Risk Factors for Fraudulent Financial Reporting


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Risk Factors for Fraudulent Financial Reporting

  1. 1. Remaining Topics from Chapter 4 (Audit Planning) • Risk Factors for Fraudulent Financial Reporting • Related Party Transactions • Using the Work of a Specialist • Using the Work of Internal Auditors • Preliminary Analytical Procedures • Preparing the Audit Program 1
  2. 2. 1. Factors Affecting the Risk of Fraudulent Financial Reporting 1. Management’s attitude toward internal control & financial reporting. 2. Extent to which management’s compensation is tied to earnings or stock price. 3. Excessive interest by management in maintaining or increasing the firm’s stock price. 4. Commitments made by the firm’s management to achieve aggressive or unrealistic forecasts. 5. New accounting or regulatory rules that could reduce financial stability or earnings. 6. High degree of industry competition, resulting in lower profit margins. 7. Extent of rapid change or general decline in the client’s industry. 8. Significant pressure to obtain additional capital to remain competitive. 9. Unusually rapid growth or profitability compared with the rest of the industry. 10. Inability to generate cash flows despite reported earnings and earnings growth. 11. Unusually high debt level. 2
  3. 3. 2. Related Party Transactions What are Related Parties? Entities that can: • __________________ the management or operating policies of one of the transacting parties, and can • __________________ the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. Examples: • Your parents lend you money, and don’t charge you interest. • Sale of goods by Co. A to Co. B, when the same person owns both companies. 3
  4. 4. Related Party Transactions (cont.) The following are parties related to a company: • its ________, ____________ or __________; • entities the company has invested in, and accounts for its investment using the equity method; • immediate family members of _______________ or ______________ of the company. What’s the auditor’s responsibility regarding the client’s related party transactions? 1. Certain relationships with other companies must be ___________ (even if there were no transactions between the two companies). • These include two companies owned or controlled by the same entity. 2. All related party transactions must be: a. _________ in the footnotes to the financial statements. b. Recorded so as to reflect the _________________ of the transaction, rather than its legal form. 1. Example: the company makes an interest-free loan to one of its officers (e.g., the CEO). 2. Economically, the company is providing additional compensation to the officer. It should: • recognize compensation expense. • recognize interest earned. 4
  5. 5. Related Party Transactions (cont.) What can the auditor do to identify related parties? 1. Inquire of appropriate management personnel; 2. Obtain written representations that all related parties have been disclosed by management to the auditor; 3. Review filings with the SEC and other regulatory agencies; 4. Review stockholder listings to identify principal stockholders; 5. Review prior years’ workpapers to identify known related parties; 6. Inquire of predecessor auditors or auditors of related entities; 7. Review material investment transactions to determine whether related party transactions were created. 5
  6. 6. 3. Using the Work of a Specialist Auditors may need to consult a specialist in order to: • determine the value of specialized _________ (e.g., works of art, jewelry, antiques); • determine quantities (e.g., mineral reserves); • determine amounts derived by specialized _________ (e.g., obligations for future pension benefits based on actuarial calculations); • interpret legal documents or regulations. The auditor should make sure that any specialist used: • has a strong ____________________; • has appropriate ____________; • has any applicable ___________ or __________. The CPA should understand the methods and assumptions used by the specialist. Why are these important? • The auditor will ___________________ the specialist in forming an opinion on the client’s financial statements. 6
  7. 7. Using the Work of a Specialist (cont.) The specialist’s findings might support the information in the client’s financial statements. • In that case, the auditor ________________ the special-ist or the specialist’s findings in the audit report. The specialist’s findings might be inconsistent with information in the client’s financial statements. In that case, the auditor needs to decide whether the specialist’s findings are reasonable. a. If they’re reasonable, the auditor will __________ the report, and refer to the specialist and his/her findings. b. If they’re not reasonable, the auditor will either: • _____________ specialist, or • perform additional ______________. The opinion issued by the auditor will depend on the results of these _______________. 7
  8. 8. 4. Using the Work of Internal Auditors Internal auditors: a. Serve as an important element of internal control, by b. providing the following to management regarding the company’s operations: • analyses • evaluations • assurances • recommendations • other information The independent auditor (CPA) may wish to review the internal auditor’s work, which might help the CPA: a. Understand the client’s ________________ system; b. Plan ___________ testing procedures c. Assess __________ risk and/or _________ risk for: • the statements as a whole, • a particular acct. balance or class of transactions, or • both. 8
  9. 9. Using the Work of Internal Auditors (cont.) The independent auditor (CPA) should not rely on the work of the internal auditors if: a. the internal auditors’ work is ________________ the independent auditor’s work, or b. the _____ to the independent auditor of relying on the internal auditors’ work _________ the _________. If the CPA believes that the internal auditor’s work is ______ and that using it would be ________, the CPA should assess the ___________ and _________ of the internal auditors (IAs). The IA’s ___________ is a function of: • his/her educational level; • his/her professional experience; • his/her certification, if any; • the quality of his/her reports and recommendations. The IA’s ___________ can be assessed by evaluating: • his/her status in the organization, & • any policies prohibiting IAs from studying particular areas of operations. The higher the level in the client the IA reports to, the more ___________ he/she is generally considered to be (other things equal). 9
  10. 10. Using the Work of Internal Auditors (cont.) If the IA is considered by the CPA to be __________ and ___________, the CPA may rely on the IA’s work if the CPA verifies the quality of the work being relied on. • For example, the IA may have tested the effectiveness of certain internal controls. • If the CPA wishes to rely on this work, the CPA should test a sample of the IA’s work to ensure that it was ___ ___________. The responsibility to audit the financial statements cannot be shared with, nor delegated to, the internal auditor. What is “outsourced” internal auditing? Why do some believe it is a threat to auditor independence? 10
  11. 11. 5. Preliminary Analytical Procedures SAS No. 56 requires the auditor to perform analytical procedures in the preliminary stages of the audit. They are usually performed at the following stages as well: • substantive testing stage; • near the end of the audit. What are analytical procedures? • ____________ of unaudited financial information based on the underlying ____________ ________ financial and nonfinancial data. For example, compare unaudited financial data with: • prior period data (e.g., by what % did sales change?) • anticipated results; • other data for the same period (same company); For example, accounts receivable vs. credit sales • data from other companies in the same industry; (accounts receivable/credit sales for this company vs. the industry average) • nonfinancial data (market share change, industry growth) 11
  12. 12. Preliminary Analytical Procedures (cont.) What’s the purpose of these procedures? • They direct the ______________________ significant changes over time, or balances that differ from expectations. These differences could be due to: • legitimate reasons (sales increased because a competitor left the market); or • misstatements contained in an account balance. If a large difference exists between the recorded balance and the expected balance in an account, the auditor generally does more extensive substantive tests related to that account. 12
  13. 13. 6. Preparing the Audit Program What is an audit program? • a written set of audit ____________to be ___________ during the audit. • it’s required for all GAAS audits. The audit program is tailor-made for the particular audit being conducted. Standardized audit programs exist for most accounts; these are modified by the auditor for the audit being conducted. 13