Chapter 5 4e Updated

Fraud in Financial
Statements
and Auditor Responsibilities
Chapter 5
Copyright ©2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Questions for Consideration
• What are the red flags that are indicators of

fraud may exist?
• What are the auditor’s responsibilities to
detect and report fraud?
• What is the role of internal controls and risk
assessment in preventing and detecting
fraud?
• Will the revised audit report provide any
tangible benefits with respect to increasing
its informational value, usefulness, and
relevance to the investing public?
Fraud in Financial Statements
• The primary responsibility for the prevention and

detection of fraud rests with both those charged with
governance of the entity and management.
• An auditor conducting an audit in accordance with
generally accepted auditing standards is responsible for
obtaining reasonable assurance that the financial
statements as a whole are free from material
misstatements, whether by fraud or error.
• An unavoidable risk exists that some material misstatements
of the financial statements may not be detected, even though
the audit was conducted in accordance with GAAS.
• When the financial statements are materially misstated,
the auditor should not give an unmodified or unqualified
opinion but should modify the opinion as either qualified
or adverse opinion.
Fraudulent Financial Reporting
• Involves either intentional misstatements or

omissions of amounts or disclosures in
order to deceive financial statement users
• Deception – manipulation, falsification or
alteration of accounting records or
supporting documents
• Misrepresentation in, or intentional omission
from, events, transactions, or other
significant information
• Intentional misapplication of accounting
principles
Nature and Causes of Misstatements
• An inaccuracy in gathering or processing data from which

financial statements are prepared
• A difference between the amount, classification, or
presentation of a reported financial statement element,
account, or item in accordance with GAAP
• The omission of a financial statement element, account, or
item
• A financial statement disclosure that is not presented in
conformity with GAAP
• The omission of information required to be disclosed in
conformity with GAAP
• An incorrect accounting estimate due to oversight,
misrepresentation of facts, or fraud
• Management’s judgments concerning an estimate or the
selection or application of accounting policies that the auditor
may consider unreasonable or inappropriate
Error, Fraud and Illegal Acts
• Error
• Innocent mistake in math or application of
GAAP
• Innocent mistake in omission of information
• Fraud
• Deliberate decision made to deceive others
through
• Fraudulent financial reporting
• Misappropriation of assets
• Illegal Acts
• Violations of laws or regulations
• Bribery
Illegal Acts
• Assess the impact and materiality of the acts

on the financial statements
• Consult with legal counsel and other specialists
• Report the acts to audit committee
• Consider client’s remedial actions
• Disciplinary actions
• Controls to safeguard against recurrence
• Reporting effects of the acts
• If client does not take remedial actions
necessary, the auditor should consider
withdrawing from engagement
Private Securities Litigation
Reform Act (PSLRA)
• Additional requirements upon public companies and their
auditors when
• The illegal act has a material effect on financial statements
• Senior management and the board have not taken
appropriate remedial action
• Failure to take remedial action may warrant departure from a
standard audit report (or resignation of auditors)
• When illegal act has material effect on the financial
statements
• Auditors must report act to the client
• Client must inform Board of Directors which has one day to inform
the SEC
• If client does not inform the SEC
• Auditors must furnish the report to the SEC within one day
• Or resign from the engagement within one day
• Ethical obligation of confidentiality is waived
The Fraud Triangle
• Incentives/Pressures to • Rationalization
Commit Fraud • Explain away actions as
• Self-serving acceptable
• Pressures to meet financial • Perpetrators are often in denial
numbers • A good person may get caught
• Financial distress up in the fraud
• Home Problems • Other Rationalizations
• Opportunity • Company had to make numbers
• Fear losing job
• Employees who have access • I’m entitled since I’m underpaid
to assets such as cash and
inventory • Link to GVV
• Internal controls to help • One-time event
safeguard assets • Loyalty
• Segregation of duties • Expected/standard practice
• Reconciliations • Not your responsibility
• Backdating stock options
• Override internal controls by
management
Tyco Fraud
• Tyco board members did business with the

company
• Directors and officers had loans from the
company
• Related party disclosures were not made
• Other Red Flags
• Acquired personal assets with company funds
• Lavish parties using company funds
• Decorating NY apartment with company funds
• PwC partner on Tyco was issued a cease and
desist order
• Failed to follow GAAS
• Violated antifraud provisions of securities law
Fraud Risk Assessment
• AU-C240 requires the auditor to evaluate risk assessment

during the audit
• Evaluation of evidence about the potential client before
accepting engagement
• Communication with predecessor auditor
• Reasons for firing or the reasons for no longer servicing client
• Management’s and key accounting personnel’s integrity
• Disagreement with management over accounting principles
• Make inquiries about the risks of fraud and how they are
addressed
• Consider any unusual or unexpected relationships
• Consider whether one or more fraud risk factors exist
• Consider other information
• Approach each engagement with a healthy dose of skepticism
Internal Control Assessment
• The risk that internal controls will not help prevent

or detect a material misstatement is a critical
evaluation to provide reasonable assurance
• Components of internal control under the COSO
framework
• Control environment
• Risk assessment
• Control activities
• Monitoring
• Information and communication
• Attention should be focused on areas of highest
risk that a material weakness could exist in a
particular area of the company’s internal control
over financial reporting
COSO Findings in Fraudulent Financial
Reporting: 1998 -2007
• 347 alleged cases of public company

fraudulent financial reporting
• CEO and/or CFO had some level
involvement in 89% of the fraud cases
• Most common fraud techniques
• Improper revenue recognition
• Overstatement of existing assets
• Capitalization of expenses
• 26% of fraud firms changed auditors during
fraud period, over double the rate of non-
fraud firms
Enterprise Risk Management – Integrated
Framework
• Internal control enhanced with corporate

governance and risk management
• Aligning risk appetite and strategy
• Enhancing risk response decisions
• Reducing operational surprises and losses
• Identifying and managing multiple and
cross-enterprise risks
• Seizing opportunities
• Improving deployment of capital
COSO Guidance on Monitoring Internal
Control Systems
• Management should monitor controls to determine whether
they are operating effectively and the need for redesign when
risks change
• Effective monitoring involves
• Establishing a baseline for control effectiveness
• Designing and executing monitoring procedures that are based on
the significance of business risks relative to the entity’s objectives
• Assessing and reporting results, including follow-up on corrective
actions
• Framework adopts the position that management should
determine its risk appetite and align it with strategic objectives
• ERM seems to place emphasis in the wrong areas by
focusing on risk appetite
• Emphasis needed on the ethical dimensions of making
strategic decisions
Audit Committee Responsibilities for
Fraud Risk Assessment
• Audit Committee should

• Evaluate management’s identification of fraud risks
• Implementation of antifraud measures
• Creation of the appropriate tone at the top
• Active oversight by the audit committee can help
reinforce management’s commitment to create a
culture with “zero tolerance” for fraud
• Audit committee’s evaluation and oversight can
serve as a deterrent to senior management
engaging in fraudulent activity
• Audit committee should encourage management to
provide a mechanism for employees to report
concerns about unethical behavior, suspected
fraud, or violations of ethical codes or policies
Auditor’s Communication with Those
Charged with Governance
• AU-C 240 requires communication by auditors of evidence of
fraud to appropriate level of management, even
inconsequential or minor misappropriation
• Fraud that causes a material misstatement should be reported
directly to those charged with governance
• Good governance principles suggest that
• The auditor has access to the audit committee as necessary
• The chair of the audit committee meet with the auditor periodically
• The audit committee meets with the auditor without management at
least annually
• Auditors should communicate about accounting estimates
• Nature of significant assumptions/degree of subjectivity/relative
materiality
• Communicate to management/those charged with governance
risks due to fraud that have continuing control implications
Management Representations and Financial
Statement Certifications
• Management responsible for preventing and

detecting fraud
• Management can override internal controls and
create deceptive accounting
• Management representation letters from CEO,
CFO, and other appropriate officers (Section 302 of
SOX)
• Provides access to all known information bearing on fair
presentation of financial statements
• 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
Audit Reports and Auditing Standards
• Since 1926, the New York Stock Exchange has

required an auditor’s report
• The Securities Exchange Act of 1934 requires
all public companies to have an independent
auditor’s report in annual financial statements
• The PCAOB oversees public companies audits
since SOX in 2002
• The AICPA Auditing Standards Board (ASB)
oversees the audits of nonpublic companies
• Independent auditors express or disclaim an
opinion on whether an entity’s financial
statements and related disclosures are
presented in accordance with GAAP
Audit Reports
• Exhibit 5.5 (ASB) Unmodified Opinion for Non-

Public Companies
• Exhibit 5.6 (PCAOB)Unmodified or Unqualified
Report for Public Companies
• International Requirements
• Section ISA 700 of the International Standards on
Auditing allows the signature of the audit firm, the
personal name of the auditor who directed the
audit, or both
• After December 15, 2016, the personal name of the
auditor who directed the audit will ordinarily be required
• Also, after December 15, 2016, the audit reports of public
companies will include a “key audit matter” section
Differences between ASB and PCAOB
Unmodified Reports
• Title of Audit Report
• ASB – Independent Auditor’s Report
• PCAOB – Report of Independent Registered Audit Firm
• Headings
• ASB – Section headings
• PCAOB – No headings
• Management’s and Auditor’s Responsibilities
• ASB – Detailed descriptions
• PCAOB – Less detailed descriptions
• Auditing Standards
• ASB – GAAS
• PCAOB – Standards of PCAOB
• Internal Control over Financial Reporting
• ASB – Not included in auditor’s report
• PCAOB – Report on internal control included in an additional
paragraph in the report
Unmodified or Unqualified Audit Opinions
• Financial statements “present fairly”

• Financial position
• Results of operations
• Cash flows
• Stockholders’ Equity
• Optional additional paragraph
• Emphasis-of-matter
• Going concern
• Consistent application of accounting principles
• Litigation uncertainty
• Other-matter
• Supplemental information
Modified or Qualified Audit Opinions
• Modifies the audit when

• Based upon evidence financial statements are materially misstated,
or
• Unable to obtain sufficient appropriate evidence
• Qualified
• Concludes misstatements, individually or in the aggregate, are
material but not pervasive to the financial statements, or
• Unable to obtain sufficient appropriate audit evidence; possible
effect on financial statements could be material but not pervasive
• Adverse
• Concludes that misstatements, individually or in the aggregate, are
material and pervasive
• Basis for Modifications
• Separate paragraph describes matter giving rise to modification
• Placed immediately before the opinion paragraph
• Titled “Basis for (Qualified, Adverse, Disclaimer) Opinion
Disclaimer/Withdrawal from the
Engagement
• Disclaimer
• Unable to gather sufficient evidence to warrant the
expression of an opinion on the statements as a whole
• Withdrawal
• If significant conflict exists with management or the
auditor decides that management cannot be
trusted, then a withdrawal may be justified
• Trust issues are a matter of ethics
• The auditor must consider whether the breakdown
between management and the auditor has
advanced to the point that any and all information
provided by the client is suspect
• Withdrawal triggers the filing of the SEC’s 8-K form
by management
Limitations of the Audit Report
Reasonable Assurance
• Reasonable Assurance
• Due care
• Relation of independence and client
relationships
• Not an absolute guarantee
• Followed GAAS, gathering sufficient competent
evidential matter
• Failure to follow GAAS: allegation of negligence
Materiality
• Magnitude of an omission or misstatement of

accounting information that the judgment of
reasonable person relying on the information would
have been changed or influenced by the omission or
misstatement
• Judging Materiality
• May not rely solely on a quantitative threshold as a “rule
of thumb”
• 5% is a common materiality test
• SEC wants qualitative matters to be considered as well
• Unintended consequence of materiality is that it is
subject to manipulation
• An item may not be material and ignored even
though it is wrong to produce financials with
mistakes from an ethical (Rights Theory) perspective
Present Fairly
• Present Fairly
• Auditor’s assessment of fair presentation
depends on whether
• Accounting principles used have general
acceptance
• Accounting principles are appropriate
• Financial statements are informative
• Information presented is classified and
summarized in a reasonable manner
• Financial statements reflect the underlying
transactions and events in a manner that is
consistent with materiality and reflects economic
substance
Generally Accepted Auditing Standards
(GAAS)
• Auditing standards provide a measure of audit

quality and the objectives to be achieved in an audit
• Auditing standards differ from auditing procedures
because the procedures are steps taken by the
auditor during the course of the audit to comply with
GAAS
• The application of auditing standards entails
making judgments with regard to the nature of audit
evidence, sufficiency, competency, and reliability
• Materiality considerations are important to assess
whether the audit opinion should be modified
GAAS
• General Standards
• Adequate technical training and proficiency
• Independence in mental attitude
• Due care in the performance of the audit and preparation of the report
• Standards of Field Work
• Adequately plan the audit work and supervise assistants
• Obtain a sufficient understanding of internal control to adequately plan the audit
and determine the nature, timing, and extent of tests to be performed
• Gather sufficient competent evidential matter to provide a basis for an opinion
• Standards of Reporting
• The statements have been in conformity with GAAP
• Accounting principles have been consistently applied
• Adequate informative disclosures have been made
• Expression of an opinion on statements taken as a whole, or indication that an
opinion cannot be expressed
Auditing Evidence
• Consideration of the competency and sufficiency of

evidence
• Management representations are not a substitute
for application of proper audit procedures
• Audit risk and materiality considered together
• Determination of nature, timing and extent of procedures
• Evaluation of results of procedures
• Assess risks of material misstatements due to fraud
• Application of professional skepticism
• Audit procedures – specific acts performed to
gather evidence about specific assertions
Professional Skepticism
• An important role in gathering audit evidence and evaluating

usefulness
• Auditor should exercise professional judgment and skepticism
• Determining the nature, timing, and extent of audit procedures
• Determining the sufficiency, competency, and relevancy of evidence
• Evaluating management’s judgments and estimates
• Considering fraud in the audit
• Determining the conclusions based on the audit evidence obtained
• A state of mind and requires documentation to provide evidence that
the audit was planned and performed in accordance with GAAS
• Document the thought process, alternative views considered, judgments
made, audit evidence gathered, and support for final conclusion
• Document challenges to management’s views and assumptions
• Document the basis for unusual, one-time transactions and related business
rationale
• Include a complete and comprehensive record of discussions with
management
• Document assessments of the reliability of the source of documents
• Document professional skepticism in significant matters
Challenges to Professional Skepticism
• Motivated Blindness: Auditors may see what they

want to see and easily miss contradictory
information when it’s in their best interest to remain
ignorant
• Results over Efficiency: Link between skeptical
judgment and action and how it relates to reward
structure in auditing: rewarding results rather than
high-quality decisions
• Personality Traits: Diligence, thoroughness,
objectivity and reliability are traits that influence
level of professional skepticism
• Levers: Accountability to reviewers and regulators
serve as a lever that impacts skeptical judgment
and skeptical action(PCAOB inspections)
PCAOB Standards
• Auditing Std No. 5 – audit of assessment of

effectiveness of internal control over financial
reporting
• Auditing Std No. 7 – engagement quality review
• Auditing Std No. 14 – requirements regarding the
auditor’s evaluation of audit results and
determination of whether the auditor has obtained
sufficient appropriate audit evidence
• Auditing Std No. 15 – requirements for designing
and performing audit procedures to obtain sufficient
appropriate audit evidence to support the opinion
expressed in the auditor’s report
• Auditing Std No. 16 – communications with audit
committees on significant issues
Audit Committee Communications
• Significant accounting policies and practices

• Critical accounting policies and practices
• Critical accounting estimates
• Significant unusual transactions
• Quality of financial reporting information
• Contentious issues with
management/disagreements
• Modifications to audit report
Specific Items to Communicate:
Quality of Financial
Reporting
• Qualitative aspects of accounting policies and
procedures
• Assessment of reasonableness of estimates in
financial statements
• Assessment of management’s disclosures re:
critical policies/procedures
• Whether presentation and disclosures are in
conformity with applicable financial reporting
framework
• Management’s response to issues raised
• Possibility of alternative treatments in financial
statements
Audit Deficiencies - SEC Actions
• Findings of a study of audit deficiencies for the Center

for Audit Quality that resulted in sanctions from the SEC
include
• Failure to gather sufficient competent evidence
• Failure to exercise due care
• Insufficient level of professional skepticism
• Failure to obtain adequate evidence related to management
representations
• Failure to express an appropriate audit opinion
• Satyam Case resulted in PwC being sanctioned due to a
lack of due care and exercise of professional skepticism
by accepting evidence provided by management that
was less than persuasive.
• PwC also failed to perform the necessary procedures
and report likely illegal acts that had a material effect on
the financial statements
PCAOB Inspection Program
• SOX authorized the PCAOB to inspect and set

professional standards for public accounting
firms
• PCAOB enforcement proceedings are non-
public unless
• The parties consent to a public hearing
• The board has imposed sanctions and the time to
file an appeal with the SEC has expired
• The SEC, on appeal, issues an order regarding the
sanctions imposed
• The process, including appeals, can take years
to complete and the enforcement actions may
not yet nor never be known to the public
Inspections and Audit Deficiencies
• A significant issue addressed in many enforcement

actions against audit firms is a lack of professional
skepticism and due care
• Examples that can inhibit professional skepticism
• Incentives and pressures to build or maintain a long-term
audit engagement
• Incentives and pressures to avoid significant conflicts with
management
• Desire to achieve high client satisfaction ratings
• Desire to keep audit costs low
• Desire to cross-sell services to clients
• Deficiency rates of the Big-4 CPA firms range from
28 to 50 percent
• In 2014, PCAOB said that the firms have shown
real improvements in its internal control audits
PCAOB Inspections of Chinese Firms
• Reluctance of foreign-based entities operating under the

banner of a Big-4 CPA firm to cooperate with the
PCAOB inspections of audits conducted by the foreign
entities that list stocks on the U.S. exchanges
• Chinese authorities find the disclosure about Chinese
companies to non-Chinese regulators to be
unacceptable
• The dilemma for U.S. regulators is the growing number
of Chinese companies listing stock in the U.S. that are
found to have engaged in financial fraud
• The contentious nature of relationship between PCAOB
and Chinese audit firms raises questions about the
quality, reliability, and trustworthiness of the audits and
brings into question whether the best interests of U.S.
investors are being adequately protected
Concluding Thoughts
• Financial statement fraud threatens the

foundation of the financial reporting process
and jeopardizes the integrity of the auditing
function
• The audit and evaluation of audit evidence
must be controlled through an ethical approach
that emphasizes objectivity, due care, and the
exercise of professional skepticism
• “Trust but verify” should be the mantra of a
sound audit
• Audit firms and auditors should recommit to the
public interest ideal that is the foundation for
the accounting profession
Video Links
• Tyco (Dennis Kozlowski 60 Mins interview)

• https://www.youtube.com/watch?v=MYmLaVYsyHw

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Chapter 5 4e Updated

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Fraud in Financial

• What are the red flags that are indicators of

• The primary responsibility for the prevention and

• Involves either intentional misstatements or

• An inaccuracy in gathering or processing data from which

• Assess the impact and materiality of the acts

• Tyco board members did business with the

• AU-C240 requires the auditor to evaluate risk assessment

• The risk that internal controls will not help prevent

• 347 alleged cases of public company

• Internal control enhanced with corporate

• Audit Committee should

• Management responsible for preventing and

• Since 1926, the New York Stock Exchange has

• Exhibit 5.5 (ASB) Unmodified Opinion for Non-

• Financial statements “present fairly”

• Modifies the audit when

• Magnitude of an omission or misstatement of

• Auditing standards provide a measure of audit

• Consideration of the competency and sufficiency of

• An important role in gathering audit evidence and evaluating

• Motivated Blindness: Auditors may see what they

• Auditing Std No. 5 – audit of assessment of

• Significant accounting policies and practices

• Findings of a study of audit deficiencies for the Center

• SOX authorized the PCAOB to inspect and set

• A significant issue addressed in many enforcement

• Reluctance of foreign-based entities operating under the

• Financial statement fraud threatens the

• Tyco (Dennis Kozlowski 60 Mins interview)

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