BULE HORA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE
Nagele Campus

Course title:- Advanced Auditing

Group Assignment Titile:- Fraud Auditing

Group 3
1. Tigistu Gizaw Id. No.WP0298/14

2. Zegeye Tiruneh Id. No.WP0303/14

3. Jemal Umer Id. No.WP0302/14

4.Deresa Bedada Id. No.WP0304/14

February,2023
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Table of Contents
1. Meaning and categories of Fraud ................................................................................................... 1
1.1 Fraudulent Financial Reporting ..................................................................................................... 1
1.2 Misappropriation of Assets ........................................................................................................... 2
2. The fraud triangle. ........................................................................................................................... 2
3. Assessing the risk of Fraud ........................................................................................................... 5
4. Factors that reduce fraud risks ........................................................................................................ 6
4.1 Culture of honesty and high ethics ............................................................................................. 7
4.2 Management’s Responsibility to Evaluate Risks of Fraud ........................................................ 9
4.3 Audit Committee Oversight ....................................................................................................... 10
5. Responding To The Risk Of Fraud (Auditor responses to fraud risk) ....................................... 10
6. Specific Fraud Risk Areas and their warning signs ....................................................................... 12
6.1 Revenue and Accounts Receivable Fraud Risks ......................................................................... 12
6.2 Inventory Fraud Risks ............................................................................................................ 13
6.3 Purchases and Accounts Payable Fraud Risks ....................................................................... 14
6.4 Other Areas of Fraud Risk ..................................................................................................... 15
7.Reference ............................................................................................................................................ 16

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 1. Meaning and categories of Fraud
As a broad legal concept, fraud describes any intentional deceit meant to deprive another
person or party of their property or rights. In the context of auditing financial statements,
fraud is defined as an intentional misstatement of financial statements.

The two main categories are fraudulent financial reporting and misappropriation of assets.

1.1 Fraudulent Financial Reporting

Fraudulent financial reporting is an intentional misstatement or omission of amounts or
disclosures with the intent to deceive users. Most cases involve the intentional misstatement
of amounts, rather than disclosures.

For example, WorldCom capitalized as fixed assets billions of dollars that should have been
expensed. Omissions of amounts are less common, but a company can overstate income
by omitting accounts payable and other liabilities

While most cases of fraudulent financial reporting involve an attempt to overstate

income—either by overstatement of assets and income or by omission of liabilities and
expenses, companies also deliberately understate income. At privately held companies, this
may be done in an attempt to reduce income taxes. Companies may also intentionally
understate income when earnings are high to create a reserve of earnings or “cookie jar
reserves” that may be used to increase earnings in future periods. Such practices are called
income smoothing and earnings management.

Earnings management involves deliberate actions taken by management to meet earnings

objectives. Income smoothing is a form of earnings management in which revenues and
expenses are shifted between periods to reduce fluctuations in earnings. One technique to
smooth income is to reduce the value of inventory and other assets of an acquired
company at the time of acquisition, resulting in higher earnings when the assets are later
sold. Companies may also deliberately overstate inventory obsolescence reserves and
allowances for doubtful accounts to counter higher earnings

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1.2 Misappropriation of Assets
Misappropriation of assets is fraud that involves theft of an entity’s assets. In many cases,
but not all, the amounts involved are not material to the financial statements. However,
the theft of company assets is often a management concern, regardless of the materiality
of the amounts involved, because small thefts can easily increase in size over time.

The term misappropriation of assets is normally used to refer to theft involving employees
and others internal to the organization. According to estimates of the Association of
Certified Fraud Examiners, the average company loses five percent of its revenues to fraud,
although much of this fraud involves external parties, such as shoplifting by customers and
cheating by suppliers.

Misappropriation of assets is normally perpetrated at lower levels of the organization

hierarchy. In some notable cases, however, top management is involved in the theft of
company assets. Because of management’s greater authority and control over organization
assets, embezzlements involving top management can involve significant amounts.

2. The fraud triangle.

Three conditions for fraud arising from fraudulent financial reporting and
misappropriations of assets are

These three conditions are referred to as the fraud triangle.

Incentives/Pressures
Opportunities
Attitudes/Rationalization

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 Incentives/Pressures

Financial pressures are a common incentive for employees who misappropriate assets.
Employees with excessive financial obligations, or those with drug abuse or gambling
problems, may steal to meet their personal needs. In other cases, dissatisfied employees
may steal from a sense of entitlement or as a form of attack against their employers.

Opportunities

Opportunities for theft exist in all companies. However, opportunities are greater in
companies with accessible cash or with inventory or other valuable assets, especially if they
are small or easily removed

Weak internal controls create opportunities for theft. Inadequate separation of duties is
practically a license for employees to steal. Whenever employees have custody or even
temporary access to assets and maintain the accounting records for those assets, the
potential for theft exists.

For example, if inventory storeroom employees also maintain inventory records, they can
easily take inventory items and cover the theft by adjusting the accounting records

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 Attitudes/Rationalization

Management’s attitude toward controls and ethical conduct may allow employees and
managers to rationalize the theft of assets. If management cheats customers through
overcharging for goods or engaging in high pressure sales tactics, employees may feel that
it is acceptable for them to behave in the same fashion by cheating on expense or time
reports

Source: The 2007 Oversight System Report on Corporate Fraud, Oversight Systems, Inc., 2007
Figure 1- highlights an Oversight Systems Inc. survey finding that the pressure to do “whatever it
takes” to meet goals and the desire for personal gain are often cited as primary incentives to engage
in fraudulent actions.

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 3. Assessing the risk of Fraud
Professional skepticism

Auditors must maintain a level of professional skepticism as they consider a broad set of
information, including fraud risk factors, to identify and respond to fraud risk.

The auditor has a responsibility to respond to fraud risk by planning and performing the
audit to obtain reasonable assurance that material misstatements, whether due to errors or
fraud, are detected. Auditing standards state that, in exercising professional skepticism, an
auditor “neither assumes that management is dishonest nor assumes unquestioned
honesty.”

Questioning Mind

Auditing standards emphasize consideration of a client’s susceptibility to fraud, regardless

of the auditor’s beliefs about the likelihood of fraud and management’s honesty and
integrity. During audit planning for every audit, the engagement team must discuss the
need to maintain a questioning mind throughout the audit to identify fraud risks and
critically evaluate audit evidence. There is always a risk that even an honest person can
rationalize fraudulent actions when incentives or pressures become extreme.

Critical Evaluation of Audit Evidence

Upon discovering information or other conditions that indicate a material misstatement

due to fraud may have occurred, auditors should thoroughly probe the issues, acquire
additional evidence as needed, and consult with other team members. Auditors must be
careful not to rationalize or assume a misstatement is an isolated incident. For example,
say an auditor uncovers a current year sale that should properly be reflected as a sale in
the following year. The auditor should evaluate the reasons for the misstatement,
determine whether it was intentional or a fraud, and consider whether other such
misstatements are likely to have occurred.

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Documenting Fraud Assessment

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

• The discussion among engagement team personnel in planning the audit about
the susceptibility of the entity’s financial statements to material fraud.

• Procedures performed to obtain information necessary to identify and assess the

risks of material fraud. • Specific risks of material fraud that were identified, and a
description of the auditor’s response to those risks.

• Reasons supporting a conclusion that there is not a significant risk of material

improper revenue recognition.

• Results of the procedures performed to address the risk of management over -

ride of controls.

• Other conditions and analytical relationships indicating that additional auditing

procedures or other responses were required, and the actions taken by the auditor.

• The nature of communications about fraud made to management, the audit

committee, or others.

After fraud risks are identified and documented, the auditor should evaluate factors that
reduce fraud risk before developing an appropriate response to the risk of fraud.

4. Factors that reduce fraud risks

According to the AICPA the three elements to prevent, deter, and detect fraud:

1. Culture of honesty and high ethics

2. Management’s responsibility to evaluate risks of fraud

3. Audit committee oversight

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4.1 Culture of honesty and high ethics
Research indicates that the most effective way to prevent and deter fraud is to implement
antifraud programs and controls that are based on core values embraced by the company.
Such values create an environment that reinforces acceptable behavior and expectations
that employees can use to guide their actions.

These values help create a culture of honesty and ethics that provides the foundation for
employees’ job responsibilities.

Creating a culture of honesty and high ethics includes six elements.

Setting the Tone at the Top

Management and the board of directors are responsible for setting the “tone at the top”
for ethical behavior in the company. Honesty and integrity by management reinforces
honesty and integrity to employees throughout the organization. Management cannot act
one way and expect others in the company to behave differently.

Through its actions and communications, management can show that dishonest and
unethical behaviors are not tolerated, even if the results benefit the company. A tone at
the top based on honesty and integrity provides the foundation upon which a more
detailed code of conduct can be developed to provide more specific guidance about
permitted and prohibited behavior.

Creating a Positive Workplace Environment

Research shows that wrongdoing occurs less frequently when employees have positive
feelings about their employer than when they feel abused, threatened, or ignored. A
positive workplace can generate improved employee morale, which may reduce
employees’ likelihood of committing fraud against the company. Employees should also
have the ability to obtain advice internally before making decisions that appear to have
legal or ethical implications.

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Hiring and Promoting Appropriate Employees

To be successful in preventing fraud, well-run companies implement effective screening

policies to reduce the likelihood of hiring and promoting individuals with low levels of
honesty, especially those who hold positions of trust. Such policies may include background
checks on individuals being considered for employment or for promotion to positions of
trust.

Background checks verify a candidate’s education, employment history, and personal

references, including references about character and integrity. After an employee is hired,
continuous evaluation of employee compliance with the company’s values and code of
conduct also reduces the likelihood of fraud.

Training

All new employees should be trained about the company’s expectations of employees’
ethical conduct. Employees should be told of their duty to communicate actual or
suspected fraud and the appropriate way to do so.

In addition, fraud awareness training should be tailored to employees’ specific job

responsibilities with, for example, different training for purchasing agents and sales agents.

Confirmation

Most companies require employees to periodically confirm their responsibilities for

complying with the code of conduct. Employees are asked to state that they understand
the company’s expectations and have complied with the code, and that they are unaware
of any violations.

These confirmations help reinforce the code of conduct policies and also help deter
employees from committing fraud or other ethics violations. By following-up on
disclosures and non-replies, internal auditors or others may uncover significant issues.

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Discipline

Employees must know that they will be held accountable for failing to follow the
company’s code of conduct. Enforcement of violations of the code, regardless of the level
of the employee committing the act, sends clear messages to all employees that compliance
with the code of conduct and other ethical standards is important and expected. Thorough
investigation of all violations and appropriate and consistent responses can be effective
deterrents to fraud

4.2 Management’s Responsibility to Evaluate Risks of Fraud

Fraud cannot occur without a perceived opportunity to commit and conceal the act.
Management is responsible for identifying and measuring fraud risks, taking steps to
mitigate identified risks, and monitoring internal controls that prevent and detect fraud.

Identifying and Measuring Fraud Risks

Effective fraud oversight begins with management’s recognition that fraud is possible and
that almost any employee is capable of committing a dishonest act under the right
circumstances. This recognition increases the likelihood that effective fraud prevention,
deterrence, and detection programs and controls are implemented.

Mitigating Fraud Risks

Management is responsible for designing and implementing programs and controls to

mitigate fraud risks, and it can change business activities and processes prone to fraud to
reduce incentives and opportunities for fraud. For example, management can outsource
certain operations, such as transferring cash collections from company personnel to a bank
lockbox system. Other programs and controls may be implemented at a company-wide
level, such as the training of all employees about fraud risks, and strengthening
employment and promotion policies.

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Monitoring Fraud Prevention Programs and Controls

For high fraud risk areas, management should periodically evaluate whether appropriate
antifraud programs and controls have been implemented and are operating effectively.
For example, management’s review and evaluation of results for operating units or
subsidiaries increases the likelihood that manipulated results will be detected.

4.3 Audit Committee Oversight

The audit committee has primary responsibility to oversee the organization’s financial
reporting and internal control processes. In fulfilling this responsibility, the audit committee
considers the potential for management override of internal controls and oversees
management’s fraud risk assessment process, as well as antifraud programs and controls.
The audit committee also assists in creating an effective “tone at the top” about the
importance of honesty and ethical behavior by reinforcing management’s zero tolerance
for fraud.

Audit committee oversight also serves as a deterrent to fraud by senior management. For
example, to increase the likelihood that any attempt by senior management to involve
employees in committing or concealing fraud is promptly disclosed, oversight may include:

• Direct reporting of key findings by internal audit to the audit committee

• Periodic reports by ethics officers about whistle-blowing
• Other reports about lack of ethical behavior or suspected fraud

5. Responding To The Risk Of Fraud (Auditor responses to fraud risk)

When risks of material misstatements due to fraud are identified, the auditor should first
discuss these findings with management and obtain management’s views of the potential
for fraud and existing controls designed to prevent or detect misstatements.

management may have programs designed to prevent, deter, and detect fraud, as well as
controls designed to mitigate specific risks of fraud. Auditors should then consider whether
such antifraud programs and controls mitigate the identified risks of material misstatements

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due to fraud or whether control deficiencies increase the risk of fraud. Auditor responses
to fraud risk include the following:

1. Change the overall conduct of the audit

Auditors can choose among several overall responses to an increased fraud risk. If the risk
of misstatement due to fraud is increased, more experienced personnel may be assigned to
the audit. In some cases, a fraud specialist may be assigned to the audit team.

For example, auditors may visit inventory locations or test accounts that were not tested
in prior periods. Auditors should also consider tests that address misappropriation of assets,
even when the amounts are not typically material.

2. Design and perform audit procedures to address fraud risks

The appropriate audit procedures used to address specific fraud risks depend on the
account being audited and type of fraud risk identified. For example, if concerns are raised
about revenue recognition because of cutoff or channel stuffing, the auditor may review
the sales journal for unusual activity near the end of the period and review the terms of
sales

3. Design and perform procedures to address management override of controls

The risk of management override of controls exists in almost all audits. Because
management is in a unique position to perpetrate fraud by overriding controls that are
otherwise operating effectively, auditors must perform procedures in every audit to
address the risk of management override.

Three procedures must be performed in every audit.

• Examine Journal Entries and Other Adjustments for Evidence of Possible

Misstatements Due to Fraud.
• Review Accounting Estimates for Biases.
• Evaluate the Business Rationale for Significant Unusual Transactions.

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 6. Specific Fraud Risk Areas and their warning signs

Depending on the client’s industry, certain accounts are especially susceptible to

manipulation or theft.

6.1 Revenue and Accounts Receivable Fraud Risks

Revenue and related accounts receivable and cash accounts are especially susceptible to
manipulation and theft. Similarly, because sales are often made for cash or are quickly
converted to cash, cash is also highly susceptible to theft.

Several reasons make revenue susceptible to manipulation. Most important, revenue is

almost always the largest account on the income statement, therefore a misstatement only
representing a small percentage of revenues can still have a large effect on income. An
overstatement of revenues often increases net income by an equal amount, because related
costs of sales are usually not recognized on fictitious or prematurely recognized revenues.

Another reason revenue is susceptible to manipulation is the difficulty of determining the

appropriate timing of revenue recognition in many situations.

Three main types of revenue manipulations are:

1. Fictitious revenues

The most egregious forms of revenue fraud involve creating fictitious revenues.

2. Premature revenue recognition

Companies often accelerate the timing of revenue recognition to meet earnings or sales
forecasts. Premature revenue recognition, the recognition of revenue before accounting
standards requirements for recording revenue have been met, should be distinguished
from cutoff errors, in which trans actions are inadvertently recorded in the incorrect
period. In the simplest form of accelerated revenue recognition, sales that should have
been recorded in the subsequent period are recorded as current period sales.

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3. Manipulation of adjustments to revenues

The most common adjustment to revenue involves sales returns and allowances. A
company may hide sales returns from the auditor to overstate net sales and income.

Warning Signs of Revenue Fraud

Many potential warning signals or symptoms indicate revenue fraud. Two of the most
useful are analytical procedures and documentary discrepancies

❖ Analytical Procedures

Analytical procedures often signal revenue frauds, especially gross margin percentage
and accounts receivable turnover.

❖ Documentary Discrepancies

Despite the best efforts of fraud perpetrators, fictitious transactions rarely have the
same level of documentary evidence as legitimate transactions.

Auditors should be aware of unusual markings and alterations on documents, and

they should rely on original rather than duplicate copies of documents. Because
fraud perpetrators attempt to conceal fraud, even one unusual transaction in a
sample should be considered to be a potential indicator of fraud that should be
investigated.

6.2 Inventory Fraud Risks

Inventory is often the largest account on many companies’ balance sheets, and auditors
often find it difficult to verify the existence and valuation of inventories. As a result,
inventory is susceptible to manipulation by managers who want to achieve certain
financial reporting objectives. Because it is also usually readily saleable, inventory is also
susceptible to misappropriation.

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Fraudulent Financial Reporting Risk for Inventory

Fictitious inventory has been at the center of several major cases of fraudulent financial
reporting. Many large companies have varied and extensive inventory in multiple
locations, making it relatively easy for the company to add fictitious inventory to
accounting records. While auditors are required to verify the existence of physical
inventories, audit testing is done on a sample basis, and not all locations with inventory
are typically tested.

Warning Signs of Inventory Fraud

Similar to deceptions involving accounts receivable, many potential warning signals or

symptoms point to inventory fraud. Analytical procedures are one useful technique for
detecting inventory fraud

❖ Analytical Procedures

Analytical procedures, especially gross margin percentage and inventory turnover,

often help uncover inventory fraud. Fictitious inventory understates cost of goods sold
and overstates the gross margin percentage. Fictitious inventory also lowers inventory
turnover.

6.3 Purchases and Accounts Payable Fraud Risks

Cases of fraudulent financial reporting involving accounts payable are relatively
common although less frequent than frauds involving inventory or accounts receivable.
The deliberate understatement of accounts payable generally results in an
understatement of purchases and cost of goods sold and an overstatement of net
income. Significant misappropriations involving purchases can also occur in the form of
payments to fictitious vendors, as well as kickbacks and other illegal arrangements with
suppliers.
❖ Misappropriations in the Acquisition and Payment Cycle
The most common fraud in the acquisitions area is for the perpetrator to issue payments
to fictitious vendors and deposit the cash in a fictitious account. These frauds can be
prevented by allowing payments to be made only to approved vendors and by

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carefully scrutinizing documentation supporting the acquisitions by authorized
personnel before payments are made.
6.4 Other Areas of Fraud Risk

Although some accounts are more susceptible than others, almost every account is
subject to manipulation. Some other accounts with specific risks of fraudulent financial
reporting or misappropriation include:-

▪ Fixed Assets
▪ Payroll Expenses

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7.Reference
Alvin A. Arens, Randal J. Elder, Mark S. Beasley Auditing And Assurance Services . Pearson
Education, Inc., Upper Saddle River, New Jersey

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