GSA 552 Midterm 1

Data Flow Diagrams (DFDs) - Part 2
Class Notes
Audit Committee Responsibilities
1) Providing confidential reporting for F/S and I/C matters (Hotline)
2) Appointment, compensation, and oversight of external auditors
3) Review of significant F/S matters w/ external auditors
4)Review I/C reports w/ external auditors
5) review results of audit w/ external auditors and mgmt
6) Discuss any necessary accounting changes to F/S
Class Notes
Members of Board of Directors
Made up of exec members but majority must be non-exec members per the SOX guidelines
Class Notes
Earnings Management
-Income smoothing
-manipulating reserves, allowances, deferred revenue, estimates, and accruals
Class Notes
Earnings Management Continuum
Tool that auditors use to assess a company's earnings management. The scale ranges from conservative to neutral to aggressive to fraudulent.
Elements of Internal Control
Communication and Information (hiring practice)
Risk Assessment
Activities (seg of duties, independent checks, authorization)
Environment ("tone at the top," hotline, whistleblowing)
Class Notes
-Contingent Liabilities (e.g. lawsuits) - must be probable and estimable to record, otherwise it is footnoted.
-if at 12/31 not determined but then on 1/15 it is
settled, it is considered as a subsequent event and
the liability should be recorded in the prior year
-Mandatory if probable and can be reasonably estimated.
-Auditors must be careful to pay attention to accruals that are up to mgmt's discretion (e.g. bonuses)
Class Notes
Definition of Materiality
Magnitude of an omission/misstatement of acct info that in the light of surrounding circumstances makes it probable that the judgement of a reasonable person relying on the info would have been changed or influences by the omission/misstatement.
Class Notes
6 Pillars of Character
Civic Duty
Accountability and Responsibility
Fairness (justice)
Trustworthiness (integrity, honesty, reliability, ethical courage...)
Class Notes
SAS 99
-Provides guidance for behavioral characteristics of mgmt (Barry Minkow at ZZZZ Best)
-Specific Red Flags (look at whether direct access to BoD exists, or (-) cf to (+) cf in short period of time)
-Fraud categories (timing schemes, diff auditors for diff branches)
-Detection Methods (analytic ratios, patterns)
Class Notes
In regards to detecting fraud, auditors should...
(1) Use fraud triangle to assess risk of material misstatement
(2) Obtain info to assess risk of fraud while using professional skepticism
(3) Assess tone at the top, the ethics of the organization as part of the I/C review
(4) Brainstorming w/ audit team to discuss data collection and concerns
(5) Use analytical procedures to identify fraud risks
(6) Carefully review estimates and unusual transactions
(7) Meet with Audit committee to discuss audit results, required adjusting entries, application of GAAP and internal controls
Class Notes
Organizational Structure
[BoD]---[CEO]---[CFO]--- [Controller]--- [Acct Dept]
Class Notes
Accountants should pay attention to...
Cutoff at y/e
ST vs LT debt
Marketable Securities (Trading has changes on I/S, while A4S records changes on OCI)
Class Notes
Negative Work Environment
Unrealistic Expectations
Poor Training
Mgmt not Recognizing performance
Lack of promotion opportunities
Autocratic rather than participative mgmt
Lack of attention to fraud risk
Low Company loyalty
Reactive rather than proactive mgmt
Chapter 2
3 elements of fraud
(1) the theft act
(2) concealment
(3) conversion (spending the stolen assets)
Chapter 2
Elements of the Fraud Triangle
Perceived Pressure, Rationalization, Opportunity

Works on a scale (with a lot of two, only a small amount of the third makes it likely)
Chapter 2
Elements of the Fraud Triangle - Pressure
-Financial (greed, living beyond one's means, ZZZZ Best)

-Vices (gambling, addictions)

-Work-related (getting little recognition, generally occurs in smaller companies due to lack of I/C)

-Most common - when management fraud occurs, companies overstate assets & NI

-Individuals with high integrity and low opportunity need high pressure to be dishonest. Without some kind of pressure, fraud rarely occurs.
Chapter 2
Elements of the Fraud Triangle - Opportunity
-Lack of controls that prevent/detect fraud
>have effective control framework
>Control environment
>Accounting System
>Control Activities (procedures)

-Inability to judge quality of performance

-failure to discipline the fraud perpetrator (Perceived opportunity is removed when there is a high probability that perpetrators will be punished, not just discovered)

-lack of access to info

-ignorance, apathy, and incapacity (Pigeon drops: designed to take advantage of elderly victims)

-lack of audit trail
Chapter 2
(Elements of the Fraud Triangle - Opportunity)
Control Environment
-tone at the top (proper modeling and labeling)
-consistent mgmt communication
-appropriate hiring
-clear organizational structure
-effective internal audit depts (visible, effective security system)
Chapter 2
(Elements of the Fraud Triangle - Opportunity)
Accounting System
-provides audit trail that makes concealment difficult
-system makes sure that all transactions are valid, properly authorized, complete, properly classified, reported in the proper period, properly valued, and summarized correctly)
Chapter 2
(Elements of the Fraud Triangle - Opportunity)
Control Activities
-segregation of duties and dual custody
-system of authorizations (spending limits, passwords)
-independent checks
-physical safeguards
-documents and records
Chapter 2
Elements of the Fraud Triangle - Rationalization
Common: "I deserve more, I am only borrowing the money and will pay it back, nobody will get hurt, it's for a good purpose, I pay more than my fair share of taxes, the gov't wastes money"
Chapter 2
DQ 2: What motivate people to commit fraud?
People are motivated by financial pressures, vices, and work-related pressures. When the opportunity and pressure exists, people are able to rationalize their fraud by saying "I deserve more," or "its for a good purpose."
Chapter 3
Fighting Fraud
-Fraud Prevention
-Early fraud protection
-Fruad investigation
-follow up/legal action with perpetrators
Chapter 3
(Fighting Fraud)
Fraud Prevention
-Sustain culture of honesty
-Assess risks for fraud
-develop concrete responses to mitigate risk
-eliminate those opportunities for fraud
Chapter 3
(Fighting Fraud - Fraud Prevention)
Sustain a culture of Honesty
-Top Mgmt model behavior
-Appropriate hiring
-Communicate expectations with written acceptance
-create positive work environment
-enforce policies for handling fraud
Chapter 3
(Fighting Fraud - Fraud Prevention - Sustain a culture of Honesty)
Appropriate hiring
-Proactive Hiring Procedures (Background checks, honesty tests, references)
-Use the Ethical Maturity Model:
i.Ethical Leadership: helping others to be ethical
ii.Ethical courage: willingness to pay the price for ethics (conviction)
iii.Application of ethics to business situations: application of ethical understanding in business setting
iv.Personal Ethical Understanding: Right/Wrong, Integrity, Respect
Chapter 3
(Fighting Fraud - Fraud Prevention - Sustain a culture of Honesty)
Communicate expectations with written acceptance
-Identify & codify appropriate values and ethics
-Training employees in fraud awareness
-Communicating consistent expectations about punishment of violators
-Using a Code of Conduct
Chapter 3
(Fighting Fraud - Fraud Prevention - Sustain a culture of Honesty)
Enforce Policies for Handling Fraud
Ensure that:
-Facts are investigated thoroughly
-Firm and consistent actions are taken against perpetrators
-Risks and controls are assessed and improved
-Communication and training are ongoing
Chapter 3
(Fighting Fraud - Fraud Prevention )
Eliminate opportunities for fraud
-Identify and measure fraud risks
-Implement preventative and detective controls
-Create widespread monitoring by employees
-Have internal and external auditors provide independent checks on performance
Chapter 3
(Fighting Fraud)
Fraud Detection
Involves activities to determine whether or not it is likely that fraud is occurring; allows companies to identify suspicions or predictions of fraud
-By chance
-By providing "whistle-blowing" systems
-By data mining
Chapter 3
(Fighting Fraud - Fraud Detection)
Data Mining
Examining transaction records and docs to determine if there are anomalies that could represent fraud

This is an example of proactive fraud detection
Chapter 3
(Fighting Fraud - Fraud Detection)
-A reporting hotline or online system that allows others to call and submit an anonymous tip of fraud suspicion
-Internal system/hotlines, Association of CFE, allegiance

This is an example of proactive fraud detection
Chapter 3
(Fighting Fraud)
Fraud Investigation (Predication)
Fraud investigation should occur only if a predication of fraud exists.

Predication refers to the circumstances, taken as a whole, that would lead a reasonable, prudent professional to believe a fraud has occurred, is occurring, or will incur.
Chapter 3
(Fighting Fraud - Fraud Investigation)
Types of Fraud Evidence
-Testimonial : gathered from individuals (interviewing, honesty tests, interrogation)
-Documentary: gathered from papers, computers (doc examinations, data mining, public record searches, audits, f/s analysis)
-Physical: fingerprints, tire tracks, stolen property
-Personal Observation: Evidence that is "sensed" (seen, heard, felt)
Chapter 3
(Fighting Fraud - Fraud Investigation)
-Undertaken only to "establish the truth"
-Experienced and objective investigators
-Need to know
-Evidence independently corroborated
-No questionable investigative techniques
-Fair and objective communication
Chapter 3
DQ 2: How does building a culture of honesty and high ethics help reduce the possibility of fraud?
-Management through its own actions can show that dishonest, questionable, or unethical behavior will not be tolerated.
-By hiring the right kind of employees, management can select people who are less likely to rationalize their illegal or unethical actions as acceptable.
-By communicating expectations, management can give fraud awareness training that helps employees understand potential problems they may encounter and how to resolve or report them.
-Creating an honesty-driven culture, management can help to develop a positive work environment.
-Research indicates that fraud occurs less frequently when employees have feelings of ownership toward their organization than when they feel abused, threatened, or ignored
Chapter 3
DQ 3: Hoes does a company assess and mitigate the risk of fraud within an organization?
-Identifying sources and measuring risk means that an organization needs a process in place that both defines areas of greatest risk and evaluates and tests controls that minimize those risks.

-Risks that are inherent in the environment of an organization can often be addressed with an appropriate system of control.

-Once risks have been assessed, the organization can identify processes, controls, and other procedures that can minimize risks.

-Appropriate internal systems include well-developed control environments, effective accounting systems, and appropriate control procedures
Chapter 4
Creating a Culture of Honesty, Openness, and Assistance
-Hiring honest people and providing fraud awareness training
-Creating a positive work environment
-Providing an Employee Assistance Program (EAP)
Chapter 4
(Creating a Culture of Honesty, Openness, and Assistance)
Hiring Honest People
-Verify applicant's résumé and application
-Require applicant endorsement
-Train interviewers to conduct thorough and skillful interviews
-Use industry-specific approaches as deemed necessary (credit checks, fingerprints, etc)
-Look at their social media
Chapter 4
(Creating a Culture of Honesty, Openness, and Assistance)
Fraud Awareness Training
-The costliness of fraud
-The effects of fraud on pay and benefits
-The nontolerance of fraud
-Actions to take if fraudulent activity is suspected
Chapter 4
(Creating a Culture of Honesty, Openness, and Assistance)
Creating a Positive Work Environment
-Setting expectations about honesty (Having a visible code of conduct based on SOX/SEC, Conveying those expectations)
-Having open-door or easy access policies
-Having positive personnel and operating procedures.
-Pygmalion Effect (People perform according to leaders' expectations)
Chapter 4
(Creating a Culture of Honesty, Openness, and Assistance)
Establishing an Employee Assistance Program (EAP)
Help employees reduce pressure by helping employees deal with Substance abuse, Gambling, Money management, Health, family, and personal problems.
Chapter 4
Eliminating Opportunities for Fraud to Occur
-Have good internal controls
-Discourage collusion
-Monitor employees and provide a whistle-blowing system (look at lifestyle)
-Create an expectation of punishment
-Conduct proactive auditing
Chapter 4
(Eliminating Opportunities for Fraud to Occur)
Have Good Internal Controls
Preventative (Segregation of duties, independent checks, proper authorizations, dual custody, documentation, physical controls)

Detective (Independent Checks, Documentation, Mandatory vacations)

COSO's I/C Framework (CRAME)
Chapter 4
(Eliminating Opportunities for Fraud to Occur)
Discouraging Collusion
-between employees and customers/vendors
-clearly informing vendors and other outside contacts of the company's policies against fraud, "right-to-audit" clause on back of agreements
Chapter 4
(Eliminating Opportunities for Fraud to Occur)
Whistleblowing system
Fail b/c of lack of anonymity, culture chastises whistleblowers, policies allow for retaliation, lack of awareness.

Must have anonymity, reporting to independent agency, accessibility, and provide for follow-up.
Chapter 4
(Eliminating Opportunities for Fraud to Occur)
Proactive Fraud Auditing
-Identify fraud risk exposures
-Identify the fraud symptoms of each exposure
-Build audit programs to proactively look for symptoms and exposures
-Investigate fraud symptoms identified
Chapter 4
Organizations and Fraud - Current Model
1. Fraud Incident>2.Investigation>3.Action>4.Resolution
Chapter 4
Organizations and Fraud - Suggested Model
1. Tone at the top
2. Education and Training
3.Integrity and Control Risks
4. Reporting and Monitoring
5. Proactive Fraud Auditing
6. Investigation and Follow-up
Chapter 4
DQ 3: What is the purpose of adopting a Code of Ethics?
-Delineate between what is acceptable and what is unacceptable.
-Having employees periodically read and sign the company's code of ethics not only reinforces their understanding of what constitutes appropriate and inappropriate behavior; it also underscores the fact that their behavior is important to the company.
-Expectations are clarified, and clear expectations reduce fraud.
-Inhibit rationalizations
Chapter 4
DQ 5: How can a company discourage collusion?
-Mandatory Vacations
-Job Transfers
Chapter 5
Symptoms of Fraud
1)Accounting Anomalies
2) I/C Weaknesses
3)Analytical behavior
4) Extravagant lifestyle
5) Unusual Behavior
6) Tips and Complaints
Chapter 5
(Symptoms of Fraud)
Accounting Anomalies
Irregularities in source docs
Faulty J/E
Inaccuracies in Ledger
Chapter 5
(Symptoms of Fraud - Accounting Anomalies)
Irregularities in source docs
Missing docs
photocopied documents
alterations to docs
excessive void or credits
Duplicate payments
common names or addresses
Chapter 5
(Symptoms of Fraud - Accounting Anomalies)
Faulty J/E
-J/E's without documentary support being made by individuals who would not normally make the entry
-Capitalizing entries at end of year
-pay extra attention to cut off point
-J/E's do not balance
Chapter 5
(Symptoms of Fraud - Accounting Anomalies)
Inaccuracies in Ledgers
-Ledger doesn't balance (Cr does not balance to Dr)
-Master Balance does not balance to sum of individual accts
-Receivables are often manipulated
Chapter 5
(Symptoms of Fraud)
Internal Control Weakness
-Lack of segregation of duties
-Lack of independent checks
-lack of proper authorization
-lack of physical safeguards
-mgmt overrides
-inadequate acct system
Chapter 5
(Symptoms of Fraud - Internal Control Weakness)
Small Business Procedures to prevent fraud
1) pay for everything with checks
2) sign every check
3)owners should open and reconcile bank statements
Chapter 5
(Symptoms of Fraud)
Analytical Fraud Symptoms
-unexplained inventory shortages
-deviations from specifications
-increased scrap
-strange F/S relationships (increased rev. with decreased inventory (would be buying more inventory), increased rev with decreased rec, increased inventory with decreased warehouse cost, increased volume with increased cost per unit)

-Make sure to develop an expectation to compare to
Chapter 5
(Symptoms of Fraud)
Unusual Behavior
Guilt > Fear > Stress > Behavior Changes
Chapter 5
(Symptoms of Fraud)
Tips and Complaints
Majority of fraud is discovered through tips.

Employees are in best position to detect fraud

Tips are just symptoms, not evidence itself
Chapter 6
Anomalies vs. fraud
Anomaly - are not intentional and will be found through a dataset
Fraud - intentional, found in very few datasets
Chapter 6
Data Analysis Process - 6 steps in Proactive Method
1) Understand the Business
2)Identify possible frauds that could exists
3) catalog possible fraud symptoms (5 groups)
4)Use tech to gather info about symptoms
5)Analyze results
6) Investigate Results
Chapter 6
(Data Analysis Process)
Steps 1 - Understanding the Business
Tour plant
talk to key personnel
review process docs
observe employees
Chapter 6
Data Analysis Process
Step 3 - Catalog Fraud Symptoms
example of kickbacks
Analytical: increasing prices, larger order quantities, increasing purch from favored vendors, decreasing quality
Control Symptoms: all transactions with one buyer/vendor
Document Symptoms: 1099's from vendor to buyer
Tips: decreased quality
Chapter 6
Data Analysis Techniques
Data Preparation
Benford's Law
Digital Analysis
Stratification and Summarization
Fuzzy Matching (matching employee and vendor address)
Time Trend Analysis (vertical vs horizontal)
Chapter 6
Analyzing F/S reports
Calculate ratios
vertical/horizontal analysis
Intra/Intercompany Analysis (limited by changes in acct methods over time, diff companies use diff methods)
EBIT: not allowed in annual report
Projected earnings = prop forma earnings
Can be misleading so must address MD&A
Chapter 6
DQ 9: How can fraud be detected by analyzing financial statements?
1)focus on the three primary financial statements: the balance sheet, income statement, and statement of cash flows. Changes in these primary financial statements can be analyzed to determine whether they make sense or represent symptoms that should be investigated

2)convert balance sheet and income statements to change statements by using horizontal and/or vertical analysis.

3)compute key financial ratios, such as the quick ratio, current ratio, and accounts receivable turnover, and compare these ratios from period to period.