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1Chapter 11 - Fraud Auditing

■ Multiple Choice Questions From CPA Examinations

11-20 a. (3) b. (4) c. (1) d. (2)

11-21 a. (1) b. (4)

11-22 a. (1) b. (1) c. (1)


Information Fraud Condition

1. Management has a strong interest in employing
inappropriate means to minimize reported Incentives/Pressures
earnings for tax-motivated reasons.
2. Assets and revenues are based on significant
estimates that involve subjective judgments and
uncertainties that are hard to corroborate.
3. The company is marginally able to meet
exchange listing and debt covenant
4. Significant operations are located and conducted
across international borders in jurisdictions
where differing business environments and
cultures exist.
5. There are recurring attempts by management to
justify marginal or inappropriate accounting on
the basis of materiality.
6. The company’s financial performance is
threatened by a high degree of competition and
market saturation.
a. Management fraud is often called fraudulent financial reporting, and is the
intentional misstatement or omission of amounts or disclosures by management
with the intent to deceive users. In contrast, defalcations, which are also called
misappropriation of assets, involve theft of an entity’s assets, and normally
involve employees and others below the management level.
b. The auditor’s responsibility to detect management fraud is the same as for other
errors that affect the financial statement. The auditor should design the audit to
obtain reasonable assurance that material misstatements in the financial
statements due to errors or fraud are detected.
c. The auditor should evaluate the potential for management fraud using the fraud
triangle of incentives/pressures, opportunities, and attitudes/ rationalizations.
 Incentives/pressures – Auditors should evaluate incentives and pressures
that management or other employees may have to misstate financial
statements, including:
1. Declines in the financial stability or profitability of the company due to
economic, industry, or company operating conditions.
2. Pressure to meet debt repayment or debt covenant terms.
3. Net worth of managers or directors is materially threatened by financial
 Opportunities – Circumstances provide an opportunity for management to
misstate financial statements, such as:
1. Financial statements include significant accounting estimates that
are difficult to verify.
2. Ineffective board of director or audit committee oversight.
3. High turnover in accounting personnel or ineffective accounting,
internal auditing, or IT staff.
 Attitudes/Rationalizations – An attitude, character, or set of values exist
that allows management to rationalize committing a dishonest act.
1. Inappropriate or ineffective communication of entity values.
2. History of violations of securities laws or other laws and
3. Aggressive or unrealistic management goals or forecasts.

d. There are potentially many factors that should heighten an auditor’s concern
about the existence of management fraud. The factors (1) of an intended public
placement of securities, and (2) management compensation dependent on
operating results are both factors that affect incentives to manipulate financial
statements. The auditor should be alert for other incentives, such as the
existence of debt covenants or planned use of stock to acquire another company
that may provide incentives to manipulate the financial statements.
11-24, continued

The third factor of weak internal control reflects both an opportunity to

misstatement financial statements, and an attitude that allows rationalization of
actions to misstate the financial statements. As additional examples, the auditor
should be alert to the potential to use accounting estimates or discretion over the
timing of revenues to misstate financial statements. The auditor should also
consider the attitude of management, and whether they are overly aggressive or
have previously violated securities laws or other regulations.
In addition to the risk factors from the fraud triangle, the auditor should
consider other signals of the potential existence of management fraud. These
signals may include unusual changes in ratios or other performance measures,
as well as inquiries of management and communication amount the audit team.
11-25. a.

1. There is no basis for Prenumbered admission tickets should be issued upon
establishing the documentation payment of the admission fee.
of the number of paying
2. There is no segregation of One clerk (hereafter referred to as the cash receipts
duties between persons clerk) should collect admission fees and issue
responsible for collecting prenumbered tickets. The other clerk (hereafter
admission fees and persons referred to as the admission clerk) should authorize
responsible for authorizing admission upon receipt of the ticket or proof of
admission. membership.
3. An independent count of paying The admission clerk should retain a portion of the
patrons is not made. prenumbered admission ticket (admission ticket stub).
4. There is no proof of accuracy of Admission ticket stubs should be reconciled with cash
amounts collected by the clerks. collected by the treasurer each day.
5. Cash receipts records are not The cash receipts should be recorded by the cash
promptly prepared. receipts clerk daily on a permanent record that will
serve as the first record of accountability.
6. Cash receipts are not promptly Cash should be deposited at least once each day.
deposited. Cash should not be
left undeposited for a week.
7. There is no proof of the Authenticated deposit slips should be compared with
accuracy of amounts deposited. daily cash receipts records. Discrepancies should be
promptly investigated and resolved. In addition, the
treasurer should establish policy that includes a review
of cash receipts.
8. There is no record of the The treasurer should issue a signed receipt for all
internal accountability for cash. proceeds received from the cash receipts clerk. These
receipts should be maintained and should be
periodically checked against cash receipts and deposit

b. All of the deficiencies increase the likelihood of misappropriation of assets, by allowing

individuals access to cash receipts or failing to maintain adequate records to establish
accountability for cash receipts.
c. The deficiencies have less of an effect on the likelihood of fraudulent financial reporting
than they do for misappropriation of assets. The first four deficiencies increase the
likelihood of fraudulent financial reporting for reported revenues due to the lack of
adequate records to establish the number of patrons.
11-29 a. The auditor must conduct the audit to detect errors and fraud, including
embezzlement, that are material to the financial statements. It is more difficult to
discover embezzlements than most types of errors, but the auditor still has
significant responsibility. In this situation, the deficiencies in internal control are
such that it should alert the auditor to the potential for fraud. On the other hand,
the fraud may be immaterial and therefore not be of major concern. The auditor
of a public company must also consider the impact of noted deficiencies when
issuing the auditor’s report on internal control over financial reporting. When
noted deficiencies are considered to be material weaknesses, whether
individually or combined with other deficiencies, the auditor’s report must be
modified to reflect the presence of material weaknesses.

b. The following deficiencies in internal control exist:

1. The person who reconciles the bank account does not compare payees
on checks to the cash disbursements journal.
2. The president signs blank checks, thus providing no control over
3. No one checks invoices to determine that they are cancelled when paid.

c. To uncover the fraud, the auditor could perform the following procedures:
1. Comparison of payee on checks to cash disbursements journal.
2. Follow up all outstanding checks that did not clear the bank during the
engagement until they clear the bank. Compare payee to cash
disbursements journal.