06/24/22 1 Historical Overview of Auditor Responsibili ty and Characterist ics of Fraud Dr. Donald K. McConnell Jr.
Feb 25, 2016
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Fraud Detection: An Historical Overview of Auditor Responsibility and Characteristics of Fraud
Dr. Donald K. McConnell Jr.
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Evolution of the Auditor’s Fraud Detection Responsibilities Circa 1900: fraud detection the auditor’s
primary responsibility The late 1930s: McKesson and Robbins-
Did the auditor’s miss something? The mid-1960s: a “Catch-22”fraud
detection scenario Treadway committee findings led to SAS
53: the first defined responsibilities for detecting “irregularities”
Contemporary responsibilities: SAS 82 (AU 316) –a watershed event
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Report of the National Commission on Fraudulent Financial Reporting
Commonly referred to as the Treadway Committee Report (1987)
The Committee of Sponsoring Organizations (COSO) AICPA AAA FEI IIA IMA
Charge: identify environmental factors present when highest management level fraud occurs
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The Most Important Findings A proper “tone at the top” (corporate
environment or corporate culture) is the most important factor in combating fraud for the entity
Almost all management level fraud involved three types of schemes: Improper revenue recognition schemes Overvalued assets Improperly capitalized expenditures
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Improper Revenue Recognition Schemes Fraudulent sales Bill and hold arrangements Improper sales cut off’s Parking lot transactions Sales with liberal rights of return Channel stuffing
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Overvalued Assets Assets management knows should
be written down Examples:
Inventories Accounts receivable Impaired fixed assets
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Improperly Capitalized Expenditures “Creative” asset theory regarding
future benefit Expenditures booked as assets,
which should have been expensed WCOM capitalized ordinary line
expenses as fixed assets
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Other Treadway Committee Report Findings Perpetrators almost always had complete,
accurate audit trails Highest level management rarely embezzles Rarely does management fraud involved
manipulated financial data or incomplete records
Most management fraud was committed in the area of Accounting estimates
Accounting estimates are: Hard to develop, and easy to manipulate Hard to control Hard to audit
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What Is the Auditor’s Greatest Nightmare?
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What is the Auditor’s Fraud Detection Responsibility? The auditor has a responsibility to plan
and perform the audit to obtain REASONABALE ASSURANCE about whether the financial statements are free of MATERIAL misstatement, whether caused by fraud or error. (SAS 99.01)
That responsibility is couched by the terms Reasonable assurance and material
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Fraud Is a Broad Legal Concept: the Auditor’s Interest Is in Fraudulent Acts Causing Financial Statements to Be Materially Misstated
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Fraud Schemes Generally Involve: Pressure or incentive to commit
fraud (SAS 99.07) Perceived opportunity Attitudes/Rationalization (per
ACFE) These three elements form what
CFE’s call “A Fraud Triangle”
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Misstatements Arising from Fraudulent Financial Reporting [“Fraud for the Entity”]:
Intentional Misstatements or Omissions of Amounts or Disclosures in Financial Statements
Involving Manipulation, Falsification, or Alteration of Accounting Records or Documents,
Misrepresentation or Intentional Omissions, or Intentional Misapplication of Generally
Accepted Accounting Principles. (SAS 99.06)
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Misstatements Arising from Misappropriation of Assets [“Fraud Against the Entity”]
involves theft of entity assets wherein the effect of the theft causes financial statements not to be in conformity with GAAP. (SAS 99.06)
Examples include: Embezzlement of cash Purchasing kick back schemes Theft of small, valuable, marketable
assets (computer chips or small fixed assets)
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The Auditor is Interested in Fraud Which has the Effect of Causing the Financial Statements to be Materially Misstated; not just in Material Fraud
Doesn’t all material fraud cause the financial statements to materially misstated?An example where this isn’t the case.
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Fraud Schemes Typically Have Certain Characteristics (Au 316.07)
The schemes typically are concealed
Fraud can involve collusion, which is difficult to detect in an audit
Falsified documentation: Traditional auditors not expected to be experts in ascertaining authenticity
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Other Characteristics of Fraud All big frauds started as little ones Often occur through serendipity Fraudsters consider it a
“borrowing” Most embezzlers would be truly
appalled if accused of being a thief!
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What Does a Typical Fraudster Look like? You and me! They are often intelligent Almost always well-respected,
TRUSTED employees Often male, over 50, college-
educated
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Profile of a Typical Management Fraudster Glibness or
superficial charm Grandiose sense
of self worth or egocentric
Pathological liar Lack of remorse
or guilt
Shallow emotions Callousness or
lack of empathy Failure to accept
responsibility for their actions
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Motives for “Fraud for The Entity” Reach or exceed quotas or goals Meet regulatory requirements Manipulate stock price/value Maintain corporate ability to borrow Personal ambition
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Profile of a Typical Employee Fraudster Lifestyle does not
fit income Has access to
money or assets Problems at
home Problems dealing
with pressures Heavily indebted
Real or imagined grievances
Takes little or no vacation
Works odd hours Low morale Drug or gambling
problems Personality
changes
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Motives for “Fraud against the Entity” Enhance lifestyle Cure financial problems Revenge against the company Cure perceived injustice Ego-”beat the system” Personal ambition
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Various Fraud Issues Are auditors expected to seek out such indicators
of personal financial stress and company/employee conflict?
No, but an awareness of the following should be considered: Employee layoffs are anticipated Employees with access to assets susceptible to
defalcation exhibit: Unusual behavioral changes Lifestyle changes Appear disgruntled Known personal financial pressures
Is most fraud detected internally [internal auditors, hot lines] or by external audits?