Chapter 3

Management Fraud and Audit Risk

"It takes 20 years to build a reputation and five minutes to ruin

it. If you think about that, you'll do things differently."
- - Warren Buffet, billionaire investor

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 Presentation Outline
I. Errors, Fraud, and Illegal Acts
II. Steps in Considering the Risk of Fraud (SAS 99)
III. The Audit Risk Model
IV. Audit Programs and Procedures

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 I. Errors, Fraud, and Illegal Acts

A. Errors
B. Management Fraud
C. Consideration of Fraud in a Financial Statement
Audit
D. Reasons Auditors Fail to Detect Fraud
E. Auditor Responsibility for Detecting Errors,
Frauds, and Illegal Acts
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 A. Errors

Errors are
unintentional
misstatements or
omissions of
amounts or
disclosures in
financial statements.

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 B. Management Fraud

Management fraud is
intentional
misstatements or
omissions of amounts
or disclosures in
financial statements

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C. Consideration of Fraud in a Financial
Statement Audit

SAS 99 requires auditors to understand fraud,

assess fraud risks, design audits to provide
reasonable assurance of detecting material
management/employee fraud that could have a
material effect on the financial statements, and
report the findings to management, directors,
users of financial statements (sometimes), and
outside agencies (under certain conditions).

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 D. Reasons Auditors Fail to Detect Fraud

Over reliance on client representations.

Lack of awareness or failure to recognize that an
observed condition may indicate a material fraud.
Lack of experience.
Personal relationships with clients.
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 E. Auditor Responsibility for Detecting Errors,
Frauds, and Illegal Acts
Responsible for Must Communicate Findings?
Detection?

Material Immaterial Material Immaterial

Yes
Errors Yes No (Audit No
Committee)

Yes Yes
Fraud Yes No (Audit (One level
Committee) above)

Yes
Illegal Yes No Yes (One level
Acts (Direct Effect) (Audit above)
Committee)
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II. Steps in Considering the Risk of Fraud (SAS 99)

Step 1: Staff discussion

Step 2: Identify information necessary
to assess fraud risk factors
Step 3: a. Identify and
b. Assess fraud risk factors

Step 4: Respond to risk assessment

Step 5: Evaluate audit evidence

Step 6: Communicate fraud matters

Step 7: Document
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Step 1: Discussion Among Engagement Personnel
Objectives:
Gain understanding of
• Previous experiences with
client
• How a fraud might be
perpetrated and concealed
in the entity
• Procedures that might
detect fraud
Set proper tone
Should be continuous

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Step 2: Obtain Information to Identify Risks
Inquiries:
Management
Audit committee
Internal auditors
Others

Planning analytical procedures

Analytical procedures are very useful in identifying
unusual relationships among financial statement
accounts that merit additional investigation.

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 Step 3a: Identify Risk Factors
Related to Fraudulent Financial
Reporting

1) Management’s characteristics and

influence
2) Industry Conditions
3) Operating Characteristics and Financial
Stability

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 1) Management’s Characteristics and Influence

 Management has a motivation to engage in fraudulent reporting.

 Management decisions are dominated by an individual or a small
group.
 Management fails to display an appropriate attitude about internal
control.
 Managers’ attitudes are very aggressive toward financial
reporting.
 Managers place too much emphasis on earnings projections.
 Nonfinancial management participates excessively in the selection
of accounting principles or determination of estimates.
 The company has a high turnover of senior management.
 The company has a known history of violations.
 Managers and employees tend to be evasive when responding to
auditors’ inquiries.
 Managers engage in frequent disputes with auditors.

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2) Industry conditions

Company profits lag the industry.

New requirements are passed that could impair stability
or profitability.
The company’s market is saturated due to fierce
competition.
The company’s industry is declining.
The company’s industry is changing rapidly.
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 3) Operating Characteristics
A weak internal control environment prevails.
The company is not able to generate sufficient cash flows to
ensure that it is a going concern.
There is pressure to obtain capital.
The company operates in a tax haven jurisdiction.
The company has many difficult accounting measurement
and presentation issues.
The company has significant transactions or balances that
are difficult to audit.
The company has significant and unusual related-party
transactions.
Company accounting personnel are lax or inexperienced in
their duties.
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 Step 3b: Assess Fraud
Risks

Required risk assessments include:

Presume that improper revenue recognition is a fraud risk.
Identify risks of management override of controls.
– Examine journal entries and other adjustments.
– Review accounting estimates for biases.
– Evaluate business rationale for significant unusual
transactions.

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Step 4: Respond to Assessed Risks

Assignment of personnel (i.e., level of

experience)
Predictability of auditing procedures
Examination of journal entries and other
adjustments
Retrospective review of prior year accounting
estimates

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