Ethics and Conduct of accounting profession
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CHAPTER05-FraudinFinancialStatementsandAuditorResponsibilities.pptxCOLLEGE OF BANKING AND FINANCIAL STUDIES UNDERGRADUATE DEGREE PROGRAMME B.Sc. in Accounting, Auditing and Finance Semester - 8
MODULE TITLE: ETHICS AND CONDUCT OF ACCOUNTING PROFESSION
Chapter 5: Fraud in Financial Statements and Auditor Responsibilities
Learning Objectives
After studying Chapter 5, you should be able to:
Distinguish between audit requirement for errors, fraud and illegal act.
Explain the component of the Fraud Triangle
Describe fraud risk assessment procedures
Explain the standards for audit reports
Discuss the characteristics of professional skepticism
5.1 Fraud in Financial Statement
The primary responsibility for the prevention and detection of fraud rests with both those charges with governance of the entity and management..
A strong emphasis should be placed on fraud prevention, which may reduce opportunities for fraud to take place.
Fraud deterrence, which could persuade individuals not to commit fraud because of the likelihood of detection and punishment.
As mention in Chapter 3. this involves a commitment to creating a culture of ethical behaviour, tone at the top, and reinforced through governance structure.
Fraud deterrence involves conditions and procedures analysis to keep fraud from taking place. Could include the use of detection systems to spot fraud before it worsens. The cost of fraud deterrence is a fraction of the cost of the fraud being prevented.
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5.1 Fraud in Financial Statement
An auditor conduction an audit is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatements, whether caused by error or fraud.
Due to inherent limitation of an audit, there always exist an unavoidable risk.
The auditing profession recognized its obligation to look for fraud by being alert to certain red flags,
assessing the control environment of the organization.
Passing judgment on internal controls
Considering the audit risk and materiality
When performing the audit
5.1 Fraud in Financial Statement
Nature and Cause of Misstatements;
Misstatements in the financial statements can result from errors and fraud and may consist of any of the following;
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 and the way that it should have been reflected under Accounting standards.
The omission of a financial statement element, account or item.
An incorrect accounting estimate due to oversight, misrepresentation of facts and fraud.
Omission of disclosure requirements.
Accounting estimate is an approximation of the amount to be debited or credited on items for which no precise means of measurement are available. They are based on specialized knowledge and judgment derived from experience and training.
Useful life of non-current assets
Impairment of non-current assets
Bad debts
Provision for obsolete and slow-moving stock
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Misstatements in the Financial Statements could be due to fraud or error.
There are also other unlawful activities like corruption, money laundry and others.
Error
Fraud
Other Unlawful/Illegal activities.
5.1 Fraud in Financial Statement
Errors, Fraud, and Illegal Act.
Material errors, fraud and illegal acts represent situations where the financial statements should be restated.
Error in Financial Statement
An error can occur due to unintentional misstatements or omissions of amounts or disclosures in the financial statements.
Errors may involve mistakes in gathering or processing data, unreasonable accounting estimates.
Auditors are responsible for detecting errors that have a material effect on the financial statements and reporting their findings to the audit committee.
5.1 Fraud in Financial Statement
Auditors should be sensitive to red flags that warn fraud is possible.
The intentional act of fraud occur when an individual(s) in management, those charged with governance, employees or third parties, use deception in a way that results in a material misstatement in the financial statements.
Most common form of fraud is, management fraud involves top management’s deceptive manipulation of financial statements.
Illegal Acts
Illegal acts are violations of laws or governmental regulations.
Eg: a violation of the Foreign Corrupt Practices Act that prohibits bribery constitutes and illegal act.
Illegal acts expose the company to both legal liability and public disgrace.
Auditor’s responsibility is to detect and report misstatements resulting from illegal acts that have direct and material effect on the determination of financial statement amounts.
The auditor should assure him/herself that the audit committee is informed as soon as practicable and prior to the issuance of the auditor’s report with respect to illegal acts that come to the auditor’s attention.
ILLEGAL
ACT
The Sarbanes – Oxley Act 2002 ( SOX )
Why was the Act passed?
Financial scandals at Enron, WorldCom, and others
Desire to restore investor confidence and increase the transparency of the financial statements of publicly traded companies
Desire to protect investors by improving the accuracy and reliability of corporate disclosures
The Sarbanes – Oxley Act 2002 ( SOX )
The Sarbanes – Oxley Act was designed primarily to regulate corporate conduct in an attempt to:
promote ethical behaviour and
Prevent fraudulent financial reporting.
The legislation applies to companies’
Board of Directors
Audit committee
Chief Executive Officer
Chief Financial Officer
Other management personnel who have influence over the accuracy and adequacy of external financial reporting.
ALTHOUGH, SARBANES-OXLEY IS NOT THE LAW IN OMAN, IT IS APPARENT THAT ENRON AND THE REQUIREMENTS OF SARBANES-OXLEY WERE CONSIDERED WHEN THE CAPITAL MARKET AUTHORITY (CMA) ISSUED OMAN’S FIRST CODE OF CORPORATE GOVERNANCE IN NOVEMBER 2002 (CIRCULAR 11/2002).
Sarbanes – Oxley Act
Includes reforms in corporate governance and accounting profession intended to:
Improve corporate financial reporting and internal control
Strengthen audit committees
Change the relationship between auditor and client
Improve auditor independence
Provide additional auditor assurance
Provide oversight and regulation for auditors of publicly traded companies.
Types of Internal Frauds
Internal Frauds
Asset Misappropriation
Fraudulent Statement
Cash
Non cash
Financial
Conflict of interest
Bribery and extortion
Corruption
Fraudulent Financial Reporting
This is usually in the form of falsification of financial statements in order to obtain some form of improper
benefit.
Management intentionally makes false entries to make the company looks more profitable (cook the books of accounts)
Deceives investors and creditors
Fraudulent financial reporting
Manipulation/falsification/alteration of accounting records.
Omission of events, transactions or significant information in the financial statements.
Intentional misapplication of accounting principles
Misappropriation of Assets
This involves the theft or misuse of an organisation’s assets.
Asset misappropriation fraud happens when people who are entrusted to manage the assets of an organisation steal the assets. Asset misappropriation fraud involves third parties or employees in an organisation who abuse their position to steal from it through fraudulent activity. It can also be known as insider fraud.
This type of fraud can be committed by company directors, or its employees, or anyone else entrusted to hold and manage the assets and interests of an organisation.
Misappropriation of assets
Embezzling receipts
Stealing company assets/inventory
Causing an entity to pay for goods not received
Using assets for personal use
Examples include theft of plant, inventory or cash, false invoicing, accounts receivable fraud, and payroll fraud
Bribery and corruption
Corruption can be defined as deviation from honest behavior.
This includes activities such as the use of bribes or acceptance of ‘kickbacks’, improper use of confidential information, conflicts of interest and collusive tendering.
Various forms of corruption include the following:
BRIBERY: offering/giving/receiving/soliciting of any item of value to influence the actions of an official or other person in charge of a public or legal duty.it may not be money/tangible gift. It can be a privilege. It need not be paid and can be just promised.
ABUSE OF A SYSTEM: using a system for improper purpose
BID RIGGING: Promising a contract in advance to one party, although other parties have been invited to bid for the contract.
CARTEL: a secret agreement by supposedly competing producers to fix prices, quantity or market share.
INFLUENCE PEDDLING: Using personal influence in government or connections with persons in authority to obtain favors or preferential treatment for another, usually in return for payment
Opportunities
Attitudes/ rationalisations
Incentive/ pressure
The fraud triangle factors are used to understand the reason for a person’s decision to commit fraud. It consists of three components which, together, lead to fraudulent behaviour
These factors are generally present when misstatements due to fraud occur.
Pressure/Incentive
This is the motivational factor that pushes the person to commit fraud.
Opportunities
These are the circumstances that enable fraud to be perpetuated.
Attitude/Rationalisation
This is the justification that is given for committing the fraud.
5.2 FRAUD TRIANGLE
Pressure
In simple terms, motivation is typically based on either greed or need. Stoy Hayward’s (BDO) most recent FraudTrack survey found that greed continues to be the main cause of fraud, resulting in 63% of cases in 2007 where a cause was cited.
Financial pressure is the most common type of pressure to commit fraud.
The Element of Pressure
Financial pressures
Vices
Work-related pressures
Other pressures
5.2 Fraud Triangle
The Element of Pressure
| Financial Pressures | Vice Pressures | Work-related Pressures |
| Greed Living beyond one’s means High bills or personal debt Poor credit Personal financial losses Unexpected financial needs | 1.Gambling 2.Drugs 3.Alcohol 4.Expensive extramarital relationships | Motivated by these factors: Getting little recognition Feeling job dissatisfaction Fear of losing one’s job Being overlooked for a promotion Feeling underpaid |
Opportunity
In terms of opportunity, fraud is more likely in companies where there is a weak internal control system, poor security over company property, little fear of exposure and likelihood of detection, or unclear policies with regard to acceptable behavior.
Six major factors that increase opportunity:
Lack of controls
Inability to judge performance quality
Fail to discipline fraudsters
Lack of access to information
Ignorance, apathy and incapacity
Lack of audit trail
Rationalization
Many people obey the law because they believe in it and/or they are afraid of being shamed or rejected by people they care about if they are caught.
However, some people may be able to rationalize fraudulent actions as:
Necessary – especially when done for the business
Harmless – because the victim is large enough to absorb the impact
Justified – because ‘the victim deserved it’ or ‘because I was mistreated.’
| Incentive/Pressure | Opportunities | Rationalizations/Attitude |
| Financial stability/profitability is threatened | Significant related party transactions | Relationship between management and current/predecessor auditor is strained |
| Pressure on management to meet the expectations of third party | Complex transactions/significant estimates | Practice by management of committing to aggressive/unrealistic forecasts |
| Personal financial situation of management threatened by the entity’s financial performance. | Domination of management by single person/small group | Known history of violations of security laws/other laws and regulations |
| Excessive pressure on management or operating personnel to meet the expectations of third parties. | Complex or unstable organizational structure | Ineffective communication/enforcement of entity’s values or ethical standards by the management |
| Personal financial obligations | Internal control components are deficient | Low morale among senior management |
| Adverse relationships between the entity and employees with access to cash or other assets susceptible to theft. | Inventory/assets are small in size and high in value | Behavior indicating displeasure/dissatisfaction with the entity |
| Cash intensive business | Changes in behavior or lifestyle | |
| Easily convertible assets (computer chips, diamonds, bearer bonds) | Failing to correct known control deficiency. Overriding existing controls |
Fraud Triangle
5.3 Fraud Consideration and Risk Management
Fraud consideration in an audit require that the auditor should evaluate the risk of fraud, including the effectiveness of internal controls, and communicate with those charged with governance responsibilities about fraud.
Fraud may be harder to detect than error, because with a fraud the fraudster is actively trying to hide what they have done.
Whose responsibility is it to prevent fraud?
Management and those charged with governance are primarily responsible for preventing and detecting fraud.
How can they do so?
Establish strong control environment and establish a culture of honesty and ethical behavior.
Emphasis within the company on fraud prevention and set up fraud hotlines, reporting procedure and protection. Adopt a zero tolerant policy toward fraud.
Emphasize good corporate governance
Discussion with the engagement team.
The audit team can discuss the following factors:
How fraud can be done?
How to maintain professional skepticism throughout the audit?
Types of circumstances that might indicate fraud.
How unpredictability can be incorporated into audit?
Any allegations of fraud that have come to the auditors notice
The risk of management override of controls.
What audit procedures to be carried out to answer any suspicions of fraud?
2. Fraud Risk Assessment
Fraud risk assessment depends in large part on maintaining professional skepticism when evaluating the reliability of audit evidence obtained and assessing whether a material misstatement due to fraud exists.
The broad goal of fraud risk assessment;
make inquiries of management and others within the organization to obtain their views about the risks of fraud and how they are addressed. This can include employees, TCWG, internal audit department.
Consider any unusual or unexpected relationships that have been identified in performing analytical procedures
Consider whether one or more fraud risk factors exist.
Consider other information that may be helpful in identifying risks of material misstatement due to fraud.
3. Internal Control
The system of internal controls and whether it operates as intended, enables the auditors to gain confidence about the internal processing of transaction.
Auditors should ensure that there is effective internal controls on place.
As part of evaluating the control environment, the auditor should assess whether
Management’s philosophy and operating style promote effective internal control over financial reporting
Sound integrity and ethical values, particularly of top management, are developed and understood.
The board or audit committee understands and exercises oversight responsibility over financial reporting.
5.5 Professional Skepticism
Professional Skepticism plays a fundamentally important role in the audit by facilitating professional judgement, particularly regarding decision about:
The nature, timing and extend of audit procedures to performed to reduce the risk of material misstatement to an appropriate level
Whether sufficient, competent, and relevant evidence has been obtained and whether additional evidence needs to be gathered to support risk analysis
The evaluation of management’s judgement and estimates used in recording transactions and financial statement presentation
Consideration of fraud in the audit
The conclusion reached based on the audit evidence obtained.
Reference
Steven , M. M., & Roselyn, E. M. (2017). Ethical Obligation and Decision Making in Accounting (4 ed.). New York: McGraw- Hill Education.
