Unformatted text preview: Forensic and Investigative Accounting Forensic Chapter 4 Detecting Fraud in Financial Reporting
© 2007 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com Definition of Fraud
Four major legal elements of fraud would be: A false representation or willful omission false regarding a material fact. regarding The fraudster knew the representation was The false. false. The target relied on this misappropriation. The victim suffered damages or incurred a The loss. loss.
Chapter 4 Forensic and Investigative Accounting 2 Audit Procedures
Audit evidence is gathered in two fieldwork Audit stages: stages: 1. Internal control testing phase. 2. Account balance testing phase. Chapter 4 Forensic and Investigative Accounting 3 Definitions
Materiality is the measure of whether something is significant enough to change an investor’s investment decision. investor’s Control risk is risk that a material error in the balance or transaction class will not be prevented or detected. prevented Chapter 4 Forensic and Investigative Accounting 4 Definitions
Inherent risk is risk that an account or transactions contain material misstatements before the effects of the controls. before Detection risk is risk that audit procedures will not turn up material error when it exists. exists. Chapter 4 Forensic and Investigative Accounting 5 External Auditors and Fraud Detection
Although auditors have previously had the Although responsibility to detect material misstatement caused by fraud, SAS No. 82 details more precisely what is required to fulfill those responsibilities.
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Now, auditors must specifically assess and Now, respond to the risk of material misstatement due to fraud and must assess that risk from the perspective of the broad categories in the SAS. External auditors have to satisfy new documentation and communication requirements. SAS No. 82 superseded by SAS No. 99. No.
Chapter 4 Forensic and Investigative Accounting 7 SAS No. 99 Recommendations
Increased emphasis on professional Increased skepticism. skepticism. Discussions with management. Unpredictable audit tests. Responding to management override of Responding controls. controls. Chapter 4 Forensic and Investigative Accounting 8 SAS No. 99: Skepticism
An auditor is instructed to conduct an audit An “with a questioning mind that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management’s honesty and integrity.” management’s FA’s motto should be “Trust no one; FA’s question everything; verify.” question Chapter 4 Forensic and Investigative Accounting 9 Public Company Accounting Public Oversight Board (PCAOB) Oversight
The Sarbanes-Oxley Act of 2002 created a The new, five-member oversight group called the PCAOB. PCAOB. The PCAOB is empowered to set accounting The standards that establish auditing, quality control, and ethical standards for accountants. (continued on next slide) (continued Chapter 4 Forensic and Investigative Accounting 10 Public Company Accounting Public Oversight Board (PCAOB) Oversight The PCAOB is also empowered to adopt or The amend standards issued or recommended by private accounting industry groups or to adopt its own standards independent of such private industry standards or recommendations. recommendations. Chapter 4 Forensic and Investigative Accounting 11 Walkthroughs According to the PCAOB, in a walkthrough, an According auditor traces “company transactions and events auditor – both those that are routine and recurring and those that are unusual – from origination, through the company’s accounting and information systems and financial report preparation processes, to their being reported in the company’s financial statements.” the Source: PCAOB Briefing Paper, Proposed Auditing Standards, October 7, 2003. Chapter 4 Forensic and Investigative Accounting 12 Internal Auditors and Fraud Detection
The Institute of Internal Auditors’ Due The Professional Care Standard (Section 280) assigns the internal auditor the task of assisting in the control of fraud by examining and evaluating the adequacy and effectiveness of the internal control system. internal
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However, Section 280 says that management However, has the primary responsibility for the deterrence of fraud, and management is responsible for establishing and maintaining the control systems. In general, internal auditors are more concerned with employee fraud than with management and other external fraud. management
Chapter 4 Forensic and Investigative Accounting 14 When Fraud Is Discovered
1. 2. Notify management or the board when the Notify incidence of significant fraud has been established to a reasonable certainty. established If the results of a fraud investigation indicate If that previously undiscovered fraud materially adversely affected previous financial statements, for one or more years, the internal auditor should inform appropriate management and the audit committee of the board of directors of the discovery. directors
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Chapter 4 Forensic and Investigative Accounting 15 When Fraud Is Discovered
1. 2. A written report should include all findings, written conclusions, recommendations, and corrective actions taken. corrective A draft of the written report should be draft submitted to legal counsel for review, especially where the internal auditor chooses to invoke client privilege. to Chapter 4 Forensic and Investigative Accounting 16 Audit Committee
The audit committee is the subcommittee of The an organization’s board of directors charged with overseeing the organization’s financial reporting and internal control processes. The audit committee’s biggest responsibility is monitoring the component parts of the audit process. process. Chapter 4 Forensic and Investigative Accounting 17 Management’s Role
The Sarbanes-Oxley Act of 2002 mandates The that CEOs and CFOs certify in periodic reports containing financial statements filed with the SEC the appropriateness of financial statements and disclosures. statements Chapter 4 Forensic and Investigative Accounting 18 Board of Directors’ Role
Oversee the integrity, quality, transparency, Oversee and reliability of the financial reporting process. process. Oversee the adequacy and effectiveness of Oversee the internal control structure in preventing, detecting, and correcting material misstatements in the financial statements. misstatements Oversee the effectiveness, efficacy, and Oversee objectivity of audit functions. objectivity Chapter 4 Forensic and Investigative Accounting 19 Enter the Forensic Accountant
Forensic accountants may be brought in to: – Investigate the minute any irregularities Investigate surface. surface. – Measure risk factors and create policy that Measure brings the forensic accountant in when certain scores are attained. certain – Check in randomly as a matter of routine. Chapter 4 Forensic and Investigative Accounting 20 Audit Tests
The Panel on Audit Effectiveness recommended The that surprise or unpredictable elements should be incorporated into audit tests, including: incorporated – Recounts of inventory and unannounced visits Recounts to locations. to – Interviews of financial and nonfinancial client Interviews personnel in different locations. personnel (continued on next slide)
Chapter 4 Forensic and Investigative Accounting 21 Audit Tests
– Requests for written confirmations from Requests client employees regarding matters about which they have made representations to the auditors. auditors. – Tests of accounts not normally performed Tests annually. annually. – Tests of accounts traditionally or frequently Tests deemed “low risk.” deemed Chapter 4 Forensic and Investigative Accounting 22 Financial Statement Fraud Financial Categories and Red Flags Categories Overstated revenues. Management estimates. Pro formas can mislead. Earnings problems: masking reduced cash flow. Earnings before interest, tax, depreciation, and Earnings amortization (EBITDA). amortization Excessive debt. Inventory problems.
Forensic and Investigative Accounting 23 Chapter 4 Financial Statement Fraud Financial Categories and Red Flags Categories
CPA problems. Sales and expenses problems. Big bath. Balance sheet account problems. Pension plan problems. Reserve estimates (cookie jar accounting). Personal piggy bank. Barter deals. Chapter 4 Forensic and Investigative Accounting 24 HealthSouth From 1999 to 2001, HealthSouth’s net income From increased nearly 500 percent, but revenue grew only five percent. only On March 19, 2003, the SEC said that On HealthSouth faked at least $1.4 billion in profit since 1999. since Professional fees associated with the Professional reconstruction of HealthSouth’s financial records and restatement of 2001 and 2002 consolidated financial statements totaled over $270 million. financial
Forensic and Investigative Accounting 25 Chapter 4 Financial Fraud Detection Tools
Interviewing the executives. Analytics. Percentage analysis: – Horizontal analysis. – Vertical analysis. – Ratio analysis. Chapter 4 Forensic and Investigative Accounting 26 Financial Fraud Detection Tools Using checklists to help detect fraud: – SAS checklist. – Attitudes/Rationalizations checklist. – Audit test activities checklist. – Miscellaneous fraud indicator checklist. Chapter 4 Forensic and Investigative Accounting 27 Behavioral Approaches Some fraud schemes cannot be effectively Some detected using data-driven approaches. Instead, behavioral considerations may help an auditor find fraud. Employee attitudes, feelings, values, norms, interaction with peers, and general satisfaction should all be considered when looking for fraud. considered Chapter 4 Forensic and Investigative Accounting 28 ...
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