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CHAPTER 3

Management Fraud and Audit Risk


LEARNING OBJECTIVES
Review
Checkpoints

Exercises, Problems
and Simulations

1.

Define and explain the differences among


several kinds of fraud, errors, and illegal acts
that might occur in an organization.

43

2.

Explain auditors responsibilities with respect


to detecting and reporting fraud.

2, 3

45, 53, 56, 57, 60

3.

List and explain some conditions that can lead


to frauds.

4, 5

46, 50

4. Explain auditors responsibilities with


respect to illegal acts.

61

5.

Describe the conceptual audit risk model and


explain the meaning and importance of its
components in terms of professional judgment
and audit planning.

7, 8, 9, 10

47, 51, 55, 58, 59

6.

Define materiality and explain its relationship


to the audit risk model.

11, 12

7.

Describe the content and purpose of audit


programs.

13, 14, 15

54

8.

List and describe eight general types of audit


procedures for gathering evidence.

16, 17, 18, 19

44, 48, 49

9.

Discuss the effectiveness of various audit


procedures.

20, 21

52

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3-1

SOLUTIONS FOR REVIEW CHECKPOINTS


3.1

White collar crime is the frauds perpetrated by people who work in offices and steal with a pencil or a
computer terminal. The contrast is violent street crime.
Employee fraud is the use of fraudulent means to take money or other property from an employer. It
consists of three phases: (1) the fraudulent act, (2) the conversion of the money or property to the
fraudster's use and (3) the cover-up.
Embezzlement is a type of fraud involving employees' or nonemployees' wrongfully taking money or
property entrusted to their care, custody, and control, often accompanied by false accounting entries and
other forms of lying and cover-up.
Larceny is simple theft of an employers property that is not entrusted to an employee's care, custody or
control.
Defalcation is another name for employee fraud and embezzlement.
Errors are unintentional misstatements or omissions of amounts or disclosures in financial statements.
Direct-effect illegal acts are violations of laws or government regulations by the company or its
management or employees that produce direct and material effects on dollar amounts in financial
statements. "Illegal acts" (far-removed) are violations of laws and regulations that are far removed from
financial statement effects (for example, violations relating to insider securities trading, occupational health
and safety, food and drug administration, environmental protection, and equal employment opportunity).

3.2

3.3

AICPA auditing standards require:


a.

understanding and awareness of signs of errors, frauds (including direct-effect illegal acts), and
illegal acts (far removed).

b.

design the audit to respond to knowledge of fraud risks and provide reasonable assurance of
detecting material errors and frauds (including direct-effect illegal acts).

c.

auditors should have the proper degree of professional skepticism, assuming neither dishonesty
nor unquestioned honesty of management.

d.

for reporting, the materiality concept is different: (1) for errors, the usual idea of materiality
prevails, (2) for frauds (including direct-effect and far-removed illegal acts) immateriality is
expressed in terms of "clearly inconsequential." Matters that fall below the threshold apparently
can be reported to levels of management below the board of directors and audit committee. More
important matters go to the director level, and management involvement in frauds and illegal acts
is never considered inconsequential.

The seven steps specified by SAS 99: Consideration of Fraud in a Financial Statement
Audit are:
Step 1:
Step 2:

Discussion Among Engagement Personnel


Obtain Information to Identify Risks

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3-2

Step 3:
Step
Step
Step
Step
3.4

4:
5:
6:
7:

(a) Identify Risk Factors Related to Fraudulent Financial Reporting and (b)
Assess Fraud Risks
Respond to Assessed Risks
Evaluate Audit Evidence
Communicate Fraud Matters
Document

Below are some other conditions and circumstances that have existed along with frauds in the past:

A weak internal control environment prevails.


Management decisions are dominated by an individual or a small group.
Managers attitudes are very aggressive toward financial reporting.
Managers place too much emphasis on earnings projections.
Company profit lags the industry.
Company is decentralized without much monitoring.
Auditors have doubt about whether the company can continue as a going concern.
Company has many difficult accounting measurement and presentation issues.
Company has significant transactions or balances that are difficult to audit.
Company has significant and unusual related-party transactions.
Managers and employees tend to be evasive when responding to auditors inquiries.
Managers engage in frequent disputes with auditors.
Company accounting personnel are lax or inexperienced in their duties.

3.5

Auditors should know how to preserve the chain of custody of evidence. The chain of custody is the crucial
link of the evidence to the suspect, called the "relevance" of evidence by attorneys and judges. If
documents are lost, mutilated, coffee-soaked, compromised (so a defense attorney can argue that they were
altered to frame the suspect), they can lose their effectiveness for the prosecution.

3.6

a.

There is no difference among the categories at the awareness level.

b.

The expectation is lower for far-removed illegal acts, where audit procedures (other than inquiry
and familiarity) are performed only when specific information indicates that possible illegal acts
may have a material indirect effect on financial statements.

c.

About the same degree of skepticism with respect to all the categories; in connection with errors
and frauds (including direct-effect illegal acts) auditors should have the proper degree of
professional skepticism, assuming neither dishonesty nor unquestioned honesty of management; in
connection with far-removed illegal acts, auditors should make inquiries about management's
policies and procedures for compliance with laws and regulations and obtain written management
representations concerning the absence of violations of laws and regulations.

d.

for reporting, the materiality concept is different: (1) for errors, the usual idea of materiality
prevails, (2) for frauds (including direct-effect and far-removed illegal acts) immateriality is
expressed in terms of "clearly inconsequential." Matters that fall below the threshold apparently
can be reported to levels of management below the board of directors and audit committee. More
important matters go to the director level, and management involvement in frauds and illegal acts
is never considered inconsequential.

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3-3

3.7

Audit risk is a concept applied both to the probability of giving an inappropriate opinion and to the
probability of failing to discover material errors and frauds in a particular disclosure or account balance.
Audit risk is a conceptual combination of the other risks: Audit Risk = Inherent Risk x Internal Control
Risk x Detection Risk.
"Audit risk in an overall sense" refers to the audit taken as a whole and the probability that an auditor will
give an inappropriate opinion on financial statements. Generally, this is the risk of giving the standard
unqualified report when a the financial statements contain material misstatements or the report should be
qualified or modified in some manner.
"Audit risk applied to individual account balances" refers to the probability that auditors will fail to
discover misstatement in a particular account balance at least equal to the tolerable misstatement assigned
to the audit of that balance. This version of audit risk is applied in concept at the individual account
balance level.

3.8

The three components of audit risk are:


Inherent risk--the probability that material errors or frauds have entered the data processing system.
Internal control risk--the probability that the client's system of internal control will fail to detect material
errors and frauds, provided any enter the accounting system in the first place.
Detection risk--the probability that audit procedures will fail to find material errors and frauds, provided
any have entered the system and have not been detected or corrected by the client's internal control system.

3.9

From the Audit Risk Alert


Some of the effects of bad economic times auditors should be alert to detect in clients' financial statements:
Asset valuations--recoverability and bases of accounting.
Inappropriate offsetting of assets and liabilities.
Changes in cost-deferral policies and the reasonableness of amortization periods.
Allowances for doubtful accounts, in general, and loan-loss allowances for financial institutions, in
particular.
Compliance with financial covenants and the necessity to obtain waivers from lending institutions to meet
current requirements.
Changes in sales practices or terms that may require a change in accounting.

3.10

The nature of audit procedures refers to their effectiveness in detecting errors and fraud. Confirmation with
third parties is more effective in detecting errors and fraud than verbal inquiry.
The timing of audit procedures refers to when they are performed, usually at (1) interim, or at (2) year-end.
However, timing may have other aspects such as surprise procedures (unannounced to client personnel) or
procedures performed after the year-end.
The extent of the application of procedures usually refers to the sample sizes of data examined, such as the
number of customer accounts receivable to confirm, or the number of inventory types to count.

3.11

"Material information" in accounting and auditing is "information that should be disclosed if it is likely to
influence the economic decisions of financial statement users.
"Planning materiality" in an audit context is the largest amount of uncorrected dollar misstatement that
could exist in published financial statements, yet they would still fairly present the company's financial
position and results of operations in conformity with GAAP.

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3-4

3.12

Auditing standards do not require auditors to express planning materiality as a specific dollar amount. An
event or amount may be material by its significance, either quantitatively or qualitatively.

3.13

An audit program is a specification (list) of procedures designed to produce evidence directed toward
achieving a particular objective. Auditors indicate when they have performed each procedure, and where the
evidence is documented. Thus, audit programs are used not only for quality control and supervision, but
also as documentation that the audit team is following generally accepted auditing standards.

3.14

One type of audit program was called the "internal control program," and its objective is to guide the work
involved in:

Obtaining an understanding of the client's business and industry.


Obtaining an understanding of management's internal control.
Assessing the inherent risk and the control risk related to the financial account balances.

The other type of audit program was called the "balance-audit program," and its objective is to specify the
substantive procedures for gathering direct evidence on the assertions (i.e. existence, completeness,
valuation, rights and obligations, presentation and disclosure) about dollar amounts in the account balances.
3.15

Four "cycles" and accounts in them:


Revenue and collection cycle
Acquisition and expenditure cycle
Production and conversion cycle
Financing and investment cycle
X
X
X
X
X
X

X
X
X
X
X
X

Inventory
Fixed assets
Accumulated depreciation
Accounts payable
Accrued expenses
General expense

X
X

Cost of goods sold


Depreciation expense

X
X
X
X
X
X
X
X

Cash
Accounts receivable
Allowance for doubtful accounts
Sales
Sales returns
Bad debt expense

Bank loans
Long term notes
Accrued interest
Capital stock
Retained earnings
Dividends declared
Interest expense
Income tax expense

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3-5

3.16

"Vouching" means the examination of documents. Generally, an item of financial information is selected
from an account, and the auditor them goes backward through the bookkeeping-filing system to find the
source documentation which supports the item selected.
"Tracing" essentially is the opposite direction compared to "vouching". In the process of tracing, the
auditor selects sample items of basic source documents and proceeds forward through the bookkeeping
process to find the final recording of the accounting transactions.

3.17

3.18

"Scanning" refers to the auditor's scrutinizing documentation for unusual items and events.
Auditors use eight general audit procedures to gather evidence: 1) inspection of records and documents
(vouching, tracing, scanning), 2) inspection of tangible assets, 3) observation, 4) inquiry, 5) confirmation, 6)
recalculation, 7) reperformance, and 8) analytical procedures. One or more of these procedures may be used
no matter what account balance, control procedure, class of transactions, or other information is under audit.
Five types of general analytical review procedures:
1.
2.
3.
4.
5.

Compare financial information with prior period(s).


Compare financial information with budgets or forecasts.
Study predictable financial information patterns based on the entity's experience.
Compare financial information to industry statistics.
Study financial information relationships to nonfinancial information.

3.19

Yes, the Hylas and Ashton research brief in the chapter showed that auditors have credited discovery of
errors and frauds to analytical review procedures in 27.1% of the cases in a set of audits, and another 18.5%
discovery rate was attributed to "prior expectations" and "discussions."

3.20

Judging from the Wright-Ashton data from KPMG Peat Marwick audits: the
overstatements/understatements look mixed in the current assets; understatements are in the majority in the
noncurrent assets; understatements appear to be in the majority in the liabilities, and; understatements
appear to be in the majority in the expense accounts.

3.21

Initial Event/Audit Procedures in Order of Apparent Effectiveness for Detecting Financial Statement
Misstatements
1.
2.
3.
4.
5.
6.
7.
8.

Substantive procedures: examination of transaction amounts and descriptions, account balance


details, workups to support account balances, data on various reconciliations.
Expectations from the prior year.
Analytical procedures: comparison of current unaudited balances with balances of prior years,
predictions of current balances based on exogenous data, analyses of interrelationships.
Client inquiry.
Test of detail: checks for mathematical accuracy.
General audit procedures.
Accounts receivable confirmation
Inventory observation

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3-6

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS


3.22

a.

Correct

b.
c.
d.

Incorrect
Incorrect
Incorrect

a.
b.

Incorrect
Incorrect

c.

Incorrect

d.

Correct

a.
b.
c.

Incorrect
Incorrect
Incorrect

d.

Correct

a.
b.

Incorrect
Incorrect

c.

Incorrect

d.

Correct

3.26

b.

Correct

DR = AR/ (IRxCR) = 0.05/0.50 = 0.10

3.27

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

An audit program does not specify audit standards. All the GAAS are relevant in
all audits.
An audit program contains specifications of procedures the auditors believe
appropriate for the financial statements under audit.
Documentation of the assertions under audit, the evidence obtained, and the
conclusions reached describe audit documentation, not audit programs.
Reconciliation of the account balances in the financial statements with the
account balances in the client's general ledger is one element of the content of
audit documentation, not audit programs.

a.
b.
c.
d.

Incorrect
Incorrect
Correct
Incorrect

3.23

3.24

3.25

3.28

Management is responsible for making the estimates in the first place, just as
management is primarily responsible for all the financial statement elements.
Auditors need to determine the reasonableness of estimates.
Auditors need to determine estimates are presented in conformity with GAAP.
Auditors need to determine whether estimates are adequately disclosed in the
financial statements.
Independent auditors are supposed to understand the nature of errors and frauds.
Independent auditors are supposed to assess the risk of occurrence of errors and
frauds.
Independent auditors are supposed to design audits to provide reasonable
assurance of detecting errors and frauds.
Independent auditors are not required to report all finding of errors and frauds to
police authorities.
This is the risk of giving an inappropriate opinion.
This is the risk of misstatements entering the accounting system.
This is the risk that the client's internal control will not detect misstatements that
enter.
This is the risk that auditors will not detect misstatements.
The business situation creates inherent risk.
Relative risk is a theoretical expression of relative susceptibility to
misappropriation.
Control risk is a function of management's design and operation of its internal
controls.
Auditors are responsible for performing the evidence-gathering procedures that
manage and control detection risk.

These accounts are part of the acquisition cycle.


These accounts are part of the conversion cycles.
These accounts are part of the revenue cycle.
These accounts are part of the financing and investment cycle.

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3-7

3.29

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

a.

Incorrect

b.
c.
d.

Incorrect
Correct
Incorrect

a.
b.

Incorrect
Incorrect

c.
d.

Correct
Incorrect

This is a type of overall response, not a specific procedural response.


Auditors ought to direct specific procedures toward the area where the suspicion
lies.
This is a specific procedural response mentioned in SAS 99.
This is an overall response, not a specific procedural response.

3.32

a.
b.
c.
d.

Correct
Incorrect
Incorrect
Incorrect

The objective is to perform a quality audit and keep audit risk low.
Control risk = 0 is generally not warranted.
Inherent risk = 0 is generally not warranted.
40% audit risk is too high.

3.33

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

Confirmation of accounts receivable are selected from recorded amounts and


thus give no chance for selection of missing amounts; responses do not produce
evidence of probability of collection.
See valuation note above. Confirmation yields some evidence of rights
(ownership).
Confirmations produce evidence of existence in debtors' admission of their
debts. See rights note above.
Confirmations produce evidence about existence but not so much about
completeness.

3.34

a.
b.
c.
d.

Incorrect
Incorrect
Incorrect
Correct

The accounting is credit sales, debit receivables, not inventory.


The accounting is credit sales, debit receivables, not cost of goods sold.
The accounting is credit sales, debit receivables, not bad debt expense.
The accounting is (fictitious) credit sales, debit (fictitious) receivables.

3.35

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

Falsification of documents is characteristic, but management fraud does not


involve stealing money from an employer.
Management fraud is victimization of investors through the use of materially
misleading financial statements.
Management fraud principally involves misleading financial statements which
might or might not involve illegal acts committed by management to evade laws
and regulations.
Conversion of stolen inventory to cash deposited in a falsified bank account
describes an employee fraud.

3.30

3.31

You won't find an unrecorded item (completeness assertion) by looking in the


financial statement numbers.
Starting with the potentially unrecorded items is an audit for the completeness
assertion, not the existence assertion.
You can find evidence of existence of recorded amounts by selecting from the
recorded amounts (general ledger) and going back to the supporting original
transaction documents.
Selecting from the supporting original transaction documents and going to the
general ledger is an audit for the completeness assertion, not the existence
assertion.
While solving for DR works mathematically, you will find that IR (not given in
the problem) has to be greater than 100%, therefore the solution is not possible.
(Very tricky!)
If control risk rises, detection risk should decrease.
This solution is both mathematically and practically correct.
If control risk rises, detection risk should decrease.

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3-8

3.36

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

3.37

a.
b.
c.
d.

Incorrect
Incorrect
Incorrect
Correct

Materiality may be qualitative rather than quantitative.


Materiality may be quantitative rather than qualitative.
AICPA guidelines are silent as to materiality judgments.
Materiality is a matter of professional judgment.

3.38

a.

Incorrect

b.

Incorrect

c.

Incorrect

d.

Correct

The audit team would be concerned if key factors that are not consistent with
prior periods.
The audit team would be concerned if key assumptions are not similar to
industry guidelines.
The audit team would be least concerned about measurements that are objective
and not susceptible to bias
Evidence of a systematic bias, whether aggressive or conservative would be of
most concern to the audit team.

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

3.40

c.

Correct

An audit committee is composed of members of a companys board of directors


who are not involved in the day-to-day operations of the company.

3.41

a.

Incorrect

b.

Correct

c.

Incorrect

d.

Incorrect

While the audit team may recommend remedial actions to the audit committee,
the audit teams first concern is the effect of the illegal act on the financial
statements.
The audit teams first concern is the effect of the illegal act on the financial
statements.
While the audit team may consider whether to contact law enforcement officials,
the audit teams first concern is the effect of the illegal act on the financial
statements.
While the audit team should determine whether other similar acts may have
occurred, the audit teams first concern is the effect of the illegal act on the
financial statements.

3.39

Reporting clearly inconsequential illegal acts to the board of directors is not


required.
Once informed, the board of directors has the first responsibility to report to the
SEC. If the board does not report, the law then requires the auditors to report.
Auditors are not required to report clearly inconsequential illegal acts to the
board. (Reporting to management, however, is a good idea.)
Resignation is not required. However, if the auditor resigns and the board does
not report, the law requires the auditor to report to the SEC, just as though there
had been no resignation.

Extended procedures would be used if supporting documents are not produced


when requested.
If the client made several large adjustments at year-end (a red flag), extended
procedures would be considered necessary to ensure that fraud was not taking
place.
Unless the previous CFO left the company under suspicious circumstances,
extended procedures would probably not be considered necessary.
Due to the immateriality of petty cash funds, the audit team would probably not
use extended procedures under these circumstances.

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3-9

3.42

a.

Incorrect

b.

Incorrect

c.

Correct

d.

Incorrect

The responsibility for detecting direct-effect illegal acts exactly parallels the
responsibility for errors and fraud.
The audit team must design their tests to detect all material illegal acts that
directly affect the financial statements.
The audit team must design their tests to obtain reasonable assurance that all
illegal acts with direct material statement effects are detected.
The audit team must design their tests to detect all material illegal acts that
directly affect the financial statements.

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3-10

SOLUTIONS FOR EXERCISES, PROBLEMS AND SIMULATIONS


3.43

Risk of Misstatement in Various Accounts


a.

Inventory understatements may occur from counting and pricing errors.


Fixed asset understatements may result from failure to capitalize costs (expensing them instead) or
from erroneous depreciation calculations.
Liability understatement and expense understatement appear to be quite common.
EXHIBIT 3.13
SUMMARY OF MISSTATEMENTS (SELECTED ACCOUNTS)
Account
Cash
Securities
Accounts receivable
Inventory
Property, plant
Other noncurrent
Accounts payable
Accrued liabilities
Other current liabilities
Long-term liabilities
Revenue
Cost of goods sold
Selling expense
Gen. & Admin expense

Number of Misstatements
Overstatement
Understatement
6
10
21
17
48
22
24
32
14
23
11
24
21
25
17
40
10
13
12
24
32
30
38
45
11
16
39
52

63% understated!
55% overstated
69% overstated
57% understated!
62% understated!
69% understated!
54% understated
70% understated
57% understated
67% understated
52% overstated
54% understated
59% understated
57% understated

NOTE: The effect of adjustments on income was that 43% of the adjustments reduced the reported
income, while 28% increased the reported income. The other 29% of the adjustments were
reclassifications that neither reduced nor increased income.
b.

Asset understatements can result from accounting errors, misapplication of accounting principles,
and measurement errors (such as undercounting the inventory). A company might be motivated by
tax evasion to understated assets and income.

c.

Estimated liabilities might be measured large for conservatism. The company might over accrue
expenses in order to reduce taxable income. A fraud might be imbedded in false payables to false
vendors.

d.

The KPMG data indicate that income overstatement occurs most frequently. Apparently the cause
is usually understatement of expenses (e.g. accrued expenses).

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3-11

3.44

General Audit Procedures and Financial Statement Assertions


Audit Procedures
Inspection of records or documents
(vouching).
Inspection of records or documents
(tracing).
Inspection of records or documents
(scanning).

Assertions
Existence or Occurrence

2.

Inspection of tangible assets.

Existence, Valuation.

3.

Observation.

Existence, Valuation.

4.

Confirmation.

Existence, Rights (Ownership)


Valuation (sometimes)
Completeness (sometimes).

5.

Inquiry.

All assertions; however, responses typically yield more


assertions, in turn subject to audit with corroborating
evidence.

6.

Recalculation.

Existence, Valuation.

7.

Reperformance

Valuation

8.

Analytical procedures.

Existence or occurrence
Valuation
Completeness

1a.
1b.
1c.

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Completeness
Raises questions that may be relevant to all assertions, but
may not produce actual "evidence." Since it is performed
on recorded amounts, it works best for Existence,
Valuation, Rights, and Presentation/Disclosure. When
applied to source documents, it might work for the
completeness assertion.

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3-12

3.45

Give Examples of Errors and Frauds


Students can probably think of many examples for each of the cases. This solution does not purport to be
exhaustive.
a.

Overstate an asset, understate another asset


Hold cash receipts journal open past the year end (cutoff date) and record too much cash, reducing
accounts receivable.

b.

Overstate an asset, overstate stockholder equity


Record appraised value of property, plant, and equipment, with a corresponding credit to a capital
account.

c.

Overstate an asset, overstate revenue


(1) Hold the sales journal open past the year end (cutoff date) and record too much sales revenue
and cash or accounts receivable. (2) Record fictitious sales and accounts receivable.

d.

Overstate an asset, understate an expense


(1) Capitalize maintenance expense, making the asset amount higher than warranted and the
expense amount lower. Subsequent depreciation would reverse this misstatement, but the first
effect would be to overstate the asset and understate the expense. (2) Record an expenditure as a
prepaid expense instead of a current expense.

e.

Overstate a liability, overstate an expense


Accrue too much liability for expenses not yet paid, such as wages, rent, interest, product
warranties, etc.

f.

Understate an asset, overstate an expense


(1) Calculate too much depreciation expense on assets. (2) Classify expenditures as current
expenses when they should be classified as prepaid expenses.

g.

Understate a liability, understate an expense


Fail to accrue liabilities for expenses not yet paid, such as wages, rent, interest, product warranties,
etc.

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3-13

3.46

Overall Analysis of Accounting Estimates


The company has fudged the write-offs toward being as small as possible, hoping to satisfy the auditors.
Taken one at a time, only the uncertainty about the deferred subscription costs is large enough to break the
materiality threshold. But the set of problems cannot be taken one at a time. Here is a suggested low-high
audit estimate:
Write-off deferred subscription costs (1)
Provide allowance for bad debts (2)
Provide for expected warranty expense (3)
Lower of cost or market inventory write-down (4)
Loss on government contract refund (5)

Low Estimate
$ 6,000,000
$ 4,000,000
$ 2,000,000
$ 5,600,000
$ 1,000,000

Total write-offs and losses

$18,600,000

High Estimate
$12,000,000
$ 4,000,000
$ 6,000,000
$ 5,600,000
$ 2,000,000
$29,600,000

(1)

The low estimate gives benefit of doubt to survival of the business, writing off half the deferred
costs as if one-half might be written off over the next two years. The company seems to have
taken the 50% probability ($6 million) and allocated half to each of the two years.

(2)

The company seems ready to provide allowance for all the doubtful accounts receivable.

(3)

Not much information for an auditor (such as a probability distribution).

(4)

It looks like the company plans to rebuild the inventory and recover as much as it can, namely the
$4,400,000 that can be realized from selling the rebuilt parts, but the lower of cost or market was
figured incorrectly. The company seems to have subtracted the selling price ($8 million) from the
inventory cost ($10 million) to get the $2 million write-down. The correct calculation is:
Net Realizable Value:
Selling price proceeds
Cost to rebuild
Cost to market and ship (20% x $8 million)
Ceiling (net realizable value)
Floor, Subtract "normal profit" (5% x $8 million)
Floor

$ 8,000,000
( 2,000,000)
( 1,600,000)
$ 4,400,000
( 400,000)
$ 4,000,000

Replacement cost is apparently $6 million for the modern part, so the "market" for lower of cost or
market is NRV = $4,400,000, and the inventory write-down is $10 million - $4,400,000 =
$5,600,000. Sale of the rebuilt parts will produce zero profit in subsequent period(s):
Selling price
Inventory sold (written-down cost)
Rebuilding cost
Total cost of goods sold
Cost to market and ship
Profit
(5)

$ 8,000,000
$ 4,400,000
2,000,000
(6,400,000)
(1,600,000)
-0-

For a contingency such as this government contract dispute, GAAP suggests recognizing loss at
the lower end of a range for loss, so a $1 million loss provision would satisfy GAAP.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-14

3.46

Overall Analysis of Accounting Estimates (Continued)


Recommended Adjustment:
Management's suggestion of $11,000,000 cost/loss recognition is not sufficient. It "leaves" $7,600,000
income overstatement, even using the auditors' low estimate of $18,600,000. Even booking the low
estimate "leaves" $10,000,000 unrecognized (including the government contract contingency at $1 million
instead of $2 million). The minimum adjustment, given the limited information available in this problem,
is below. Adequate disclosures should be made about the $6 million deferred subscription costs remaining
and the prospects for the business, and about the warranty expense estimate, since these are the items that
leave uncertain assets and liabilities in the financial statements.
Subscription expense
Bad debt expense
Warranty expense
Cost of goods sold
Government contract loss
Deferred subscription costs
Allowance for doubtful accounts
Estimated warranty liability
Inventory
Estimated liability on contract

3.47

Debit
$ 6,000,000
$ 4,000,000
$ 2,000,000
$ 5,600,000
$ 1,000,000

Credit

$ 6,000,000
$ 4,000,000
$ 2,000,000
$ 5,600,000
$ 1,000,000

Audit Risk Model


Evaluation of risk assessment conclusions with AR = IR x CR x DR as a model.
a.

Paul is not justified in acting upon a belief that IR = 0. He may have seen no adjustments
proposed because (1) none were material or (2) Tordik's control system has functioned well in the
past and prevented/detected/corrected material errors. If IR = 0, then AR = 0 and no further audit
work need be done. Conservative auditing standards and practice do not permit this level of
(non)work based on this little evidence and knowledge.

b.

Hill is not justified in acting upon a belief that CR = 0. She may well know that Edward's internal
accounting control is exceptionally good, but (1) her review did not cover the last month of
Edward's fiscal year and (2) control procedures are always subject to lapses. If CR = 0, then AR =
0 and no further audit work need be done. Conservative audit practice does not permit assessment
of control risk at 0% to the exclusion of other audit procedures.

c.

Insofar as audit effectiveness is concerned, Fields' decision is within the spirit of audit standards. Even
if IR = 1 and CR = 1, if DR = 0.02, the AR = 0.02. This audit risk (AR) seems quite small.
However, Fields' decision may result in an inefficient audit.

d.

This case was deliberately left ambiguous, without putting probability numbers on the audit risks.
Students will need to experiment with the model. One approach is to compare the current audit to
a hypothetical last year's audit when "everything was operating smoothly." Assume:
Last Year:
Current Year:

AR = IR (0.50) + CR (0.20) x DR (0.20) = 0.02


AR = IR (1.0) + CR (1.0) x DR (0.25) = 0.25

Features of the hypothetical comparison:


1.
Inherent risk is greater than last year.
2.
Control risk is greater than last year.
3.
The audit was done in less time, and maybe the detection risk is a little greater.
4.
Audit risk appears to be very high.
McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-15

3.47

Audit Risk Model (part d, Continued)


An alternative analysis is that Shad perceived higher inherent and control risk early, and he did not
put any audit time into trying to assess the risks at less than 100%. He proceeded directly to
performance of extensive substantive procedures and worked a lesser total number of hours, yet
still performed a high-quality audit by keeping AR low by keeping DR low.

3.48

Audit Procedures
Types of procedures used by auditors in general, with examples:
1a.

Document Inspection (Vouching)

Find brokers' invoices and cancelled checks showing agreement with record amounts for
securities investments.

1b.

Document Inspection (Tracing)

Select a sample of shipping documents and trace them to sales invoices, sales journal
recording and posting to general ledger.

1c.

Document Inspection (Scanning)

Scan expense accounts for credit entries.

Scan payroll check lists for unusually large checks.

2.

Inspection of tangible assets

Verify existence of fixed assets by locating them.

3.

Observation

Observation, test-counting of client's physical inventory-taking.

4.

Confirmation

Obtain accounts receivable confirmations.

Obtain attorney letter.

5.

Inquiry and written representations

Inquire of client personnel about accounting events.

Complete an internal control questionnaire.

Obtain management representations.

6.

Recalculation

Recompute the client's calculation of depreciation expense.

7.

Reperformance

Analyze valuation of receivables by re-aging them by due date.

8.

Analytical procedures--any example that fits one of these:

Compare financial information with prior periods.

Compare financial information with budgets and forecasts.

Study predictable financial information patterns (e.g., ratio analysis).

Compare financial information to industry statistics.

Study financial information in relation to nonfinancial information.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-16

3.49

3.50

Audit Confirmations
a.

An audit confirmation is a written statement to the CPA from someone outside the enterprise on a
fact which that person is qualified to affirm.

b.

The two main characteristics a confirmation should possess are:


1.

The party supplying the information requested must be knowledgeable and independent,
i.e., he must have knowledge of information of interest to the auditor and he must be
outside the scope of influence of the organization being audited, and

2.

The auditor must obtain the information directly from the informed party.

Auditing an Accounting Estimate


The audit problem is to develop a range of valuation of the inventory in order to evaluate management's
estimate.
Low
Selling price
Advertising and shipping
expenses
Auditors' estimate of the range
for the inventory valuation
a.

High

$ 78,000

$ 92,000

7,000

5,000

$ 71,000

$ 87,000

Yes, an adjustment can be proposed.


Loss (or Cost of Goods Sold)
Inventory

$ 12,000
$12,000

Write down the inventory to the nearest end of the auditor's range.
b.
3.51

No adjustment is necessary. The management estimate of $80,000 is within the auditors' range
estimate.

Risk Assessment
Refer to the question for the items 1-15. Discussion can range across many reasons.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Decrease overall audit risk


Increase
Increase
Increase
Decrease
No effect
Decrease
Increase
Increase
Decrease

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

11.
12.
13.
14.
15.

Increase
Increase
No effect
Increase
Increase

The McGraw-Hill Companies, Inc., 2007


3-17

3.52

Potential Audit Procedure Failures


This is a very open-ended discussion topic. Students' responses could be quite varied depending upon their
experience and imagination. The best classroom strategy is to start with one of the procedures, then list the
students' suggestions on the chalkboard. The discussion can become very lively!

3.53

SAS 99 Review
a.

Management fraud is deliberate fraud committed by management that injures investors and
creditors through materially misleading financial statements. The class of perpetrators is
management; the class of victims is investors and creditors; and the instrument of perpetration is
financial statements. Sometimes management fraud is called "fraudulent financial reporting,''
which was defined by the National Commission on Fraudulent Financial Reporting (1987) as
"intentional or reckless conduct, whether by act or omission, that results in materially misleading
financial statements."
Defalcation is another name for employee fraud, embezzlement, and larceny. Employee fraud is
the use of fraudulent means to take money or other property from an employer . It usually involves
falsifications of some kind--false documents, lying, exceeding authority, or violating an
employer's policies. Embezzlement is a type of fraud involving employees' or nonemployees'
wrongfully taking money or property entrusted to their care, custody, and control, often
accompanied by false accounting entries and other forms of lying and cover-up. Larceny is simple
theft--for example, an employee taking an employer's money or property that has not been
entrusted to the custody of the employee.

b.

Under GAAS, auditors are responsible for assessing the risk of material misstatements due to
management fraud and due to misappropriation of assets (employee fraud); consider this
assessment when designing procedural responses (overall response and specific procedural
response); ask management abut its understanding of fraud risk in the company; pay attention to
fraud risk factors; document the risk assessment and management knowledge in the audit
documentation; determine whether the company has specific control to mitigate fraud risks;
consider the effectiveness of the company's prevention, detection, and deterrence programs;
perform procedures to provide a reasonable assurance of detecting material misstatements due to
fraud.

c.

Characteristics of management fraud important for consideration: materiality of the effect on


financial statements, the level of management involved, the extent and skillfulness of
concealment, the relationship to control activities, the specific accounts affected.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-18

3.53

SAS 99 Review (Continued)


d.

Concern-heightening factors:

Management decisions are dominated by an individual or small group.


Managers accounting attitudes are unduly aggressive.
Managers place much emphasis on meeting earnings projections.
Managements business reputation is poor.
Management has engaged in opinion shopping.
Managers are evasive responding to auditors= inquiries.
Managers engage in frequent disputes with auditors.
Managers display significant disrespect for regulatory bodies.
Company has a weak internal control environment.
Company accounting personnel are lax or inexperienced in their duties.
Company employs inexperienced managers.
Company is in a period of rapid growth.
Company profit lags the industry.
Company has going concern problems (near bankruptcy).
Company is decentralized without adequate monitoring.
Company has many difficult accounting measurement and presentation issues.
The company may be offered for sale.
The company makes acquisitions using its stock.

These next "red flags" have more to do with employee frauds (misappropriations of assets) than
management fraud, but auditors are supposed to know about them:

Missing documents.
Second endorsements on checks.
Unusual endorsements.
Unexplained adjustments to inventory balances.
Unexplained adjustments to accounts receivable.
Old items in bank reconciliations.
Old outstanding checks.
Customer complaints.
Unusual patterns in deposits in transit.
Cash shortages and overages.
Excessive voids and credit memos.
Customer complaints.
Common names or addresses for refunds.
Adjustments to receivables and payables.
General ledger does not balance.
Increased past due receivables.
Inventory shortages.
Increased scrap.
Alterations on documents.
Duplicate payments.
Employees cannot be found.
Second endorsements on checks.
Documents photocopied.
Dormant accounts become active.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-19

3.53

SAS 99 Review (Continued)


e.

3.54

Disclosure might be required:


1.

To comply with legal and regulatory requirements (including reporting a change of


auditors on SEC Form 8-K, reporting control matters and disagreements according to
Item 304 of SEC Regulation S-K).

2.

To report to the SEC under the requirements of the Private Securities Litigation Reform
Act (when illegal acts material to the financial statements are not reported to the SEC by
the company's board of directors).

3.

To respond to a successor auditor's inquiries (SAS 84).

4.

To respond to a subpoena.

5.

To communicate with a funding or other agency when required in audits of entities that
receive governmental financial assistance.

Internet Exercise: Audit Programs on the Internet


This is a very open-ended question. Students' responses could be quite varied depending upon their
interests.

3.55

Kaplan CPA Exam Simulation: Inherent Risk


To: The President of the Ferreira Company
From: Partner, Riley & Associates CPAs
As one step in performing an audit to provide reasonable assurance that financial statements are presented
fairly in conformity with United States generally accepted accounting principles, the CPA must make an
assessment of the inherent risk that exists within the reporting entity. Inherent risk is the possibility that a
material misstatement will occur within the reporting entitys accounting system. The auditor normally
assesses inherent risk early in the audit process. If inherent risk is judged to be especially high, the auditor
will frequently have to compensate by decreasing detection risk (the possibility that a material
misstatement will not be caught by the external auditors testing) to a level lower than anticipated so that
overall audit risk is reduced to an acceptably low level. Detection is reduced by carrying out additional
substantive testing or by performing substantive testing that renders a higher quality of audit evidence.
Inherent risk is assessed by steps such as (a) performing analytical procedures, (b) looking at problems
found in prior audits, (c) analyzing the number of accounts that require significant estimations to be made,
(d) studying the quality of the accounting systems used by the company, (e) evaluating the experience,
training, and competency of the individuals working with the accounting systems, and (f) analyzing the risk
associated with accounts having particularly high balances or number of transactions.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-20

3.56

Kaplan CPA Exam Simulation: SAS 99 Fraud Guidelines


An auditor should conduct the audit with
professional skepticism which includes an
attitude that assumes balances are
incorrect until verified by the auditor by
gathering evidence.

Due professional care requires the auditor to


exercise professional skepticism. Professional
skepticism is an attitude that includes a
questioning mind and a critical assessment of audit
evidence. Standards go on to state that an auditor
should neither assume that management is
dishonest nor assume unquestioned honesty.

The fact that a company needs to obtain


additional debt or equity financing to stay
competitive may be a fraud risk factor.

The following fraud risk factors are associated


specifically with fraudulent financial reporting:
Excessive pressure exists for management to meet
the requirements or expectations of third parties
due to the following: a) Profitability expectations
of investment analysts, investors, or significant
creditors. b) Company needs to obtain additional
debt or equity financing to stay competitive. c)
Company has marginal ability to meet debt
repayment or other debt covenant requirements.

Professional skepticism should be


exercised throughout the audit process.

Since evidence is gathered and evaluated


throughout the audit, professional skepticism
should be exercised throughout the audit process.

The three components of the fraud


triangle are incentive, opportunity and
fraud risk factors.

The three components of the fraud triangle are


incentive, opportunity and rationalization.

If fraud is detected and misstatement does


exist, an auditor assesses if it is material.
If it is not material, the auditor tells
management and has no other
responsibility.

If fraud is detected and it is deemed to be


immaterial, an auditor need only inform members
of management at least one level above those
involved.

If a material problem is resolved, it is not


necessary for the auditor to inform the
audit committee.

Even if a material problem is resolved, the audit


committee of the board of directors must be
informed because the issue had a significant
impact on the financial reporting of the company.

When performing a financial statement


audit, auditors are required to explicitly
assess the risk of material misstatement
due to fraud.

AU 312 and AU 316 both required that auditors


specifically assess the risk of material
misstatements due to fraud and consider that
assessment in designing the audit procedures to be
performed.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-21

3.57

Kaplan CPA Exam Simulation: Financial Statement Assurance

What assurance does the auditor provide


that misstatements due to errors that are
material to the financial statements will
be detected?

Reasonable

AU 110 and AU 316 require the auditor to


design the audit to provide reasonable
assurance that material misstatements,
whether caused by error or fraud, be
detected.

What assurance does the auditor provide


that misstatements that are material to the
financial statements due to fraudulent
financial reporting will be detected?

Reasonable

AU 110 and AU 316 require the auditor to


design the audit to provide reasonable
assurance that material misstatements,
whether caused by error or fraud, be
detected. Fraudulent financial reporting
is one of the major types of fraud.

What assurance does the auditor provide


that misstatements due to direct effect
illegal acts that are material to the
financial statements will be detected?

Reasonable

AU 110 requires the auditor to design the


audit to provide reasonable assurance of
detecting material errors, fraud and direct
effect illegal acts. A direct effect illegal
act is one that would have an effect on the
determination of financial statement
amounts.

What assurance does the auditor provide


that misstatements that are material to the
financial statements due to
misappropriation of assets will be
detected?

Reasonable

AU 110 and AU 316 require the auditor to


design the audit to provide reasonable
assurance that material misstatements,
whether caused by error or fraud, be
detected. Misappropriation is one of the
major types of fraud.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-22

3.58

Kaplan CPA Exam Simulation: Audit Risk


Control risk is the possibility that
a material misstatement will
occur within Hardis accounting
system.

The statement is true for inherent risk. Control


risk, on the other hand, is the possibility that a
material misstatement that has occurred will not
be detected by the companys control system.

A CPA performing an audit has no


responsibility to look for or find
illegal acts that do not have a
direct impact on Hardis financial
statements.

Those actions are outside the scope of the audit,


and in addition, they may well be hidden.
However, auditors must maintain a skeptical
attitude and, thus, may discover such illegal
acts or situations pointing to illegal acts.

If a CPA discovers fraud that


causes a material misstatement,
then it must be reported by the
CPA to Hardis audit committee.

There should be an understanding between the


auditor and the audit client as to the reporting of
any other fraud that is uncovered, including
fraud that causes an immaterial misstatement.

A CPA would increase the level of


detection risk if it is found that
Hardis accounting system is
outdated or understaffed or
operated by individuals lacking
training and experience.

Such a situation would warrant an increase in


the level of inherent risk and control risk. Based
on the facts, it is likely that a material
misstatement will occur within the companys
accounting system, and the companys control
system is incapable of detecting such a material
misstatement.

An example of fraudulent
financial reporting would be if
Hardi improperly capitalized an
immaterial lease in a deliberate
attempt to overstate income.

Fraudulent financial reporting does not only


cover material misstatement; even immaterial
amounts can be construed to be fraudulent
financial reporting.

If Hardi has a management bonus


based on net income, it directly
suggests that a CPA should set
inherent risk at maximum.

Although the management bonus is a strong


indicator of high inherent risk, the auditor must
assess the Hardi audit on an overall basis and
not make a conclusion on inherent risk based
simply on one piece of information.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-23

3.59

Kaplan CPA Exam Simulation: Audit Risk


Ridge will use statistical
sampling rather than judgment
sampling.

Decreases
audit risk

Detection risk decreases whenever auditor gathers more


evidence or obtains evidence of a better quality. Evidence is
considered to be of a better quality if it is gathered using
more sophisticated techniques (such as statistical sampling
rather than judgment sampling).

This is Ridges first audit of


Western.

Increases audit
risk

The fact that it is a first- time audit by Ridge increases the


possibility that misstatements have occurred (for 2003 and
for prior years) and will not be detected by Ridge. This
increases the auditors assessment of inherent risk.

Reconciliation of bank
statements.

Decreases
audit risk

Based on the documentation, bank reconciliations are


performed in a timely manner. This decreases audit risk.
(In contrast, the lack of complete and timely reconciliations
of assets represents inadequate internal control over assets
which may increase the susceptibility of misappropriation
of those assets and thus increase audit risk).

There are a large number of


transactions within the
accounts receivable general
ledger control account and its
subsidiary ledgers.

Increases audit
risk

The existence of accounts with large balances or many


transactions usually increases inherent risk due to the
complexity of auditing them.

Level of turnover in the


accounting department.

Decreases
audit risk

The clerk has been employed by Western for 12 years and


the controller for ten years; therefore, two of the key
employees have remained in their positions for a long time
which indicates low turnover. This would generally
decrease audit risk. (In contrast, a high turnover rate in the
accounting department would represent a deficiency in
internal accounting control and thus increase audit risk).

The accounting system is three


years old.

Decreases
audit risk

The system is not outdated (it is only three years old) and
appears to be meeting Westerns needs. The system was
tested very recently (last year) by the prior auditors and
found to be operating effectively. (In contrast, an outdated
accounting system would increase inherent risk).

Western is the only provider of


water in the three surrounding
counties.

Has no impact
on audit risk

The fact that Western is the only provided of water in the


three surrounding counties has no impact on audit risk.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-24

3.59

3.60

Kaplan CPA Exam Simulation: Audit Risk (Continued)


The clerk handles nearly all
aspects of the accounts
receivable/cash receipts
system.

Increases audit
risk

Because the clerk handles nearly all aspects of the accounts


receivable/cash receipts system, there is a general lack of
segregation of duties within the accounts receivable/cash
receipts application. This increases control risk and audit
risk.

Ridge bid on the audit of


Western along with four other
firms. Ridge was selected
because the audit committee
determined that Ridge had the
best and lowest bid.

Has no impact
on audit risk

The fact that Ridge was selected because it had the best and
lowest bid has no impact on audit risk.

There are two new housing


developments within
Westerns service area, but
contrary to expectations, tapin fee income is down
significantly from last year
and from budget.

Increases audit
risk

Inherent risk is increased if, during the performance of


analytical procedures in the initial audit planning stages, it
is discovered that client balances vary significantly from the
auditors expectations.

The clerks high level of


personal debt.

Increases audit
risk

The advanced age of the water


treatment plant.

Has no impact
on audit risk

Personal debts or other financial obligations may create


pressure on management or other employees (who have
access to cash or other assets susceptible to theft) to
misappropriate such assets. In the case of Westerns clerk it
represents a potential incentive or pressure, which is a fraud
risk factor that increases audit risk.
The advanced age of the plant has no impact on audit risk.

Kaplan CPA Exam Simulation: Consideration of Fraud in a Financial Statement 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 error or fraud. Because of the
nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not
absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and
perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, not
material to the financial statements are detected (AU sec. 110, par. 2).

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-25

3.61

Kaplan CPA Exam Simulation: Illegal Acts.


Subject: Illegal Acts F.D.A. violations
During the audit of Woodson Flavors International, we discovered that the company has several
Environmental Protection Agency (E.P.A.) violations resulting in fines totaling $6,000. In accordance with
U.S. GAAS, the auditor does not include audit procedures specifically intended to detect illegal acts with
an indirect effect. Although, when other audit procedures uncover illegal acts, the auditor should apply the
necessary procedures to determine whether an illegal act has occurred. Further testing is now necessary
because the discovery of the payment to the E.P.A indicates the possibility of an indirect illegal act.

McGraw-Hill/Irwin
Auditing and Assurance Services, Louwers et al., 2/e

The McGraw-Hill Companies, Inc., 2007


3-26