Audit Ch. 10

b.

All of the weaknesses 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.

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a.

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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 weaknesses in Bargon's processes are such that they 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.

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a. This fraud is an example of both asset misappropriation and financial statement fraud. Ms. Sachdeva used corporate funds to purchase goods and then manipulated the financial statements to cover up the fraud.

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1. a. Fraud.

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Auditing standards require that auditors document the following matters related to the auditor's consideration of material misstatements due to fraud:

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Auditing standards require the audit team to conduct discussions to share insights from more experienced audit team members and to "brainstorm" ideas that address the following:

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Auditors are required to take three actions to address potential management override of controls: (1) examine journal entries and other adjustments for evidence of possible misstatements due to fraud; (2) review accounting estimates for biases; and (3) evaluate the business rationale for significant unusual transactions.

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Auditors must inquire whether management has knowledge of any fraud or suspected fraud within the company. Auditing standards also require auditors to inquire of the audit committee about its views of the risks of fraud and whether the audit committee has knowledge of any fraud or suspected fraud. If the entity has an internal audit function, the auditor should inquire about internal audit's views of fraud risks and whether they have performed any procedures to identify or detect fraud during the year. Auditing standards further require the auditor to make inquiries of others within the entity whose duties lie outside the normal financial reporting lines of responsibility about the existence or suspicion of fraud.

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.

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Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users. Two examples of fraudulent financial reporting are accelerating the timing of recording sales revenue to increase reported sales and earnings, and recording expenses as fixed assets to increase earnings.

3.

How assets of the entity could be misappropriated.

2.

How management could perpetrate and conceal fraudulent financial reporting.

4.

How the auditor might respond to the susceptibility of material misstatements due to fraud.

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Management and the board of directors are responsible for setting the "tone at the top" for ethical behavior in the company. It is important for management to behave with honesty and integrity because this reinforces the importance of these values to employees throughout the organization.

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Management has primary responsibility to design and implement antifraud programs and controls to prevent, deter, and detect fraud. The audit committee has primary responsibility to oversee the organization's financial reporting and internal control processes and to provide oversight of management's fraud risk assessment process and antifraud programs and controls.

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Misappropriation of assets is fraud that involves theft of an entity's assets. Two examples are an accounts payable clerk issuing payments to a fictitious company controlled by the clerk, and a sales clerk failing to record a sale and pocketing the cash receipts.

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Professional skepticism suggests the auditor should neither assume that management is dishonest, nor assume unquestioned honesty, and an auditor should remain professionally skeptical throughout the entire audit process. A questioning mind will encourage the auditor to gather more persuasive evidence to corroborate management responses, which would help the auditor distinguish intentional from unintentional misstatements. Critically assessing the evidence means the auditor evaluates each piece of evidence separately, but also evaluates all of the evidence gathered as a whole. For example, if all of management's estimates are biased in the direction of increasing net income, the auditor would be more likely to conclude the misstatements are intentional.

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Revenue and related accounts receivable and cash accounts are especially susceptible to manipulation and theft. Research finds that a majority of financial statement fraud instances involve revenues and accounts receivable. As a result of the frequency of financial reporting frauds involving revenue recognition, auditing standards require the auditor to presume fraud risk is present in revenue recognition in all audits. In light of this presumption, auditors should evaluate the types of revenue and revenue transactions, and the assertions related to these transactions, which may increase fraud risk.

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The auditor can choose among several overall responses to increased fraud risk. The auditor may begin by first discussing the auditor's findings about fraud risk with management to obtain management's views of the potential for fraud and the existing controls designed to prevent or detect misstatements. The auditor should consider whether antifraud programs and controls mitigate the identified risks of material misstatement due to fraud. If the risk of material misstatement due to fraud is increased, the auditor may decide to assign more experienced personnel to the engagement, including fraud specialists, and greater emphasis may be placed on the importance of increased professional skepticism. The auditor may place greater emphasis on management's choice of accounting principles with special attention given to those that involve subjective measurements or complex transactions. Auditing standards also require auditors to incorporate unpredictability in the audit strategy.

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The corporate code of conduct establishes the "tone at the top" of the importance of honesty and integrity and can also provide more specific guidance about permitted and prohibited behavior. Examples of items typically addressed in a code of conduct include expectations of general employee conduct, restrictions on conflicts of interest, and limitations on relationships with clients and suppliers.

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The following are examples of risk factors for fraudulent financial reporting for each of the three fraud conditions:

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The following are examples of risk factors for misappropriation off assets for each of the three fraud conditions:

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The handling of cash by individuals operating cash registers is particularly susceptible to theft. The notice "your meal is free if we fail to give you a receipt" is designed to ensure that every customer is given a receipt and all sales are entered into the register to establish accountability for the sale.

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The three types of inquiry are informational, assessment, and interrogative. Auditors use informational inquiry to obtain information about facts and details that the auditor does not have. For example, if the auditor suspects financial statement fraud involving improper revenue recognition, the auditor may inquire of management as to revenue recognition policies. The auditor uses assessment inquiry to corroborate or contradict prior information. In the previous example, the auditor may attempt to corroborate the information obtained from management by making assessment inquiries of individuals in accounts receivable and shipping. Interrogative inquiry is used to determine if the interviewee is being deceptive or purposefully omitting disclosure of key knowledge of facts, events, or circumstances. For example, a senior member of the audit team might make interrogative inquiries of management or other personnel about key elements of the fraud where earlier responses were contradictory or evasive.

c.

The weaknesses have less of an effect on the likelihood of fraudulent financial reporting than they do for misappropriation of assets. The first four weaknesses increase the likelihood of fraudulent financial reporting for reported revenues due to the lack of adequate records to establish the number of patrons.

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When making inquiries of a deceitful individual, three examples of verbal cues are frequent rephrasing of the question, filler terms such as "well" or "to tell the truth," and forgetfulness or acknowledgements of nervousness. Three examples of nonverbal cues by the individual are creating physical barriers by blocking their mouth, leaning away from the auditor, and signs of stress such as sweating or fidgeting.

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When the auditor suspects that fraud may be present, auditing standards require the auditor to obtain additional evidence to determine whether material fraud has occurred. Auditing standards also require the auditor to consider the implications for other aspects of the audit. When the auditor determines that fraud may be present, auditing standards require the auditor to discuss the matter and audit approach for further investigation with an appropriate level of management that is at least one level above those involved, and with senior management and the audit committee, even if the matter might be considered inconsequential. For public company auditors, the discovery of fraud of any magnitude by senior management is at least a significant deficiency and may be a material weakness in internal control over financial reporting. This includes fraud by senior management that results in even immaterial misstatements. If the public company auditor decides the fraud is a material weakness, the auditor's report on internal control over financial reporting will contain an adverse opinion.