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Chapter 5 Fraud in Financial Statements and Auditor Responsibilities

Questions for Consideration

What are the red flags that are indicators of fraud may exist?

What are the auditor’s responsibilities to detect and report fraud?

What is the role of internal controls and risk assessment in preventing and detecting fraud?

Will the revised audit report provide any tangible benefits with respect to increasing its informational value, usefulness, and relevance to the investing public?

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Fraud in Financial Statements (1 of 2)

The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management.

An auditor conducting an audit in accordance with generally accepted auditing standards is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatements, whether by fraud or error.

An unavoidable risk exists that some material misstatements of the financial statements may not be detected, even though the audit was conducted in accordance with GAAS.

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Fraud in Financial Statements (2 of 2)

When the financial statements are materially misstated, the auditor should not give an unmodified or unqualified opinion but should modify the opinion as either qualified or adverse opinion.

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Fraudulent Financial Reporting

Involves either intentional misstatements or omissions of amounts or disclosures in order to deceive financial statement users

Deception – manipulation, falsification or alteration of accounting records or supporting documents

Misrepresentation in, or intentional omission from, events, transactions, or other significant information

Intentional misapplication of accounting principles

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Nature and Causes of Misstatements (1 of 2)

An inaccuracy in gathering or processing data from which financial statements are prepared

A difference between the amount, classification, or presentation of a reported financial statement element, account, or item in accordance with GAAP

The omission of a financial statement element, account, or item

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Nature and Causes of Misstatements (2 of 2)

A financial statement disclosure that is not presented in conformity with GAAP

The omission of information required to be disclosed in conformity with GAAP

An incorrect accounting estimate due to oversight, misrepresentation of facts, or fraud

Management’s judgments concerning an estimate or the selection or application of accounting policies that the auditor may consider unreasonable or inappropriate

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Error, Fraud and Illegal Acts

Error

Innocent mistake in math or application of GAAP

Innocent mistake in omission of information

Fraud

Deliberate decision made to deceive others through

Fraudulent financial reporting

Misappropriation of assets

Illegal Acts

Violations of laws or regulations

Bribery

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Illegal Acts

Assess the impact and materiality 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

If client does not take remedial actions necessary, the auditor should consider withdrawing from engagement

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Private Securities Litigation Reform Act (PSLRA) (1 of 2)

Additional requirements upon public companies and their auditors when

The illegal act has a material effect on financial statements

Senior management and the board have not taken appropriate remedial action

Failure to take remedial action may warrant departure from a standard audit report (or resignation of auditors)

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Private Securities Litigation Reform Act (PSLRA) (2 of 2)

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 within one day

Ethical obligation of confidentiality is waived

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The Fraud Triangle (1 of 2)

Incentives/Pressures to Commit Fraud

Self-serving

Pressures to meet financial numbers

Financial distress

Home 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

Override internal controls by management

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The Fraud Triangle (2 of 2)

Rationalization

Explain away actions as acceptable

Perpetrators are often in denial

A good person may get caught up in the fraud

Other Rationalizations

Company had to make numbers

Fear losing job

I’m entitled since I’m underpaid

Link to GVV

One-time event

Loyalty

Expected/standard practice

Not your responsibility

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Fraud Risk Assessment (1 of 2)

AU-C240 requires the auditor to evaluate risk assessment during the audit

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 and key accounting personnel’s integrity

Disagreement with management over accounting principles

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Fraud Risk Assessment (2 of 2)

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

Approach each engagement with a healthy dose of skepticism

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Internal Control Assessment

The risk that internal controls will not help prevent or detect a material misstatement is a critical evaluation to provide reasonable assurance

Components of internal control under the COSO framework

Control environment

Risk assessment

Control activities

Monitoring

Information and communication

Attention should be focused on areas of highest risk that a material weakness could exist in a particular area of the company’s internal control over financial reporting

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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 cross-enterprise risks

Seizing opportunities

Improving deployment of capital

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COSO Guidance on Monitoring Internal Control Systems (1 of 2)

Management should monitor controls to determine whether they are operating effectively and the need for redesign when risks change

Effective monitoring involves

Establishing a baseline for control effectiveness

Designing and executing monitoring procedures that are based on the significance of business risks relative to the entity’s objectives

Assessing and reporting results, including follow-up on corrective actions

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COSO Guidance on Monitoring Internal Control Systems (2 of 2)

Framework adopts the position that management should determine its risk appetite and align it with strategic objectives

ERM seems to place emphasis in the wrong areas by focusing on risk appetite

Emphasis needed on the ethical dimensions of making strategic decisions

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Audit Committee Responsibilities for Fraud Risk Assessment

Audit Committee should

Evaluate management’s identification of fraud risks

Implementation of antifraud measures

Creation of the appropriate tone at the top

Active oversight by the audit committee can help reinforce management’s commitment to create a culture with “zero tolerance” for fraud

Audit committee’s evaluation and oversight can serve as a deterrent to senior management engaging in fraudulent activity

Audit committee should encourage management to provide a mechanism for employees to report concerns about unethical behavior, suspected fraud, or violations of ethical codes or policies

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Auditor’s Communication with Those Charged with Governance (1 of 2)

AU-C 240 requires communication by auditors of evidence of fraud to appropriate level of management, even inconsequential or minor misappropriation

Fraud that causes a material misstatement should be reported directly to those charged with governance

Good governance principles suggest that

The auditor has access to the audit committee as necessary

The chair of the audit committee meet with the auditor periodically

The audit committee meets with the auditor without management at least annually

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Auditor’s Communication with Those Charged with Governance (2 of 2)

Auditors should communicate about accounting estimates

Nature of significant assumptions/degree of subjectivity/relative materiality

Communicate to management/those charged with governance risks due to fraud that have continuing control implications

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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 (Section 302 of SOX)

Provides 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

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Audit Reports and Auditing Standards

Since 1926, the New York Stock Exchange has required an auditor’s report

The Securities Exchange Act of 1934 requires all public companies to have an independent auditor’s report in annual financial statements

The PCAOB oversees public companies audits since SOX in 2002

The AICPA Auditing Standards Board (ASB) oversees the audits of nonpublic companies

Independent auditors express or disclaim an opinion on whether an entity’s financial statements and related disclosures are presented in accordance with GAAP

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Audit Reports

Exhibit 5.5 (ASB) Unmodified Opinion for Non-Public Companies

Exhibit 5.6 (PCAOB)Unmodified or Unqualified Report for Public Companies

International Requirements

Section ISA 700 of the International Standards on Auditing allows the signature of the audit firm, the personal name of the auditor who directed the audit, or both

After December 15, 2016, the personal name of the auditor who directed the audit will ordinarily be required

Also, after December 15, 2016, the audit reports of public companies will include a “key audit matter” section

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Differences between ASB and PCAOB Unmodified Reports (1 of 2)

Title of Audit Report

ASB – Independent Auditor’s Report

PCAOB – Report of Independent Registered Audit Firm

Headings

ASB – Section headings

PCAOB – No headings

Management’s and Auditor’s Responsibilities

ASB – Detailed descriptions

PCAOB – Less detailed descriptions

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Differences between ASB and PCAOB Unmodified Reports (2 of 2)

Auditing Standards

ASB – GAAS

PCAOB – Standards of PCAOB

Internal Control over Financial Reporting

ASB – Not included in auditor’s report

PCAOB – Report on internal control included in an additional paragraph in the report

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Unmodified or Unqualified Audit Opinions

Financial statements “present fairly”

Financial position

Results of operations

Cash flows

Stockholders’ Equity

Optional additional paragraph

Emphasis-of-matter

Going concern

Consistent application of accounting principles

Litigation uncertainty

Other-matter

Supplemental information

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Modified or Qualified Audit Opinions (1 of 2)

Modifies the audit when

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; possible effect on financial statements could be material but not pervasive

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Modified or Qualified Audit Opinions (2 of 2)

Adverse

Concludes that misstatements, individually or in the aggregate, are material and pervasive

Basis for Modifications

Separate paragraph describes matter giving rise to modification

Placed immediately before the opinion paragraph

Titled “Basis for (Qualified, Adverse, Disclaimer) Opinion

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Disclaimer/Withdrawal from the Engagement

Disclaimer

Unable to gather sufficient evidence to warrant the expression of an opinion on the statements as a whole

Withdrawal

If significant conflict exists with management or the auditor decides that management cannot be trusted, then a withdrawal may be justified

Trust issues are a matter of ethics

The auditor must consider whether the breakdown between management and the auditor has advanced to the point that any and all information provided by the client is suspect

Withdrawal triggers the filing of the SEC’s 8-K form by management

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Limitations of the Audit Report Reasonable Assurance

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

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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”

5% is a common materiality test

SEC wants qualitative matters to be considered as well

Unintended consequence of materiality is that it is subject to manipulation

An item may not be material and ignored even though it is wrong to produce financials with mistakes from an ethical (Rights Theory) perspective

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Limitations of the Audit Report Present Fairly

Present Fairly

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

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Generally Accepted Auditing Standards (GAAS)

Auditing standards provide a measure of audit quality and the objectives to be achieved in an audit

Auditing standards differ from auditing procedures because the procedures are steps taken by the auditor during the course of the audit to comply with GAAS

The application of auditing standards entails making judgments with regard to the nature of audit evidence, sufficiency, competency, and reliability

Materiality considerations are important to assess whether the audit opinion should be modified

GAAS (1 of 2)

General Standards

Adequate technical training and proficiency

Independence in mental attitude

Due care in the performance of the audit and preparation of the report

Standards of Field Work

Adequately plan the audit work and supervise assistants

Obtain a sufficient understanding of internal control to adequately plan the audit and determine the nature, timing, and extent of tests to be performed

GAAS (2 of 2)

Gather sufficient competent evidential matter to provide a basis for an opinion

Standards of Reporting

The statements have been in conformity with GAAP

Accounting principles have been consistently applied

Adequate informative disclosures have been made

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 substitute for application of proper 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

Professional Skepticism (1 of 2)

An important role in gathering audit evidence and evaluating usefulness

Auditor should exercise professional judgment and skepticism

Determining the nature, timing, and extent of audit procedures

Determining the sufficiency, competency, and relevancy of evidence

Evaluating management’s judgments and estimates

Considering fraud in the audit

Determining the conclusions based on the audit evidence obtained

Professional Skepticism (2 of 2)

A state of mind and requires documentation to provide evidence that the audit was planned and performed in accordance with GAAS

Document the thought process, alternative views considered, judgments made, audit evidence gathered, and support for final conclusion

Document challenges to management’s views and assumptions

Document the basis for unusual, one-time transactions and related business rationale

Include a complete and comprehensive record of discussions with management

Document assessments of the reliability of the source of documents

Document professional skepticism in significant matters

Challenges to Professional Skepticism

Motivated Blindness: Auditors may see what they want to see and easily miss contradictory information when it’s in their best interest to remain ignorant

Results over Efficiency: Link between skeptical judgment and action and how it relates to reward structure in auditing: rewarding results rather than high-quality decisions

Personality Traits: Diligence, thoroughness, objectivity and reliability are traits that influence level of professional skepticism

Levers: Accountability to reviewers and regulators serve as a lever that impacts skeptical judgment and skeptical action(PCAOB inspections)

PCAOB Standards

Auditing Std No. 5 – audit of assessment of effectiveness of internal control over financial reporting

Auditing Std No. 7 – engagement quality review

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

Auditing Std No. 16 – communications with audit committees on significant issues

Audit Committee Communications

Significant accounting policies and practices

Critical accounting policies and practices

Critical accounting estimates

Significant unusual transactions

Quality of financial reporting information

Contentious issues with management/disagreements

Modifications to audit report

Specific Items to Communicate: Quality of Financial Reporting

Qualitative aspects of accounting policies and procedures

Assessment of reasonableness of estimates in financial statements

Assessment of management’s disclosures re: critical policies/procedures

Whether presentation and disclosures are in conformity with applicable financial reporting framework

Management’s response to issues raised

Possibility of alternative treatments in financial statements

Audit Deficiencies - SEC Actions (1 of 2)

Findings of a study of audit deficiencies for the Center for Audit Quality that resulted in sanctions from the SEC include

Failure to gather sufficient competent evidence

Failure to exercise due care

Insufficient level of professional skepticism

Failure to obtain adequate evidence related to management representations

Failure to express an appropriate audit opinion

Audit Deficiencies - SEC Actions (2 of 2)

Satyam Case resulted in PwC being sanctioned due to a lack of due care and exercise of professional skepticism by accepting evidence provided by management that was less than persuasive.

PwC also failed to perform the necessary procedures and report likely illegal acts that had a material effect on the financial statements

PCAOB Inspection Program

SOX authorized the PCAOB to inspect and set professional standards for public accounting firms

PCAOB enforcement proceedings are non-public unless

The parties consent to a public hearing

The board has imposed sanctions and the time to file an appeal with the SEC has expired

The SEC, on appeal, issues an order regarding the sanctions imposed

The process, including appeals, can take years to complete and the enforcement actions may not yet nor never be known to the public

Inspections and Audit Deficiencies (1 of 2)

A significant issue addressed in many enforcement actions against audit firms is a lack of professional skepticism and due care

Examples that can inhibit professional skepticism

Incentives and pressures to build or maintain a long-term audit engagement

Incentives and pressures to avoid significant conflicts with management

Desire to achieve high client satisfaction ratings

Desire to keep audit costs low

Desire to cross-sell services to clients

Inspections and Audit Deficiencies (2 of 2)

Deficiency rates of the Big-4 CPA firms range from 28 to 50 percent

In 2014, PCAOB said that the firms have shown real improvements in its internal control audits

PCAOB Inspections of Chinese Firms (1 of 2)

Reluctance of foreign-based entities operating under the banner of a Big-4 CPA firm to cooperate with the PCAOB inspections of audits conducted by the foreign entities that list stocks on the U.S. exchanges

Chinese authorities find the disclosure about Chinese companies to non-Chinese regulators to be unacceptable

PCAOB Inspections of Chinese Firms (2 of 2)

The dilemma for U.S. regulators is the growing number of Chinese companies listing stock in the U.S. that are found to have engaged in financial fraud

The contentious nature of relationship between PCAOB and Chinese audit firms raises questions about the quality, reliability, and trustworthiness of the audits and brings into question whether the best interests of U.S. investors are being adequately protected

Concluding Thoughts

Financial statement fraud threatens the foundation of the financial reporting process and jeopardizes the integrity of the auditing function

The audit and evaluation of audit evidence must be controlled through an ethical approach that emphasizes objectivity, due care, and the exercise of professional skepticism

“Trust but verify” should be the mantra of a sound audit

Audit firms and auditors should recommit to the public interest ideal that is the foundation for the accounting profession