SA 240 Add Ons

SA 240

What are fraud risk factors?

Fraud risk factors are events or conditions that indicate incentive or pressure to commit fraud
or provide an opportunity to commit fraud. For eg: -
Ø Need to meet expectations of 3rd parties to obtain additional equity financing may create
pressure to commit fraud
Ø Granting of significant bonuses if unrealistic profit targets are met may create an incentive
to commit fraud and
Ø Control environment that is not effective may create opportunity to commit fraud.

Examples of fraud risk factors

Risk factors relating to misstatements arising from fraudulent financial reporting
Following are eg of risk factors relating to misstatements arising from FFR: -

Incentives/Pressures
Financial stability or profitability is threatened by economic, industry, or entity operating
conditions, such as (or as indicated by): -
Ø High degree of competition or market saturation, accompanied by declining margins.
Ø Significant declines in customer demand and increasing business failures in either the
industry or overall economy.
Ø Rapid growth or unusual profitability especially compared to that of other companies in the
same industry.
Ø Operating losses making the threat of bankruptcy, foreclosure, or hostile takeover imminent.
Ø Recurring negative cash flows from operations or an inability to generate cash flows from
operations while reporting earnings and earnings growth.
Ø High vulnerability to rapid changes, such as changes in technology, product obsolescence, or
interest rates.
Ø New accounting, statutory, or regulatory requirements.

Excessive pressure exists for mgt to meet requirements or expectations of 3rd parties due to
following:
Ø Profitability or trend level expectations of investment analysts, institutional investors,
significant creditors, or other external parties including expectations created by mgt in, for
eg, overly optimistic press releases or annual report messages.
Ø Perceived or real adverse effects of reporting poor financial results on significant pending
transactions, such as business combinations or contract awards.
Ø Need to obtain Additional debt or equity financing to stay competitive— including financing
of major R&D or capital expenditures.
Ø Marginal ability to meet exchange listing requirements or debt repayment or other debt
covenant requirements.

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SA 240 Add Ons
Info indicates that personal financial situation of mgt or TCWG is threatened by entity’s financial
performance arising from following: -
Ø Significant financial interests in entity.
Ø Personal guarantees of debts of entity.
Ø Significant portions of their compensation (for eg, bonuses, stock options & earn-out
arrangements) being contingent upon achieving aggressive targets for stock price, operating
results, financial position or cash flow.
Ø There is excessive pressure on mgt or operating personnel to meet financial targets
established by TCWG, including sales or profitability incentive goals.

Opportunities: Nature of industry or entity’s operations provides opportunities to engage in FFR

that can arise from following: -
Ø Strong financial presence or ability to dominate a certain industry sector that allows entity
to dictate terms or conditions to suppliers or customers that may result in inappropriate or
non-arm’s-length transactions.
RPTs
Ø Significant related-party transactions not in ordinary course of business or with related
entities not audited or audited by another firm.
Ø Use of business intermediaries for which there appears to be no clear business justification.
Ø Significant, unusual, or highly complex transactions, close to period end that pose difficult
“substance over form” questions.
International
Ø Significant operations located or conducted across international borders in jurisdictions
where differing business environments and cultures exist.
Ø Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for
which there appears to be no clear business justification.
A/c estimates
Assets, liabilities, revenues, or expenses based on significant estimates that involve
subjective judgments or uncertainties difficult to corroborate.

There is a complex or unstable organizational structure, as evidenced by following: -

Ø Difficulty in determining organization or individuals that have controlling interest in entity.
Ø Overly complex org structure involving unusual legal entities or managerial lines of authority.
Ø High turnover of senior mgt, legal counsel, or TCWG.

Internal control components are deficient as a result of the following: -

Ø Inadequate monitoring of controls, including automated controls & controls over interim
financial reporting (where external reporting is required).
Ø High turnover rates or employment of accounting, internal audit, or IT staff not effective.
Ø Accounting & info systems that are not effective, including situations involving significant
deficiencies in internal control.

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SA 240 Add Ons

Attitudes/Rationalizations
Attitude?
Ø Excessive interest by mgt in maintaining or increasing entity’s stock price or earnings trend.
Ø Practice by mgt of committing to analysts, creditors, and other 3rd parties to achieve
aggressive or unrealistic forecasts.
Ø An interest by mgt in employing inappropriate means to minimize reported earnings for tax-
motivated reasons.
Ø Known history of violations of securities laws or other L/R, or claims against entity, its senior
mgt or TCWG alleging fraud or violations of L/R.
Ø Low morale among senior mgt.

Others:
Ø Communication, implementation, support, or enforcement of entity’s values or ethical
standards by mgt or communication of inappropriate values or ethical standards, that are not
effective.
Ø Non-financial mgt’s excessive participation or preoccupation with selection of a/c policies or
determination of significant estimates.
Ø Mgt failing to remedy known significant deficiencies in internal control on a timely basis.
Ø Owner-manager makes no distinction between personal and business transactions.
Ø Dispute between shareholders in a closely held entity.
Ø Recurring attempts by mgt to justify marginal or inappropriate a/c on basis of materiality.

Relationship b/w mgt and current or predecessor auditor is strained, as exhibited by following: -
• Domineering mgt behaviour in dealing with auditor, especially attempts to influence scope of
auditor’s work or selection or continuance of personnel assigned to or consulted on audit engg.
• Unreasonable demands on auditor, such as unrealistic time constraints regarding completion
of audit or issuance of auditor’s report.
• Frequent disputes with the current or predecessor auditor on accounting, auditing, or
reporting matters.
• Restrictions on auditor that inappropriately limit access to people or info or ability to
communicate effectively with TCWG.

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