Audit Chapter 10
Terms in this set (31)
inquiry to corroborate or contradict prior information obtained
deliberate actions taken by management to meet earnings objectives
Fraud risk factors
entity factors that increase the risk of fraud
represents the three conditions of fraud; incentives/pressures, opportunities, and attitudes/rationalization
analysis of percentage changes in financial statement numbers compared to the previous period
form of earnings management in which revenues and expenses are shifted between periods to reduce fluctuations in earnings
inquiry to obtain information about facts and details the auditor does not have
inquiry used to determine if the interviewee is being deceptive or purposefully omitting disclosure of key knowledge of facts, events, or circumstances
Premature revenue recognition
recognition of revenue before accounting standards requirements for recording revenue have been met
analysis in which financial statement numbers are converted to percentages of a base; also called common-size financial statements
. What are the 3 conditions of fraud often referred to as the "fraud triangle"?
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.
. What sources are used by the auditor to gather information to assess fraud risk
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 through other procedures such as client
acceptance and retention decisions, interim review of financial
statements, and consideration of inherent or control risks.
What are 3 ways auditors respond to fraud risks?
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.
Describe the 3 main techniques used to manipulate revenue
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
Define fraudulent financial reporting and give 2 examples that illustrate fraudulent financial reporting
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.
Define misappropriation of assets and give 2 examples of misappropriation of assets
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 failing to record a sale and
pocketing the cash receipts.
Give examples of risk factors for fraudulent financial reporting for each of the 3 fraud conditions: incentives/pressures, opportunities, and attitudes/rationalization
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
Attitudes/Rationalization - Management is overly aggressive. For
example, the company may issue aggressive earnings forecasts,
or make extensive acquisitions using company stock.
What should the audit team consider in its planning discussion about fraud risks?
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
Opportunities - There is insufficient segregation of duties that allows
the individual to handle cash receipts and related accounting records.
Attitudes/Rationalization - Management has disregarded the
inadequate separation of duties that allows the potential theft of
Auditors are required to make inquiries of individuals in the company when gathering info to assess fraud risk. Identify those with whom the auditor must make inquiries.
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
provide the opportunity for fraud to be perpetrated.
indicate a culture or environment that enables management to
rationalize fraudulent acts.
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2. How management could perpetrate and conceal fraudulent financial
3. How assets of the entity could be misappropriated.
4. How the auditor might respond to the susceptibility of material
misstatements due to fraud.
The 2 components of professional skepticism are a questioning mindset and a critical assessment of the audit evidence. How do these components help an auditor distinguish an unintentional misstatement from an international (fraudulent) misstatement?
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 separately, 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.
Describe the purpose of corporate codes of conduct and identify 3 examples of items addressed in a typical code of conduct.
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
about permitted and prohibited behavior. Examples of items typically addressed
in a code of conduct include expectations of general employee conduct,
restrictions on conflicts of interest, and limitations on relationships with clients
Discuss the importance of the control environment or "setting the tone at the top," in establishing a culture of honesty and integrity in a company.
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
to behave with honesty and integrity because this reinforces the importance of
these values to employees throughout the organization
Distinguish management's responsibility from the audit committee's responsibility for designing and implementing antifraud programs and controls within a company.
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 organization's financial reporting and
internal control processes and to provide oversight of management's fraud risk
assessment process and antifraud programs and controls.
Describe the types of overall responses by auditors to address fraud risk.
The auditor can choose among several overall responses to increased
fraud risk. 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, including 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 subjective
measurements or complex transactions. Auditing standards also require auditors
to incorporate unpredictability in the audit strategy
What 3 auditor actions are required to address the potential for management override of controls?
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.
What do auditing standards require the auditor to consider when assessing the risk of material misstatements in revenue?
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, auditing 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.
You go through the drive-through window of a fast food restaurant and notice a sign that reads, "your meal is free if we fail to give you a receipt." Why would the restaurant post this sign?
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.
Name the 3 categories of inquiry and describe the purpose of each when used by an auditor to obtain additional info about a suspected fraud.
The three types of inquiry are informational, assessment, and interrogative.
Auditors use informational inquiry to obtain information about facts and details
that the auditor does not have. For example, if the auditor suspects financial
statement fraud involving improper revenue recognition, the auditor may
inquire of management as to revenue recognition policies. The auditor uses
assessment inquiry to corroborate or contradict prior information. In the previous
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
interviewee is being deceptive or purposefully omitting disclosure of key
knowledge of facts, events, or circumstances. For example, a senior member of
the audit team might make interrogative inquiries of management or other
personnel about key elements of the fraud where earlier responses were
contradictory or evasive.
Identify 3 verbal and 3 nonverbal cues that may be observed when making inquiries of an individual who is being deceitful
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.
You have identified a suspected fraud involving the company's controller. What must you do in response to this discovery? How might this discovery affect you report on internal control when auditing a public company?
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 considered
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
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
Describe the types of info that should be included in the auditor's working papers as evidence of the auditor's fraud assessment procedures.
diting 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.
• 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
financial statement level and the assertion level and a description of the
auditor's responses to those risks.
• Reasons supporting a conclusion that there is not a significant risk of
material improper revenue recognition.
• Results of the procedures performed to address the risk of management
override of controls.
• Other conditions and analytical relationships indicating that additional
auditing procedures or other responses were required, and the actions
taken by the auditor.
• The nature of communications about fraud made to management, the
audit committee, or others.