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2-1
Auditing: A Risk Based Approach to Conducting a Quality Audit, 10e
Solutions for Chapter 2
True/False Questions
2-1 F 2-2 F 2-3 T 2-4 F 2-5 T 2-6 T 2-7 F 2-8 T 2-9 F
2-10 T
2-11 T
2-12 F
Multiple Choice Questions
2-13 B
2-14 B
2-15 B
2-16 E
2-17 D
2-18 C
2-19 C
2-20 D
2-21 A
2-22 D
2-23 A
2-24 B
Review and Short Case Questions
2-25
Fraud is an intentional act involving the use of deception that results in a misstatement of the financial statements. Two types of misstatements are relevant to auditors’ consideration of fraud (a) misstatements arising from misappropriation of assets and (b) misstatements arising from fraudulent financial reporting. Intent to deceive is what distinguishes fraud from errors.
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© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
2-2
2-26
Three common ways that fraudulent financial reporting can be perpetrated include:
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
Common types of fraudulent financial reporting include:
Improper revenue recognition Improper deferral of costs and expenses Improper asset valuation Concealed liabilities Misrepresentations or omissions in financial statement footnotes of MD&A
2-27
The reporter’s statement makes sense. Asset misappropriations are much easier to accomplish in small organizations that don’t have sophisticated systems of internal control. Fraudulent financial reporting is more likely to occur in large organizations because management often has ownership of or rights to vast amounts of the company’s stock. As the stock price goes up, management’s worth also increases. However, the reporter may have the mistaken sense that financial fraud only occurs rarely in smaller businesses. That is not the case. Many smaller organizations are also motivated to misstate their financial statements in order to (a) prop up the value of the organization for potential sale, (b) obtain continuing financing from a bank or other financial institution, or (c) to present a picture of an organization that is healthy when it may be susceptible to not remaining a going concern. Finally, smaller organizations may conduct a fraud of a different sort, i.e., misstating earnings by understating revenue or masking owner distributions as expenses. This is often done to minimize taxes. It would also be a mistake to think that asset misappropriations do not happen in larger organizations. Whenever controls are weak, there is an opportunity for asset misappropriation. When the opportunity is coupled with motivation and a belief that the fraud could be covered up, some of those opportunities will result in asset misappropriation.
2-28
- A Ponzi scheme occurs when the deposits of current investors are used to pay returns on
the deposits of previous investors; no real investment is happening.
b. The key elements of the Bernie Madoff fraud include:
Fabricated “gains” of almost $65 billion Defrauded thousands of investors Took advantage of his high profile investment leader status to establish trust in his victims
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2-3
Accomplished the scheme by keeping all the fraudulent transactions off the real financial statements of the company Employed a CPA who conducted a sham audit Led to the PCAOB now having oversight of the audits of SEC-registered brokers and dealers
- The Bernie Madoff fraud is primarily a case of asset misappropriation. However, it is
important to note that asset misappropriation then led Madoff to commit fraudulent financial reporting to hide the asset misappropriation.
2-29
- Management perpetrated the fraud by filling inside containers with water in the larger
containers filled with oil. Further, they transferred the oil from tank to tank in the order in which they knew the auditors would proceed through the location.
- The goal was to overstate inventory assets, thereby understanding cost of goods sold and
overstating income.
- The Great Salad Oil Swindle is primarily a case of fraudulent financial reporting.
2-30
Incentives relate to the rationale for the fraud, e.g., need for money, desire to enhance stock price. Opportunities relate to the ability of the fraudster to actually accomplish the fraud, e.g., through weak internal controls. Rationalization is the psychological process of justifying the fraud.
2-31
Common incentives for fraudulent financial reporting include:
Management compensation schemes Other financial pressures for either improved earnings or an improved balance sheet Debt covenants Pending retirement or stock option expirations Personal wealth tied to either financial results or survival of the company Greed—for example, the backdating of stock options was performed by individuals who already had millions of dollars of wealth through stock
2-32
Factors, or red flags, that would be strong indicators of opportunity to commit fraud include: inadequate segregation of duties opportunities for management override absence of monitoring controls complex organizational structure
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unauthorized access to physical assets inadequate reconciliations of key accounts, especially bank accounts access to cash that it not supervised or reconciled by someone else
2-33
The ability to rationalize is important. Unless fraudsters are outright criminals, they will often be able to come up with an excuse for their behavior. “Accounting rules don’t specifically disallow it” or “the company owes me” are potential rationales. Other common rationalizations include:
Unfair financial treatment (perceived) in relationship to other company employees “It is only temporary”, or “it’s a loan from the company” “I deserve it” “The company is so big they won’t miss it” “ The company is unethical” “The company comes by its profits in a way that exploits people”.
2-34
- incentive
- incentive
- opportunity
- incentive
- rationalization
- opportunity
2-35
Refer to Exhibit 2.3 for brief descriptions.
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