CHAPTER 9

AUDIT RISK, INCLUDING THE RISK OF FRAUD

9-20. (Estimated time - 25 minutes)
The following table identifies the fraud risk factors as related to fraudulent financial
reporting (FFR) or misappropriation of assets (MA), and whether they are indicators of
incentive and pressures (I/P), opportunity (O), or rationalization (R).
1. Personal financial obligations may create pressure on management or
employees with access to cash or other assets susceptible to theft to
misappropriate those assets.
2. A company has significant, unusual, or highly complex transactions,
especially those close to period end that pose difficult "substance over
form" questions.
3. A company experiences rapid growth or unusual profitability,
especially compared to that of other companies in the same industry.
4. A company has inadequate system of authorization and approval of
transactions (for example, in purchasing).
5. Employees show disregard for the need for monitoring or reducing
risks related to misappropriations of assets.
6. Personal financial obligations may create pressure on management or
employees with access to cash or other assets susceptible to theft to
misappropriate those assets.
7. There is excessive pressure on management or operating personnel to
meet financial targets set up by the board of directors or management,
including sales or profitability incentive goals.
8. Assets, liabilities, revenues, or expenses based on significant estimates
that involve subjective judgments or uncertainties that are difficult to
corroborate.
9. Nonfinancial management shows an excessive participation in or
preoccupation with the selection of accounting principles or the
determination of significant estimates.
10. Management shows a domineering behavior in dealing with the
auditor, especially involving attempts to influence the scope of the
auditor's work or the selection or continuance of personnel assigned to
or consulted on the audit engagement.
11. Employees anticipate future layoffs.
12. An employees behavior indicates displeasure or dissatisfaction with
the company or its treatment of the employee.
13. A company has significant related-party transactions not in the
ordinary course of business or with related entities not audited or
audited by another firm.

FFR or MA
MA

I/P, O, or R
I/P

FFR

FFR

I/P

FFR or MA

MA

MA

I/P

FFR

I/P

FFR

FFR

FFR

I/P

MA
MA

I/P
R

FFR

9-21. (Estimated Time 25 minutes)

Following is a discussion of the various fraud risk factors identified in the case, including
an explanation of assertions that might be affected by the risk factors.
(a) Fraud Risk Factor
The company competes in the highly competitive
market for manufactured household products. This
is combined with the fact that the company has
performed well up until a recent recession, but now
the company is having difficulty moving inventory
in most product lines as retailers have difficult
selling in a down economy.
The company is dominated by Rob Bigbucks, the
Chairman and Chief Executive Officer that has
guided the company since it was a private company
and has extensive influence all aspects of company
operations. Rob is known to have a short temper
and have been known to threaten individuals in the
accounting department with the lack of pay raises if
they dont assist him in achieving company goals.
The company has extended its influence over
customers and has dictated terms of sale to ensure
that customers are able to obtain desired quantities
of their most popular products.
Bonuses based on sales are a significant component
of the compensation package for individual product
sales managers.

Sales managers who do not meet sales targets three

quarters in a row are often replaced.

(b) Affect on Financial Statement Assertions

This combination of competitive markets and a
downturn in the economy create the incentives and
pressures for fraudulent financial reporting and it
may have a pervasive affect on multiple account
balances or financial statement assertions.
Robs threats create the incentives and pressures for
fraudulent financial reporting. This is likely to
have a pervasive impact on the financial statements
given that multiple individuals in the accounting
department feel threatened. Hence, multiple
accounts or assertions may be misstated.
The influence over customers is likely to create the
opportunity for revenue recognition issues. The
most likely assertion that might be misstated is the
existence and occurrence assertion for sales and
receivables.
Bonuses based on sales targets create the incentive
for fraudulent financial reporting, and premature
revenue recognition, in order for sales managers to
earn bonuses. The most likely assertion that might
be misstated is the existence and occurrence
assertion for sales and receivables.
In order to keep their jobs, sales managers may
engage in fraudulent financial reporting and
premature revenue recognition. The most likely
assertion that might be misstated is the existence
and occurrence assertion for sales and receivables.

9-22. (Estimated Time 25 minutes)

The following table presents the solutions to parts a and b.

c.

Situations C and G mean that the evidence obtained from risk assessment
procedures, tests of controls, and analytical procedures may reduce audit risk to
an appropriately low level.

d.

Situation E represents a situation with maximum inherent risk. In other words

this is a significant inherent risk. The proposed audit strategy emphasizes
analytical procedures and minimizes tests of details. It is not appropriate to place
such a significant emphasis on analytical procedures for assertions that represent
significant inherent risks.

e.

Assuming that inherent risk is assessed at the maximum, two important audit
strategies are (1) a lower assessed level of control risk approach, and (2) a
primarily substantive approach emphasizing tests of details. Under a lower
assessed level of control risk approach an increased understanding of internal
controls to allow for the effective design of tests of controls. Under a primarily
substantive approach emphasizing tests of details the auditor needs a sufficient
understanding of the system of internal control to effectively design substantive
tests.
9-25. (Estimated Time 20 minutes)
Inherent Risk Factor
The original CFO for a company in
the entertainment industry just retired
and a new CFO, with modest industry
experience, was hired from a CPA
firm.
2. During the last year the companys
most profitable product has
experienced significant competition
and inventory quantities are building.
3. A software company has recently
changed its product and is now selling
both a site license bundled with
consulting services to tailor the
software to the clients needs.
4. Financial difficulties during a recent
economic slowdown have put the

Pervasive Effect
(yes/ no)

Accounts Affected

Assertions Affected

Yes

Multiple

Multiple

No

Inventory and Cost

of Goods Sold

BAO Valuation and

Allocation (Net
Realizable Value)

No

Sales and Accounts

Receivable

TAO Occurrence
(Revenue
Recognition)

Yes

Multiple

Multiple

1.

company in a position where it is

close to violation of debt covenants.
5. A larger diversified retailer has just
made a decision to put a high-end
jewelry line in its stores.
6. A pharmaceutical company recently
invested $500 million in research and
development over the last five years
in a product that failed to receive
FDA approval.

No

No

Inventory and Cost

of Goods Sold

BAO Existence and

TAO Occurrence

Any Capitalized
Research and
Development Cost

BAO Valuation and

Allocation
(Impairment Test)

9-26
1. IR
2. CR
3. IR
4. AP
5. IR
6. IR
7. IR
8. IR
9. TD
10. IR

9-28. (Estimated Time 20 minutes)

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Preliminary Audit Strategy

A lower assessed level of control risk approach
A primarily substantive approach
A lower assessed level of control risk approach
A lower assessed level of control risk approach
A lower assessed level of control risk approach
A primarily substantive approach
A primarily substantive approach
A lower assessed level of control risk approach
A primarily substantive approach
A primarily substantive approach