?

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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

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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?

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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

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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

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• Multiple Choice 11-22 (a)
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• 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.