Auditing Real-World Frauds: A Practical Case Application Approach

• Chapter 0 - Overview
• Chapter 1 - Introduction to Fraud
  • Learning Objectives
  • Introduction
  • Marketplace Expectations and the Independent Auditor
  • Workplace Fraud
    • Profile of a Fraudster
  • Financial Statement Fraud
    • Fraudulent Financial Reporting
    • Misappropriation of Assets
  • How Fraud Typically Occurs in Smaller Organizations
  • Summary
  • Questions
• Chapter 2 - Internal Controls in Small Entities
  • Learning Objectives
  • Introduction
  • Characteristics of Small Entities
  • Internal Control Defined
  • The Internal Control Framework
    • Control Environment
    • Risk Assessment
    • Control Activities
    • Information and Communication
    • Monitoring
    • Guidance on Monitoring Internal Control Systems
  • Scaling the COSO Internal Control Framework to a Small Entity
    • Fraudulent Financial Reporting
  • Challenges to Effective Internal Control Systems in Small Entities
  • Summary
  • Questions
• Chapter 3 - Professional Standards: Concepts, Requirements, and Conflicts
  • Learning Objectives
  • Introduction
  • Consideration of Fraud in a Financial Statement Audit
    • Common Areas of Interest
  • Requirements under Professional Auditing Standards
    • Understanding the Entity – SAS No. 109
    • Consideration of Fraud in a Financial Statement Audit – SAS No. 99
  • Fraud Risk Factors
    • Identifying Fraud Risks
  • Fraud Risks in Every Audit
    • Improper Revenue Recognition
    • Management Override – Journal Entries
    • Management Override – Accounting Estimates
    • Management Override – Business Rationale
  • Preliminary Considerations and Evaluations
    • Consideration of Potential Fraud Risks
    • Assessment of Potential Fraud Risks
    • Identification of Potential Fraud Risks
    • Evaluation of Fraud Programs and Controls
  • Auditor Response to Identified Fraud Risks
    • Responding to Assessed Risk
    • Evaluating Audit Evidence
  • Communication and Documentation
  • Other Considerations in Audits of Small Entities
  • Summary
  • Questions
• Chapter 4 - Financial Statement Fraud in the Small Entity
  • Learning Objectives
  • Introduction
  • Common Schemes to Perpetrate Fraudulent Financial Reporting
    • Revenue Recognition
    • Expense Recognition
    • Common Schemes to Misappropriate Assets
    • Procurement and Contracting Frauds
    • Cash Receipts and Fraudulent Disbursements
    • Personnel Costs
    • Property, Plant, and Equipment
  • Management Actions When Fraud Occurs
  • Summary
  • Questions
• Chapter 5 - Cases of Financial Statement Frauds in Small Entities
  • Learning Objectives
  • Case 1 – Atlantis Pool Equipment Inc
    • Part 1
    • Part 2
    • Part 3
    • Part 4
    • Part 5
    • Part 6
  • Case 2 – Flowers to Die For
    • Part 1
    • Part 2
    • Part 3
    • Epilogue
  • Case 3 – Quick and Easy Inc
    • Part 1
    • Part 2
    • Part 3
    • Part 4
    • Epilogue
  • Case 4 – Custom Boats Inc.
    • Part 1
    • Part 2
    • Part 3
    • Part 4
    • Epilogue
  • Case 5 – Wholesale Wood Products Inc.
    • Background
    • The Case
  • Case 6 – Client Services Inc
    • Part 1
    • Part 2
    • Part 3
    • Part 4
  • Case 7 – Fix It and Forget It Inc
    • Background
    • The Case
• Chapter 6 - Latest Developments
• Appendix A - SAS No. 99
• Appendix B - Internal Control Over Financial Reporting Guidance for Smaller Public Companies
  • Characteristics of “Smallerâ€? Companies
  • Costs and Benefits
  • Meeting Challenges in Attaining Cost-Effective Internal Control
  • Achieving Further Efficiencies
  • Applying Principles in Achieving Effective Internal Control over Financial Reporting
  • Using this Guidance
• Appendix C - Supplemental Fraud Checklist
• Appendix D - Other Sources of Information
  • Other Guidance
  • Helpful Web Sites

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Chapter 0 - Overview

This course is directed toward auditors and management of small entities. A combination of background and technical information as well as case studies are used to present the information. The first half of the course consists of background and technical information related to fraud and the control environment in small entities.

In Chapter 1, marketplace expectations related to the auditor’s responsibility to detect fraud in the course of a financial statement audit are discussed. Characteristics of the typical fraudster are outlined in this chapter as well. Chapter 2 discusses internal controls in a small entity and the characteristics of small entities that affect the design, implementation, and monitoring of an effective internal control system.

This chapter also includes a discussion of the COSO internal control framework and the effect of management override on a small entity’s internal control system. Auditor responsibilities under professional standards and the challenges of applying them in audits of small entities are discussed in Chapter 3. SAS Nos. 99 and 109 are the two primary areas of focus in this chapter.

How financial statement fraud may occur in small entities is the subject of Chapter 4. While both fraudulent financial reporting and misappropriation of assets are discussed, the chapter primarily focuses on fraud through the misappropriation of assets. Emphasis is placed on the misappropriation of assets through procurement/contracting fraud, personnel fraud, cash receipts and disbursements fraud, and the personal use of entity-owned assets.

In the second half of this course, a case study approach is used to reinforce the background and technical information presented in the first half. Chapter 5 is comprised of various case studies of different types of financial statement fraud typically found in small entities. All of the cases presented in this course are based in full or in part on actual cases of fraud found in small entities. All organization names used in this course are purely fictitious, as are the individuals depicted therein. Any similarity to real organizations or persons is purely coincidental.

Chapter 1 - Introduction to Fraud

Learning Objectives

• Understand how marketplace expectations related to the objectives of a financial statement audit affect the audits of smaller entities.
• Become familiar with the types of fraud occurring most often in the workplace.
• Recognize the two categories of financial statement fraud as defined by generally accepted auditing standards.
• Understand how fraud typically occurs in smaller entities.
• Be aware of the characteristics of the person most likely to commit fraud.

Introduction

In a GAAS audit, the auditor must plan and perform the audit to obtain reasonable assurance that the financial statements are free of material misstatement, including material misstatement caused by fraud. The auditor has always had that responsibility. Unfortunately, many auditors remain confused about this issue. SAS No. 99, Consideration of Fraud in a Financial Statement Audit, did not change the auditor's overall responsibility. The reason SAS No. 99 was issued was to increase the likelihood that the auditor will detect material misstatement in the financial statements caused by fraud. The auditor is not responsible for detecting fraud per se, but rather for detecting material misstatements caused by the fraud. To avoid confusion, it is important to understand the distinction between these two responsibilities as well as the important concepts of “reasonable assurance” and “materiality” within the context of the financial statements taken as a whole.

Marketplace Expectations and the Independent Auditor

Professional auditing standards require auditors to understand the audit entity, the environment in which it operates, and its internal controls in order to determine the risk of material misstatement associated with the financial statements. As such, the audit is planned “to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” It is not possible for the auditor to obtain absolute assurance with respect to material misstatements in the financial statements because of the nature of evidential matter obtained in an audit engagement and the characteristics of fraud.

As a concept, reasonable assurance is not easily understood by users of audited financial statements, management of the audited entity, and the general public. Numerous news reports, as well as academic research, frequently indicate that these groups believe that the auditor’s primary responsibility in a financial statement audit is the detection of fraud. As a result, clients, especially when they are associated with smaller entities, often believe that any service provided by a CPA, particularly audit services, is designed to detect fraud. Therefore, businesses may tend to postpone implementation of, or ignore completely the need for, effective internal controls.

In 2008, a U.S. Treasury Department report on the auditing profession¹ identified the nature of the auditor’s obligation to detect fraud as the single most confusing issue for executives and nonauditors to understand. The report indicated that fraud detection was essential to the reliability of financial statements and, therefore, of utmost importance to investor confidence. One of the witnesses before the committee responsible for the report testified that the [auditing] profession should work with regulators and standard setters “to develop best practices and an infrastructure for effective audits designed to detect material financial fraud.”

A number of recommendations to enhance the auditor’s fraud detection capabilities were identified in the report. One significant recommendation was the creation of a national center to facilitate the sharing of fraud experiences among auditors, financial statement preparers and users, and regulators. Another recommendation was the development of best practices related to fraud prevention and detection.

A 2002 survey conducted by the AICPA indicated that this expectation gap also exists with sophisticated business decision makers and investors/shareholders. Interviews with 1,000 of these individuals revealed that over 80% of them believed the job of the external auditor was to prevent fraud. If this presumably knowledgeable group believes that the purpose of the external audit is to prevent fraud, it is not surprising that managements of smaller entities expect that any service provided by their CPA is supposed to detect fraud.

Workplace Fraud

Every two years, the Association of Certified Fraud Examiners (www.acfe.com) issues its national report on occupational fraud and abuse. Occupational fraud involves people using their positions for personal gain. It is accomplished by deliberately misusing or misapplying the resources or assets of their employers. The 2008 report covers occupational fraud investigations conducted by Certified Fraud Examiners between January 2006 and February 2008.

A diverse group of industries and sizes of business were included in the 959 cases investigated during this period. Telecommunications, manufacturing and construction suffered some of the highest median losses per scheme, ranging from $330,000 (construction) to $800,000 (telecommunications).

Following trends noted in prior studies, small businesses again experienced disproportionately higher losses. For the 2006–2008 study period, businesses with less than 100 employees incurred median losses of $200,000 per scheme. Median losses incurred in the largest organizations studied (more than 10,000 employees) were $147,000 per scheme. According to the report, these findings accentuate the unique problems in combating fraud often faced by small organizations, primarily the limited amount of fiscal and human resources available for anti-fraud efforts.

Some of the major findings in the 2008 ACFE report include the following:

• The median loss during the two-year study period was $175,000.
• The typical fraud lasted two years from the time it began until the time it was detected by the victim organization.
• Nearly 30% of the frauds studied involved employees in the accounting function.
• Almost 20% of frauds investigated involved executive-level employees.

According to a 2003 survey sponsored by Ernst & Young LLP, 20% of American workers are personally aware of fraud in the workplace. Those responding to the survey believed employers lost 20% of every dollar to some type of workplace fraud. Many of the respondents were personally aware of the following types of fraud:

• Theft of office items.
• Claiming extra hours worked.
• Expense accounts.
• Taking kickbacks from suppliers.

Profile of a Fraudster

Based on the results of the CFE biennial reports on occupational fraud, individuals perpetrating fraud are almost equally line employees or managers. While not the most frequent perpetrators of fraud, owners and executives, however, account for the largest dollar amount of loss due to fraud. Generally, the amount of an individual fraud loss increases with the perpetrator’s annual income.

There is a documented correlation between the amount of an individual fraud loss and the length of time the perpetrator has been employed by the defrauded organization. Employees with longer tenure are more likely to commit fraud than are those employed for lesser periods. Men are more often perpetrators of fraud than women and the amount of the related fraud loss is also higher.

Frauds are most often committed by employees in the 31–50 age group, with more frauds committed by individuals that are 41–50 years of age than those that are younger. The largest per case fraud losses, however, are committed by individuals over 51 years of age. Additionally, most individuals committing fraud have a college degree and work in the accounting department.

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