Chapter (1)

Fraud Auditing
Objective (0): Explaining the difference between “Error & Fraud”

 What is the difference between “Error and Fraud”?

 Error: Is un-intentional action.

 Fraud: Is intentional act by one or more (collusion).
Objective (1): Define fraud and distinguish between fraudulent financial reporting
and misappropriation of assets.

 Define fraud and distinguish between the two main categories of fraud.

 Fraud: In the context of financial statement auditing, fraud is defined

as an intentional misstatement of the financial statements.
 Types of Fraud:
‫النقطة دي لو جت‬
‫سؤال مقالى هيبقى‬
‫السؤال هو ده‬

A) Fraudulent Financial Reporting (‫)كدب‬: Is an Intentional misstatement

or Omission of Amounts or Disclosures with the Intent to Deceive Users.
- Most cases involve an attempt to overstate income, but can also
understate income. Company may use the following:
1. “Cookie Jar Reserves” which is mean to understate income when earnings
are high to create a reserve of earnings to be used to increase earnings in
the future periods, Income Smoothing is a form of earnings management in
which revenues and expenses are shifted between periods to Reduce
Fluctuations in earnings.

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 Example: Accountant in Enron admitted in court that he reduced reserves
be $14 million and added it to income in 2000.
2. Earnings management involves deliberate actions taken by management to
meet earnings objectives.
B) Misappropriation Of Assets (‫)سرقة‬: The term misappropriation of assets
is fraud that involves theft of an entity`s assets. In many cases, the amounts
involved are NOT material to the financial statements.
- 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.
Example: the former CEO of Tyco International was charged by the SEC
with stealing over $100 million in assets.

Objective (2): Describe the fraud triangle and identify conditions for fraud.

 List and briefly describe the three conditions for fraud arising from fraudulent financial reporting and
misappropriation of assets and give examples
 Conditions for fraud ‫النقطة دي لو جت سؤال مقالى هيبقى السؤال أو االسئلة اللى فى اخر النقطة‬
.... ‫دي‬
- In the auditing standards there are (3) conditions for fraud in case of
both (Fraudulent financial reporting and misappropriation of assets)

Donald Cressey`s Fraud

Tringle

Incentives Management or other employees have incentives or pressures to commit

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/Pressures fraud
Circumstances provide opportunities for management or employees to
2 Opportunities
commit fraud
Attitudes/
Set of ethical values exists that allows management or employees to
3 Rationalizatio
commit a dishonest act.
n

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 Examples of Risk Factors for Fraudulent Financial Reporting
incentives/Pressures Opportunities Attitudes

Examples of Risk Factors for Misappropriation of Assets

incentives/Pressures Opportunities Attitudes

‫ ايه الطرق التانية اللى ممكن يسألنى بيها ؟‬Essay ‫لو السؤال جه‬

 What are the three conditions of fraud often referred to as “the fraud triangle?
... ‫(هنا االجابة هتبقى اللى فوق ده كله ماعدا مش هتقول كل االمثلة اللى فى الجداول اخترلك اتنين وقولهم وخالص‬
) ‫بس اوعي تنسى ترسم المثلث عشان عاوزك تتخرج بقا وافرح بيك بقا‬

 List and briefly describe examples of risk factors for each condition of fraud for fraudulent financial
reporting.
)  ‫ جدعنة مني اختصرتلك االمثلة‬.. ‫(هنا خالى بالك هو عاوز امثلة وتكون مختصرة زي اللى موجودة فى الجدول بس مختصرة‬

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Objective (3): Develop responses to identified fraud risks.
 What are the three categories of auditor responses to fraud risks? Or What three
auditor actions are required to address the potential for management override of
controls?

.... ‫النقطة دي لو جت سؤال مقالى هيبقى السؤال كده او كده‬

 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. Auditor responses to fraud risk include
the following (4 Steps):
1. Change audit strategy :
- Fraud perpetrators are often knowledgeable about audit procedures.
For this reason, auditing standards require auditors to incorporate
unpredictability in the audit strategy.
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. Suitable Audit Procedures:
- Auditors should study management`s choice of accounting principles.
Accounting principles that involve subjective measurements (Fair value) or
complex in fact needs more attention and investigation. Because auditors
presume fraud risk in revenue recognition they should also evaluate the
company`s revenue policies.
3. Report management override of controls:

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 - Auditors are required to perform certain procedures in every audit to address
the risk of management override of internal controls. These procedures may
include:
1. Examine journal entries and other adjustments for evidence of possible
misstatements due to fraud. (Impairment test)
2. Review accounting estimates for Biases (Fraudulent financial reporting is
often accomplished through intentional misstatement of accounting estimates.
Accounting standards increasingly require that assets be recorded at fair
value. Although market value is readily determinable for some assets,
determining fair value often depends on estimates and judgment, creating
opportunities for manipulation).
3. Evaluate the business rationale for significant unusual transactions. (auditor
should determine whether the accounting treatment for any
unusual transaction is appropriate in the circumstances and whether
information about the transaction is adequately disclosed in the financial
statements)
4. Report to management and audit committee
- Auditors must inquire whether management has knowledge of any fraud or
suspected fraud within the company.
- Auditing standards also requires auditors to inquire of the audit committee
about its views of the risks of fraud and whether the audit committee has
knowledge of any fraud or suspected fraud.
Objective (4): Recognize specific fraud risk areas and develop procedures to detect
fraud
1) Fraud in Revenue and Accounts Receivables
 Why are we starting with “Revenues and A/R”?
- Several Reasons Make Revenue Susceptible To Manipulation:
1) All companies have revenues and revenue drives everything else (Diab`s hint).
2) Revenue is almost always the largest account on the income statement.
3) An Overstatement of revenues often increases net income by an equal amount
because they won't increase the related cost of sales.
4) Revenue Growth is often a key performance indicator for analysts and investors
(Such as Gross Profit Ratio).
5) Difficulty of determining the appropriate timing of revenues recognition in many
industries.

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 Describe the three main techniques used to manipulate revenue Or. What are
the three main types of revenue manipulations employed to commit fraudulent
financial reporting and give an example for each type?

- Three main techniques used to manipulate revenue include:

1) Fictitious Revenues.
2) Premature Revenue Recognition.
3) Manipulation of Adjustments to Revenues.

1) Fictitious Revenues: Simply means recording revenues when no revenues

exist (Cooked F/S). (Diab`s hint)
Real Case (1): Equity Funding of America  Company created tens of
thousands of insurance policies and nealy $2 Billion (in 1960`s – early
70`s) in nonexistent revenues by manipulating IBM mainframe system
(IT). (Diab`s hint)
Real Case (2): Satyam Computer limited  Company created 6,000 fake
sales invoice and millions in investment and interest income. Auditor
(PWC) was sleeping for almost (9) years. There were 1.47 B assets but
1.04 B was nonexistence. (Diab`s hint)
 The most common forms of revenue fraud involve that the perpetrators
creating fictitious revenues to increase income. For Example:
- The year later they will make as sales return and allowance.
- Preparation of fictitious documentary evidence for sales and reduction of
inventory

2) Premature Revenue Recognition (Accelerating revenue recognition).

- The recognition of revenue before accounting standards (U.S GAAP – IFRS)
requirements for recording revenue have been met.
- Should be distinguished from cutoff errors, in which transactions are
unintentionally recorded in the incorrect period.
- The common techniques including the following (Examples) :
A)Bill and Hold:
- Sales are normally recognized at the time goods are shipped,

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 - But in a bill and hold sale, the goods are invoiced before they are shipped.
These types of sales can be legitimate depending on the contract terms, but
can violate accounting standards if the required terms are not met.
B) Issuing side agreements :
- That modify the terms of sales transaction, for example if a customer agrees to
“buy” significant amount of inventory at year end, but a side agreement
provides him more favorable pricing (discounted price) and unrestricted return
of the goods if not sold by the customer.
- In some cases, as a result of the terms of the side agreement, the transaction
does not qualify as a sale under accounting standards.
Real Case: Bausch and Lomb  items were shipped that were not ordered
by customers, with unrestricted right of return and promises that the
goods did not have to be paid for until sold. (Diab`s hint)
3) Manipulation of Adjustments to Revenues
- The most common adjustment to revenue involves the following:
A. Sales return and allowances: a company may hide part of the returns to
overstate of income.
B. Bad Debt Expense: Companies may also Understate Bad Debt Expense, by
understating the Allowance For Doubtful Accounts.
 Fraud in cash receipts:
- One of the most difficult frauds to detect is when a sale is not recorded and
the cash from the sale is stolen. We have two cases:
A) Failure to record a sale:
- One of the most difficult frauds to detect is when a sale is not recorded and the
cash from the sale is stolen.
- Such fraud are easier to detect when goods are shipped on credit to customer.
- Tracing documents to sales entries in the sales journal can be used to verify that
all sales recorded.
B) Theft of cash:
- It is more difficult to hide the theft of cash receipts after a sale is recorded.
- The fraud committer must reduce the customer's account to hide the theft using
the following ways:
- Record a sales return or allowances,

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 - Write off the customer account and,
- Apply the payment from another customer to the customer account (lapping
between accounts).

 Methods to discover both Revenue and Cash fraud.

A) Analytical Procedures :
- Fictitious revenue over state the gross margin percentage, and
premature revenue recognitions also overstates gross margin if the
related cost of sales is not recognized.
- Fictitious revenues also lower accounts receivable turnover because
the fictitious revenues are included in uncollected receivables.
For Example:

B) Documentary differences: Auditors should be aware of unusual marking 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.
C)Internal control:
 Cash receipts relatively small thefts of sales and related cash receipts are best
prevented and detected by internal control designed to minimize the opportunity
for fraud.
 For detecting larger funds, analytical procedures and other comparisons may be
useful.

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 Questions Part
Part one: Multiple Choice Questions (MCQs)
1) Which of the following best defines fraud in a financial statement auditing context?
A) Fraud is an unintentional misstatement of the financial statements.
B) Fraud is an intentional misstatement of the financial statements.
C) Fraud is either an intentional or unintentional misstatement of the financial statements,
depending on materiality.
D) Fraud is either an intentional or unintentional misstatement of the financial statements,
depending on consistency.
Answer: B
2) Companies may intentionally understate earnings when income is high to create a reserve of
"earnings" that may be used in future years to increase earnings. This practice is known as:
A) performance-based management.
B) earnings management.
C) asset management.
D) expense management.
Answer: B
3) Which of the following is a category of fraud?

Answer: A
4) With respect to misappropriation of assets, most frauds involve:

Answer: C

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5) ________ is fraud that involves theft of an entity's assets.
A) Fraudulent financial reporting
B) A "cookie jar" reserve
C) Misappropriation of assets
D) Income smoothing
Answer: C
6) Which of the following would the auditor be most concerned about regarding a heightened risk of
intentional misstatement?
A) senior management emphasizes that it is very important to beat analyst estimates of earnings every
reporting period
B) senior management emphasizes that budgeted amounts for expenses are to be achieved for each
reporting period or explained in the variance analysis report
C) senior management emphasizes that job rotation is a worthwhile corporate objective
D) senior management emphasizes that job evaluations are based on performance
Answer: A
7) Which of the following is a form of earnings management in which revenues and expenses are
shifted between periods to reduce fluctuations in earnings?
A) fraudulent financial reporting
B) expense smoothing
C) income smoothing
D) each of the above is correct
Answer: C
8) Who is most likely to perpetrate fraudulent financial reporting?
A) members of the board of directors
B) production employees
C) management of the company
D) the internal auditors
Answer: C
9) Misappropriation of assets is normally perpetrated by:
A) members of the board of directors.
B) employees at lower levels of the organization.
C) management of the company.
D) the internal auditors.
Answer: B
10) Determine from the following the factor that would most likely elevate the auditor's concern about
the risk of financial statement fraud.
A) company cannot borrow debt capital without restrictive covenants
B) company finds it difficult to sell equity capital for expansion
C) company has a significant portion of liquid assets on its balance sheet
D) company reports substantial net income but ever decreasing cash flow from operations
Answer: D
11) Financial statement manipulation risk is arguably present for all companies' financial statements.
However, the risk is elevated for companies that:
A) are heavily regulated.
B) have foreign subsidiaries.
C) have to make significant judgments for accounting estimates.
D) operate in stable economic environments.

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Answer: C
12) Which of the following is not a factor that relates to opportunities to commit fraudulent financial
reporting?
A) Lack of controls related to the calculation and approval of accounting estimates.
B) Ineffective oversight of financial reporting by the board of directors.
C) Management's practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit, and information technology staff.
Answer: C
4) Fraud is more prevalent in smaller businesses and not-for-organizations because it is more difficult for
them to maintain:
A) adequate separation of duties.
B) adequate compensation.
C) adequate financial reporting standards.
D) adequate supervisory boards.
Answer: A
Terms: Fraud more prevalent in smaller business and not-for-profit organizations
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
5) Which of the following is a factor that relates to incentives or pressures to commit fraudulent financial
reporting?
A) Significant accounting estimates involving subjective judgments.
B) Excessive pressure for management to meet debt repayment requirements.
C) Management's practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit, and information technology staff.
Answer: B
Terms: Factor that relates to incentives or pressures to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
6) Which of the following is a factor that relates to attitudes or rationalization to commit fraudulent
financial reporting?
A) Significant accounting estimates involving subjective judgments.
B) Excessive pressure for management to meet debt repayment requirements.
C) Management's practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit and information technology staff.
Answer: C
Terms: Factor that relates to attitudes or rationalization to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
7) Which of the following is not a factor that relates to opportunities to misappropriate assets?
A) Inadequate internal controls over assets.
B) Presence of large amounts of cash on hand.
C) Inappropriate segregation of duties or independent checks on performance.
D) Adverse relationships between management and employees.
Answer: D
8) Which of the following is a factor that relates to incentives to misappropriate assets?
A) Significant accounting estimates involving subjective judgments.
B) Significant personal financial obligations.
C) Management's practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit and information technology staff.

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Answer: B
Terms: Factor that relates to incentives to misappropriate assets
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
9) Which of the following does NOT represent an increased opportunity to commit fraud?
A) Related Party Transactions
B) the company founder is the CEO and Chairman of the Board
C) the financial statements involve accounting estimates
D) the company is a new audit client for the CPA firm
Answer: D
Terms: Increased opportunity to commit fraud
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
10) In the fraud triangle, fraudulent financial reporting and misappropriation of assets:
A) share little in common.
B) share most of the same risk factors.
C) share the same three conditions.
D) share most of the same conditions.
Answer: C
Terms: Fraud triangle
Diff: Moderate

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