Chapter 17 – Fraud Awareness Accounting



What You Really Need to Know

Chapter 17: Fraud Awareness Accounting

This chapter is about a very topical theme: fraud. More specifically, it defines fraud and related concepts, considers auditors responsibilities regarding the detection of fraud, conditions that underlie fraud, fraud prevention, and various detection procedures.

I. Fraud, Irregularities, Illegal Acts, and Errors

In order to understand fraud awareness auditing, a first step is knowledge of the types of fraud, irregularities, illegal acts and errors that can take place.

Fraud is knowingly making material misrepresentations of fact, with the intent of inducing someone to believe the falsehood, act upon it, and thus suffer loss or damage. In essence, it is about lying, cheating, stealing, and misleading. It isn’t necessarily associated with a company’s financial statements.

On the other hand, the terms errors, irregularities and direct-effect illegal acts are specifically associated with financial statements:

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

Irregularities are intentional misstatements or omissions of amounts or disclosures in financial statements.

Illegal Acts are violations of laws or government regulations by the company, its management, or the employees that produce direct and significant effects on dollar amounts in financial statements.

II. Responsibilities Concerning the Detection of Fraud

External, internal and governmental auditors all have standards of care, attention, planning, detection, and reporting of some kinds of illegal acts, irregularities, and errors which to a significant degree are limited by auditing standards and materiality guidelines.

On the other hand, fraud examiners’ sole purpose is to detect fraud, so they are unconstrained by any such standards or guidelines.

In response to the growing problems of fraud, external auditors have taken on increased responsibilities for detecting fraud and other illegal acts in recent years. They need to obtain reasonable assurance that the financial statements are free of material misstatements, including those due to fraud.

On the other hand, currently, the internal auditing standards carefully impose no positive obligations for fraud detection and investigation work in the ordinary course of an internal auditor’s assignments. However, internal auditors are encouraged to be aware of various types of frauds, their signs, follow up on the signs and control weaknesses to determine whether a suspicion is justified, and then to alert management and call in the fraud experts if needed.

Fraud examiners “think like crooks” to imagine fraud schemes for getting around internal controls. Where controls are not in place, they imagine possible scenarios of white-collar crime. Their materiality threshold is much lower than that of an external auditor.

III. Conditions Underlying Fraud

Fraud usually occurs when three conditions are present: a motive, opportunity, and a lapse of integrity. A motive is a pressure a person experiences and believes cannot be shared with friends and confidants. It is often financial in nature. A fraud opportunity is like an open door for solving the unshareable problem by violating a trust by, for example, getting around an organization’s internal controls. Finally, a lapse in integrity permits motive and opportunity to take the form of fraud. It provides the rationalization to act. Together, these three factors form what is known as the “Fraud Triangle.”

IV. Fraud Prevention

Telltale hints of a cover-up often appear in the accounting records. The key is to notice exceptions and oddities such a transactions at an odd time of the day, month, or season.

Exceptions and oddities can appear in the following forms:

1. missing documents

2. second endorsement on cheques

3. unusual endorsements

4. unexplained adjustments to inventory balances

5. unexplained adjustments to accounts receivable

6. old items in bank reconciliations

7. old outstanding cheques

8. customer complaints

9. unusual patterns in deposits in transit.

Frauds that affect financial statements are often accompanied by the following conditions:

: 1. high debt

2. unfavorable industry conditions

3. excess capacity

4. profit squeeze

5. strong foreign competition

6. lack of working capital

7. rapid expansion

8. product obsolescence

9. slow customer collections

10. related party transactions.

Taking extra precautions by improving internal controls when such conditions exist can go a long way toward fraud prevention.

V. Detection Procedures

Fraud can be detected through the following warning signs:

1. Managers have lied to auditors or have been overly evasive in response to audit

enquiries.

2. The auditor’s experience with management indicates a degree of dishonesty.

3. Management places undue emphasis on earnings projections or the quantitative

targets.

4. Management has engaged in frequent disputes with auditors, particularly about

aggressive application of accounting principles that increase earnings.

5. The client has engaged in opinion shopping.

6. Management’s attitude toward financial reporting is unduly aggressive.

7. The client has a weak internal control system.

8. A substantial portion of management compensation depends on meeting

quantified targets.

9. Management displays significant disrespect for regulatory bodies.

10. Management operating and financial decisions are dominated by a single person

or a few people acting in concert.

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