1. Distinguish between the terms errors and fraud.

Fraud is an intentional act involving the use of deception that results in a material
misstatement of the financial statements while errors are not intentional.

2. Distinguish between fraudulent financial reporting and misappropriation of assets.

 Fraudulent financial reporting – the intentional manipulation of reported
financial results to misstate the economic condition of the organization.
 Asset misappropriation – occurs when a perpetrator steals or misuses an
organization’s assets. Asset misappropriation is the dominant fraud scheme
perpetrated against small business and the perpetrators are usually employee.
Discuss the likely difference between these two types of fraud on the fair
presentation of financial statements.
Fraudulent financial reporting harms users by providing them incorrect financial
statement information for their decision making. When assets are misappropriated,
stockholders, creditors, and others are harmed because assets are no longer available to
their rightful owners.

3. Define fraud, and explain the two types of misstatements that are relevant to
auditor’s consideration of fraud.
Fraud is an intentional act involving the use of deception that results in a material
misstatement of the financial statements. There are two types of misstatements that are
relevant to auditor’s consideration of fraud: Misstatements arising from misappropriation
of assets and Misstatements arising from fraudulent financial reporting. Asset
misappropriation occurs when a perpetrator steals or misuses an organization’s assets.
Asset misappropriation are the dominant fraud scheme perpetrated against small business
and the perpetrators are usually employee while fraudulent financial reporting the
intentional manipulation of reported financial results to misstate the economic condition
of the organization
4. What are the most common approaches that perpetrators use to commit fraudulent
financial reporting?
  Manipulation, falsification, or alteration of accounting records or supporting
documents.
 Misrepresentation or omission of events, transactions, or other significant
information.
 Intentional misapplication of accounting principles.

5. You are asked to be interviewed by a student newspaper regarding the nature of

accounting fraud. The reporter says, “As I understand it, assets misappropriations
are more likely to be found are more likely to be found in small organizations, but
not in large organization. On the other hand, fraudulent financial reporting is more
likely to be found in larger organizations.’’ How would you respond to the
reporter’s observation?

6. The fraud triangle identifies incentives, opportunities, and rationalization as the

three elements associated with most fraud. Describe how each of these elements is
necessary for fraud to occur.
 Incentives – The greater the incentive or pressure, the more likely an individual
will be able to rationalize the acceptability of committing fraud.
 Opportunities – Circumstances exist—for example, the absence of controls,
ineffective controls, or the ability of management to override controls—that
provide an opportunity for a fraud to be perpetrated
 Rationalization – individuals may be able to rationalize committing fraudulent
act. Some individuals possess an attitude, character or set of ethical values that
allow them knowingly and intentionally to commit a dishonest act. However,
even otherwise honest individuals can commit fraud in an environment that
imposes sufficient pressure on them.

7. If one of the three elements of the fraud triangle is not present, can fraud still be
perpetrated? Explain
The presence of allthree elements – incentives, opportunity and rationalization –
increases the probability of committing fraud. All three elements must be present for a
 fraud to occur.Therefore, this triangle can be fragmented by removing one of these
elements and thus minimizing its likelihood of occurrence.It is very important to
highlight that opportunity is key, as it is the only element within the control of
organizations. Opportunities to commit fraud can be reduced through strong and
comprehensive internal controls but unfortunately, they can never be fully eliminated
since internal control systems have inherent limitations and provide only reasonable and
not absolute assurance.

8. Identify factor (red flag) that would be strong indication of opportunities to commit
fraud.
 Significant related-party transactions
 A company’s industry position, such as the ability to dictate terms or conditions to
suppliers or customers that might allow individuals to structure fraudulent
transactions
 Management inconsistency involving subjective judgments regarding assets or
accounting estimates
 Simple transactions that are made complex through an unusual process
 Complex or difficult to understand transactions
 Ineffective monitoring of management by the board
 Complex or unstable organizational structure
 Weak or nonexistent internal controls

9. Is the ability to rationalize the fraud an important aspect to consider when

analyzing a potentially fraudulent situation?
The ability to rationalize the fraud is an important aspect to consider when
analyzing a potentially fraudulent situation because if an auditor can critically think of
different justifications a perpetrator may have to commit a fraudulent activity in turn they
would be better equipped to prevent, detect, or inquiry about potential fraudulent activity.
What are some of the common rationalization used by fraud perpetrators?
 “This is one-time thing to get us through the current crisis and survive until things
get better”
  “Everybody cheats on the financial statements a little, we are just playing the
same game”
 “We need a higher stock price to acquire company ABC, or to keep our
employees through stock options, and so forth”
 “We will be in violation of all our debt covenants unless we find a way to get this
debt off the financial statement”
 Personal situations such as needing the money for a family emergency
 An employee believing, they are “owed” because they are underpaid or
undervalued in some way
 No help is available from outside
 Having the mindset of “borrowing” the money and paying back later

10. Define and illustrate kiting.

Kitting is done by making transfers near year end from one bank account to
another bank account, recording the deposit in the second account but not recording the
disbursement on the first division’s account until the next fiscal period.
What control should the client institute to prevent it?
 Prepare a schedule of bank transfer from the client’s book.
 Determine that checks representing transfers of funds are properly recorded on the
books.
 Obtain cutoff bank statement directly from the bank covering the seven to ten day
after the balance sheet date.