Download Auditor`s Responsibility

Chapter 5
Fraud in Financial Statements
and Auditor Responsibilities
Questions for Consideration
1. What are the red flags that are indicators that
fraud may exist?
2. What is the difference between an error, a
fraud, and an illegal act and related audit
responsibilities?
3. What the auditor’s responsibilities to detect
and report fraud?
4. What is the role of internal controls and risk
assessment in preventing and detecting fraud?
What is an Audit?
• Audit, an examination of company prepared
financial statements in accordance with GAAP
– Independent opinion rendered on the
examination
– SEC requires all public companies to have an audit
– PCAOB establishes audit standards for
independent auditors and ethics standards for
companies listed on stock exchanges
– AICPA issues auditing standards for private
companies
Expectations Gap
• Difference between what the public and users of
financial statements and accounting profession
perceive as the responsibilities of auditors and the
purpose of an audit
– Investing public perceive audits should detect material
misstatements due to error and fraud
– Accounting profession perceive that audit provides only
reasonable assurance that financial statements are free
of all types of material misstatements
• Closing the Gap
– Management Integrity/Honesty
– Organizational Culture
– Audit Risks
Fraudulent Financial Reporting
Involves either intentional misstatements or
omissions of amounts or disclosures in order to
deceive financial statement users
1. Deception – manipulation, falsification or
alteration of accounting records or supporting
documents
2. Misrepresentation in, or intentional omission of,
events, transactions, or other significant
information
3. Intentional misapplication of accounting principles
Nature and Causes of Misstatements
• The auditor has responsibility to plan and
perform the audit to obtain reasonable assurance
about whether the financial statements are free
of material misstatement, whether caused by
error or fraud or illegal acts.
• Because of the nature of audit evidence and the
characteristics of fraud, the auditor is able to
obtain reasonable, but not absolute, assurance.
Error, Fraud & Illegal Acts
• Error
– Innocent mistake in math or application of GAAP
– Innocent mistake in omission of information
• Fraud
– Deliberate decision made to deceive others
– Fraudulent financial reporting
– Misappropriation of assets
• Illegal Acts
– Violations of laws or regulations
– Bribery
Procedures upon Discovery
of Illegal Acts
• Assess the impact 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
• Consider withdrawing from engagement
Private Securities Litigation
Reform Act (PSLRA)
• Additional requirements upon public companies and their auditors
when
1. The illegal act has a material effect on financial statements
2. Senior management and board of directors have not taken
appropriate remedial action
3. 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
Auditors Responsibilities for Fraud Prevention,
Detection, and Reporting
• First line of defense against fraud
– Effective system of internal controls
– Independent internal audit function
– Fraud assessment
• Internal auditors should have direct and
unrestricted access to the audit committee
• Description and Characteristics of Fraud
– Management Fraud
• Misstatements arising from fraudulent financial reporting
– Defalcations
• Misappropriation of assets
Fraud Triangle
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INCENTIVES/PRESSURES TO COMMIT FRAUD
– Self-serving
– Pressures to meet financial numbers
– Financial distress
– Personal Problems
OPPORTUNITY
– Employees who have access to assets such as cash and inventory
– Internal controls to help safeguard assets
• Segregation of duties
• Reconciliations
– Backdating stock options
RATIONALIZATION
– Explain away actions as acceptable
– Perpetrators are often in denial
– It’s a one-time event
– A good person may get caught up in the fraud
– Rationalization
• Company had to make numbers
• Fear losing job
• I’m entitled since I’m underpaid
Tyco: A Case of Corporate Greed
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Lavish parties
Decorating NY apartment
Company “loans” to avoid paying taxes
Failed corporate governance
PwC partner On Tyco issued cease and desist
order
– Failed to follow GAAS
– Violated antifraud provisions of securities law
Fraud Risk Assessment
• Approach each engagement with a healthy
dose of skepticism
• Identify risk of material misstatement due to
fraud
– Make inquiries of management and others
– Consider any unusual or unexpected relationships:
analytical procedures during planning
– Consider whether fraud risk factors exist
– Consider other information
– Consider management override of controls
– Consider improper revenue recognition
Fraud Risk Assessment
• 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 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
Fraud Considerations in the Audit
1.
2.
3.
Description and characteristics of fraud
Importance of exercising professional skepticism
Discussion among engagement personnel regarding the
risks of material misstatement due to fraud
4. Obtaining the information needed to identify risks of
material misstatements due to fraud
5. Identifying risks that may result in a material
misstatement due to fraud
6. Assessing the identified risks after taking into account an
evaluation of the entity’s programs and controls
7. Responding to the results of the assessment
8. Evaluating audit evidence
9. Communicating about fraud to management, the audit
commitment, and others
10. Documenting the auditor’s consideration of fraud
Rite Aid Fraud
• Improper adjusting entries to reduce cost of
goods sold and accounts payable
• Management failed to devise and maintain a
system of internal controls
• KPMG, auditors
– Noted failure of management to have internal
control system
Communications about Possible Fraud
If fraud may exist that causes a material
misstatement of financial statements
• Brought to the attention of appropriate level of
management
– Reported even if matter might be considered
inconsequential
– Whether caused by management or other employees
• Reported directly through governance structure
• Consider whether fraud has internal 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 (SOX requirements)
– Provided 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
The Contents of the Audit Report
• Title – Independent; addressed to BOD/stockholders
• Introductory Paragraph – identifies entity, financial statements, time
period
• Management’s Responsibility
– Preparation and fair presentation of financial statements
– Design, implementation and maintenance of internal controls
• Auditor’s Responsibility
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Express an opinion based upon audit
Procedures to obtain evidence
Auditor’s judgment and risk assessments
Consideration of internal controls
Audit evidence is sufficient and appropriate as basis for opinion
• Opinion – link to “present fairly” and conformity to GAAP
• Optional Paragraph: Report on Other Legal and Regulatory Requirement
• Signature, date, auditor’s city and state
Unmodified Audit Opinions
• Unmodified (clean or standard opinion)
– Financial statements “present fairly”
• Financial position
• Results of operations
• Cash flows
• Stockholders’ Equity
– Optional paragraph
• Emphasis-of-matter
– Going concern
– Consistent application of accounting principles
– Litigation uncertainty
• Other-matter
– Supplemental information
Modified Audit Opinions
• Modifies the audit when: explain type of modification and why
– 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 but possible effect on
financial statements could be material but not pervasive
• Adverse
– Concludes that misstatements, individually or in the aggregate, are
material and pervasive
• Disclaimer
– Unable to gather sufficient evidence to warrant the expression of an
opinion on the statements as a whole
• Basis for Modifications
– Separate paragraph describe smatter giving rise to modification
– Place immediately before the opinion paragraph
– Titled “Basis for (Qualified, Adverse, Disclaimer) Opinion
Generally Accepted Auditing Standards
(GAAS)
• AICPA Auditing Standards Board
– Privately owned businesses
• Public Company Accounting Oversight Board
(PCAOB)
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Establishes auditing standards for public companies
Required standards, not generally accepted
Establishes independence rules
Establishes quality control standards for registered
CPA firms
– Conducts peer review for registered firms
GAAS
General Standards
1.
Adequate technical training and proficiency
2.
Independence in mental attitude
3.
Due care in the performance of the audit and preparation of the report
Standards of Field Work
1.
Adequately plan the audit work and supervise assistants
2.
Obtain a sufficient understanding of internal control to adequately plan
the audit and determine the nature, timing, and extent of tests to be
performed
3.
Gather sufficient competent evidential matter to provide a basis for an
opinion
Standards of Reporting
1.
The statements have been in conformity with GAAP
2.
Accounting principles have been consistently applied
3.
Adequate informative disclosures have been made
4.
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 substitution for
application of 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
Limitations of the Audit Report
• 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
Limitations of the Audit Report
• 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” to determine materiality
• 5% is a common materiality test
• Unintended consequence of materiality is that it is subject to
manipulation
• Full analysis of all relevant considerations including
qualitative ones
• Consideration of risk of fraud
Limitations of the Audit Report
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Present Fairly
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3.
4.
5.
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
COSO Internal Control – Integrated
Framework
• Broadens the definition of internal control and
the parties that affect it by linking sound
controls to the actions of the BOD,
management and other personnel
• Identifies five interrelated components of
internal control
Control environment
Control activities
Monitoring of controls
Risk assessment
Information systems
Internal Control – Integrated
Framework
• Internal control as a process
• Effected by board of directors, management,
and other personnel
• Designed to provide reasonable assurance
– Effectiveness and efficiency of operations
– Reliability of financial reporting
– Compliance with laws and regulations
COSO Findings in Fraudulent Financial
Reporting: 1998 -2007
• 347 alleged cases of public company fraudulent
financial reporting
• CEO and/or CFO some level involvement in 89%
of the fraud cases
• Most common fraud technique
– Improper revenue recognition (60%)
– Overstatement of existing assets
– Capitalization of expenses
• 60% of fraud firms changed auditors during fraud
period
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 crossenterprise risks
• Seizing opportunities
• Improving deployment of capital
PCAOB’s Integrated Audit Concept
• Integrated audit combines an audit of internal
control over financial reporting with the audit
of the financial statements
• Objectives of the two audits are achieved
simultaneously through a single coordinated
process
• Can help to improve the quality and integrity
of both audits
PCAOB Standards
• Auditing Std No. 4 – audit of whether
previously reported material weakness no
longer exists
• Auditing Std No. 5 – audit of assessment of
effectiveness of internal control over financial
reporting
• Auditing Std No. 6 – auditor’s evaluation of
the consistency of the financial statements
PCAOB Standards
• Auditing Std No. 8 – consideration of audit risk
in an audit of financial statement as a part of
an integrated audit including internal controls
• Auditing Std No. 9 – requirements regarding
planning an audit, including assessing matters,
appropriate audit strategy, and audit plan
• Auditing Std No. 10 –requirements for the
supervision of the audit engagement
PCAOB Standards
• Auditing Std No. 11 – consideration of materiality
in planning and performing an audit
• Auditing Std No. 12 – requirements regarding the
process of identifying and assessing risks of
material misstatement of the financial statements
• Auditing Std No. 13 – requirement for responding
to risks of material misstatements in financial
statements
PCAOB Standards
• 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
Communication with Audit
Committees
• Auditing Std No. 16 – requirements of
communications with audit committees
• Understanding of the audit engagement
1. Significant accounting policies and practices
2. Critical accounting policies and practices
3. Critical accounting estimates
4. Significant unusual transactions
Auditing Quality of Financial Reporting
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Difficult or contentious matters
Going concern
Uncorrected and corrected misstatements
Departure from standard report
Disagreements with management
Difficulties encountered in performing audit
Form and documentation of communication
Restatements of Financial Statements
• Downward trend since 2006 peak year
• Improved reliability of ICFR implementations
• Relaxed approach adopted by SEC
– Materiality
– Need to file restatements
• Drop in severity of restatements
• Smaller cut out of profits
Causes behind Restatements
• Complexity of accounting standards and/or
transactions
• Weak financial governance and controls
• Increased auditor and audit committee
conservatism
• Broad application of materiality
• Earnings management driven by pressure to
make the numbers
• Lack of transparency
• Fraud