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Chapter 5: Fraud in Financial Statements and Auditor Responsibilities

1. What is an Audit?
a. Audit, an examination of company prepared financial statements in accordance with
Independent opinion rendered on the examination
SEC requires all public companies to have an audit
PCAOB establishes audit standards for independent auditors and ethics standards for
companies listed on stock exchanges
AICPA issues auditing standards for private companies
2. Expectations Gap
a. What the public think accountants should do vs. what accountants think they can do.
b. Public: audits should detect material misstatements due to error and fraud
c. Accountants: audits provide only reasonable assurance that F/S are free of all types of
material misstatements
d. Closing the Gap
Management Integrity/Honesty
Organizational Culture
Audit Risks
3. Auditors Responsibilities
a. 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 or
illegal acts.
b. Because of the nature of audit evidence and the characteristics of fraud, the auditor is
able to obtain reasonable, but not absolute, assurance.
4. Error, Fraud & Illegal Acts
a. Error
Innocent mistake in math or application of GAAP
Innocent mistake in omission of information
b. Fraud
Deliberate decision made to deceive others
Fraudulent financial reporting
Misappropriation of assets
c. Illegal Acts
Violations of laws or regulations
5. Procedures upon Discovery of Illegal Acts
a. Assess the impact on F/S
b. Consult with legal counsel and other specialists
c. Report to audit committee
d. Consider clients remedial actions
Disciplinary actions
Controls to safeguard against recurrence
Reporting effects of the acts
e. Consider modification of opinion and/or withdrawal from engagement
6. Private Securities Litigation Reform Act (PSLRA)
a. Additional requirements for public companies and their auditors when:
Act has a material effect on F/S
Mgmt and BOD not taken appropriate action
Auditors plan to modify opinion or resign
b. Required response:
Auditors must report act to the client
Client must inform BOD which has one day to inform the SEC.

If client does not inform the SEC

1. Auditors must report to the SEC within one day
2. Or resign from the engagement
7. Fraud Prevention, Detection And Reporting
a. Fraud involves intentional misstatements and can be classified into two types:
1. Fraudulent financial reporting
a. Intentional misstatements or omissions of amounts/disclosures in order to
deceive financial statement users
b. Misrepresentation in, or intentional omission of, events, transactions, or other
significant info
c. Intentional misapplication of accounting principles
1. Misappropriation of assets
8. Fraud Triangle
a. Incentives/Pressures to Commit Fraud
Pressures to meet financial numbers
Financial distress
Personal problems
b. Opportunity
Employees who have access to assets such as cash and inventory
Internal controls to help safeguard assets
1. Segregation of duties
2. Reconciliations
Backdating stock options
c. Rationalization
Explain away actions as acceptable
Perpetrators are often in denial
Its a one-time event
A good person may get caught up in the fraud
1. Company had to make numbers
2. Fear losing job
3. Im entitled since Im underpaid
9. Managements Responsibilities for Fraud Prevention, Detection, and Reporting
a. First line of defense against fraud
Effective system of IC
Independent internal audit function
Fraud assessment
b. Internal auditors should have direct and unrestricted access to the audit committee
10.COSO Internal Control- Integrated Framework
a. Effected by BOD, mgmt, and other personnel
b. Designed to provide reasonable assurance
Effectiveness and efficiency of operations
Reliability of financial reporting
Compliance with laws and regulations
c. Five Components
Control Activities
Risk Assessment
Information and Communications
Monitoring of Controls
Control Environment

d. COSO Findings in Fraudulent Financial Reporting: 1998-2007

347 alleged cases of public company fraudulent financial reporting
CEO and/or CFO some level involvement in 89% of the fraud cases
Most common fraud technique
1. Improper revenue recognition (60%)
2. Overstatement of existing assets
3. Capitalization of expenses
60% of fraud firms changed auditors during fraud period
11.Enterprise Risk Management-Integrated Framework
a. Internal control enhanced with corporate governance and risk management
b. Aligning risk appetite and strategy
c. Enhancing risk response decisions
d. Reducing operational surprises and losses
e. identifying and managing multiple and cross-enterprise risks
f. Seizing opportunities
g. Improving deployment of capital
12.Auditors Responsibilities For Fraud Prevention, Detection And Reporting
a. Fraud Considerations in the Audit
Understand characteristics of fraud
Exercising professional skepticism
Discussion among engagement personnel regarding the risks of material
misstatement due to fraud (RMMDF)
Obtaining the information needed to identify RMMDF
Identifying risks that may result in a MMDF
Assessing the identified risks after taking into account an evaluation of the entitys
programs and controls
Responding to the results of the assessment
Evaluating audit evidence
Communicating about fraud to management, the audit commitment, and others
Documenting the auditors consideration of fraud
b. Fraud Risk Identification
Communicate with predecessor auditor
1. Reasons for firing or the reasons for no longer servicing client
2. Managements integrity
3. Disagreement with management over accounting principles
Make inquiries of management and others
1. Risk assessment process
2. Any knowledge of fraud
Perform analytical procedures during planning to id any unusual or unexpected
Consider whether fraud risk factors exist
Consider other information
Consider management override of controls
Consider improper revenue recognition
c. Communications about Possible Fraud

Additionally, consider whether fraud has internal control implications

13.Management Representations and Financial Statement Certifications

a. Management responsible for preventing and detecting fraud

b. Management can override internal controls and create deceptive accounting
c. Management representation letters from CEO, CFO, and other appropriate officers (SOX
Provided access to all known information bearing on fair presentation of financial
Discloses any noncompliance with laws and regulations
Confirms that management has performed an assessment of effectiveness of internal
control over financial reporting
Concludes that effective internal controls have been maintained
Discloses any deficiencies in the design or operation of internal controls
14.Risk Assessment Standards
a. Understand entity and environment
b. Assess risk of material misstatement (RMM)
c. Respond to RMM by changing the nature, timing and extent of procedures
d. Evaluate results. Additional focus on areas noted as RMM and
Known errors
Likely errors
15.Auditing Evidence
a. Consideration of the competency and sufficiency of evidence
b. Management representations are not a substitution for application of audit procedures
c. Audit risk and materiality considered together
Determination of nature, timing and extent of procedures
Evaluation of results of procedures
Extent and nature of the evidence
16.Audit Report
a. Title- Independent; addressed to BOD/stockholders
b. Introductory Paragraph- identifies entity, financial statements, time period
c. Mgmts Responsibility
Preparation and fair presentation of F/S
Design, implementation and maintenance of IC
d. Auditors Responsibility
Express an opinion based upon audit
Procedures to obtain evidence
Auditors judgement and risk assessment
Consideration of IC
Audit evidence is sufficient and appropriate as basis for opinion
e. Opinion-link to present fairly and conformity to GAAP
f. Optional Paragraph- Report on Other Legal and Regulatory Requirement
g. Signature, date, auditors city and state
17.Unmodified Audit Opinion
a. Clean or std opinion
b. F/S present fairly
c. Optional paragraph
Emphasis of matter
1. Going concern
2. Consistent application of accounting principles
3. Litigation uncertainty
Other matter
1. Supplemental info
18.Modified Audit Opinions
a. Modify the opinion when:
F/S are MMS, or

Unable to obtain sufficient appropriate evidence

b. Options:
Qualified, adverse, or disclaimer
c. Include in opinion basis for modifications
Separate paragraph describes matter giving rise to modification
Place immediately before the opinion paragraph
Titled Basis for (Qualified, Adverse, Disclaimer) Opinion
a. Concludes misstatements, individually or in the aggregate, are material but not
pervasive to the financial statements, or
b. Unable to obtain sufficient appropriate audit evidence but possible effect on financial
statements could be material but not pervasive
a. Concludes the misstatements, individually or in aggregate, are material and pervasive
a. Unable to gather sufficient evidence to warrant the expression of an opinion on the
statements as a whole
22.Limitations of the Audit Report
a. Reasonable Assurance
Term reasonable
1. Did you exercise reasonable care
2. Would a reasonable person agree with your conclusion
Not an absolute guarantee
Followed GAAS, gathering sufficient competent evidential matter (not 100%)
Failure to follow GAAS: allegation of negligence
b. Materiality
Magnitude of an omission or misstatement that the judgment of reasonable person
relying on the information would have been changed or influenced by the omission or
Judging Materiality
1. May not rely solely on a quantitative threshold as a rule of thumb (5%) to
determine materiality
2. Must also consider qualitative factors
3. Consideration of risk of fraud
4. Unintended consequence: subject to manipulation
a. Weston Smith: 140,000 journal entries
c. Present Fairly
Auditors assessment of fair presentation depends on whether
1. Accounting principles used have general acceptance
2. Accounting principles are appropriate
3. Financial statements are informative
4. Information presented is classified and summarized in a reasonable manner
5. Financial statements reflect the underlying transactions and events in a manner
that is consistent with materiality and reflects economic substance
AICPA Auditing Standards Board
1. Privately owned businesses
Public Company Accounting Oversight Board (PCAOB)
1. Establishes auditing standards for public companies
2. Required standards, not generally accepted
3. Establishes independence rules
4. Establishes quality control standards for registered CPA firms
5. Conducts peer review for registered firms

General Standards
1. Training and Proficiency
2. Independence
3. Performance-due care
Standards of Field Work
1. Supervise assistants
2. Internal Control- obtain sufficient understanding of IC to plan the audit and
determine the nature, timing, and extent of tests to be performed
3. Evidence- gather evidence sufficient evidence to provide basis for opinion
Standards of Reporting
1. GAAP-statements conform with GAAP
2. Adequate disclosures
3. Consistency- principles have been consistently applied
4. Express opinion on stmts taken as a whole, or indication that an opinion cannot be
c. PCAOBS Integrated Audit Concept
1. Integrated audit combines an audit of internal control over financial reporting with
the audit of the financial statements
2. Objectives of the two audits are achieved simultaneously through a single
coordinated process
3. Can help to improve the quality and integrity of both audits
d. PCAOB Standards
No. 4- audit of whether previously reported material weakness no longer exists
No. 5- audit of assessment of effectiveness of IC over financial reporting
No. 6- auditors evaluation of consistency of F/S
No. 8- consideration of audit risk in an audit of F/S as a part of an integrated audit
including IC
No. 9- requirements regarding planning an audit, including assessing matters,
appropriate audit strategy, and audit plan
No. 10- requirements for the supervision of the audit engagement
No. 11- consideration of materiality in planning and performing an audit
No. 12- requirements regarding the process of identifying and assessing risk of MMS of
No. 13- requirement for responding to risks of MMS in F/S
No. 14- requirements regarding the auditors evaluation of audit results and
determination of whether the auditor has obtained sufficient appropriate audit
No. 15- requirements for designing and performing audit procedures to obtain
sufficient appropriate audit evidence to support the opinion expressed in the auditors
24.Communications with Audit Committees
a. No. 16- requirements of communications with audit committees
b. Understanding of the audit engagement
c. Significant accounting policies and practices
d. Critical accounting policies and practices
e. Critical accounting estimates
f. Significant unusual transactions
25.Auditing Quality of Financial Reporting
a. Difficult or contentious matters
b. Going concern
c. Uncorrected and corrected misstatements
d. Departure from standard report

e. Disagreements with mgmt

f. Difficulties encountered in performing audit
g. Form and documentation of communication
26.Restatements of Financial Statements
a. Downward trend since 2006 peak year
b. Improved reliability of ICFR implementations
c. Relaxed approach adopted by SEC
Need to file restatements
d. Drop in severity of restatements
e. Smaller cut out of profits
27.Causes behind Restatements
a. Complexity of accounting standards and/or transactions
b. Weak financial governance and controls
c. Increased auditor and audit committee conservatism
d. Broad application of materiality
e. Earnings mgmt driven by pressure to make the numbers
f. Lack of transparency
g. Fraud