Fraud 2.pptx

The Risk of Fraud and Mechanisms to Address Fraud: Regulation, Corporate Governance and Audit Quality

FRAUD – intentional act involving the use of deception that results in a material misstatement of financial statements. Types of Fraud: 1) Misappropriation of assets 2) Fraudulent financial reporting

ASSET MISAPPROPRIATION – Theft or misuse of an organization’s assets. Commonly perpetrated against small businesses and perpetrators are usually EMPLOYEES.

This occurs when employees: 1) Gain access to cash and manipulate accounts to cover up cash thefts. 2) Manipulate cash disbursements through fake companies. 3) Steal inventory or other assets and manipulate financial records to cover up the fraud.

Fraudulent Financial Reporting - intentional manipulation of reported financial result to misstate the economic condition of the organization. - also known as MANAGEMENT FRAUD.

Either the perpetrator seeks:

1) Direct personal gain – rise in stock price to increase personal wealth 2) Indirect Gain – to “save” the company from misfortune

Accomplish through:

1)Manipulation, falsification, or alteration of records or documents. 2) Misrepresentation or intentional omission of events and other info. 3) Intentional misapplication of accounting policies.

FRAUD TRIANGLE – introduced by career criminologist Don Cressey more than 30 years ago. It is used in assessing the likelihood of the occurrence of fraud by carefully analyzing its 3 elements.

3 Elements of Fraud Triangle: 1) Incentive OR motivation 2) Opportunity to commit and conceal fraud 3) Rationalization RED FLAGS – factors associated with these elements

For Fraudulent Reporting:

1) Management compensation schemes 2) Financial pressures, either improved earnings or an improved balance sheet 3) Debt covenants 4) Personal wealth tied to either financial results or survival of the company 5) Greed

Incentives relating to asset misappropriation include: 1) Personal factors such as severe financial considerations 2) Pressure to live a more lavish lifestyle 3) Addiction to gambling or drugs

These are junctures of circumstances that permit the occurrence of fraud. Fraud opportunities generally come from: 1) Lack of controls 2) Nature of the transaction

Opportunities to commit fraud that the auditor must consider: 1) Significant related-party transactions 2) Company's industry position 3) Management's inconsistency on assets and accounting estimates 4) Complicating simple transactions through unusual recording processes

5) Complex or difficult to understand transactions 6) Ineffective monitoring of management by the board 7) Complex or unstable organizational structure 8) Weak or nonexistent internal controls

Involves reconciling an unethical act with the common notions of decency and trust How the perpetrator justifies himself of his fraudulent act.

Rationalizing fraudulent financial reporting includes: 1) This is a one-time thing to get us through the current crisis and survive until things get better. 2) Everybody cheats on the financial statement a little, we are just playing the same game. 3) We will be in violation of all our debt covenants unless we find a way to get this debt off the financial statements.

4) We need a higher stock price to acquire company XYZ, or to keep our employees through stock options, and so forth. For Asset misappropriation: 1) Fraud is justified to save a family member or loved one from financial crisis.

2) We will lose everything if we don’t take the money. 3) No help is available from outside. 4) This is “borrowing” and we intend to pay the stolen money back at some point. 5) Something is owed by the company because others are treated better. 6) We simply do not care about the consequences of our actions or of accepted notions of decency and trust, we are out for ourselves.

Enron (2001)

a) Shifting debt to off-balance sheet special entities b) Recognizing revenue on impaired assets by selling them to specialpurpose entities that they controlled c) Engaging in round-tripping trades d) Numerous other related-party transactions

WorldCom (2002) a) Recorded bartered transactions as sales b) Used restructuring reserves established through acquisitions to decrease expenses c) Capitalized line costs rather than expensing them as would have been appropriate

Parmalat (2003) a) Overstated cash and included the false recording of cash ostensibly held at major banks b) Understated debt by entering into complex transactions with off-shore subsidiaries tax-haven places such as countries in Caribbean

HealthSouth (2003) a) Billing group psychiatric sessions as individual sessions b) Using adjusted journal entries to both reduce expenses and enhance revenues

Dell (2005)

a) Misleading investors by miscategorizing large payments from Intel, which essentially bribes to ensure that Dell would not use CPUs manufactured by Intel’s main rival b) Misrepresenting the Intel payments as involving operations, enabling the company to meet its earning targets c) Failing to disclose the true reason for the company’s profitability declines that occurred after Intel refused to continue making payments

Koss Corp. (2009)

a) Intimidation of lower-level employees b)Sole approval for large expenditures made through American Express and other corporate credit cards c) Lack of supervisory review and approval by CEO d) Lack of audit committee oversight e) Lack of an effective internal audit function

Olympus (2011)

a) Concealed large losses related to securities investment for over 2 decades b) Switched audit firms during the period because company management clashed with their external auditor over accounting issues c) Committed fraud which was eventually revealed when the company’s president was fired after discovering and objecting to accounting issues

Longtop Financial Technologies (2011) a) Exaggerated profit margins by shifting staffing expenses to another entity b) Recorded fake cash to cover up fake revenue that had been previously recognized c) Threatened the audit firm personnel and tried to physically retain the audit firm’s workpapers when the auditors uncovered the fraud.

PROFESSIONAL SKEPTICISM -an attitude that includes a questioning mind and critical assessment of audit evidence. -requires an ongoing questioning of whether the information and audit evidence obtained suggests that a material misstatement due to fraud may exist

The 3rd COSO Report -most recent study, published in 2010, companies that were cited by SEC during 1998-2007 for fraudulent financial reporting -the analysis identified major characteristics of companies that had perpetrated fraud

The 3rd COSO Report -also focused on comparing fraud

and nonfraud companies of similar sizes and in similar industries to determine which factors were the best discriminating between the fraud and the nonfraud companies

Major Findings: a) The amount and incidence of fraud remains high. Total amount of fraud was more than $120 billion spread across 300 companies. b) The media size of company perpetrating the fraud rose tenfold to $100 million during 1998-2007. c) Heavy involvement of fraud by the CEO and/or CFO at least one of them named in 89% of the cases.

d) The most common fraud involved revenue recognition-60% of the cases during 1998-2007 compared to 50% in previous periods. e) 1/3 of the companies changed auditors during the latter part of the fraud(with full knowledge of audit committee) compared to less than half that amount of auditor changes taking place with the nonfraud companies.

f) Consistent with previous COSO studies, majority of frauds took place at companies that were listed on the Over-The-Counter (OTC) market rather than those listed in NYSE or NASDAQ. Overall, the 3rd COSO report shows that fraudulent financial reporting remains a very significant problem.

Auditor's Responsibility is present in all audit phases: 1.) Planning Phase 2.) Testing Phase 3.) Completion Phase

PLANNING PHASE Auditor should make inquiries of management about: 1.) Management's assessment of risk due to fraud 2.) Controls established to address such risks and the adequacy of such controls 3.) Any material error or fraud that has affected the entity or suspected fraud that is under investigation 4.) Integrity of management

PLANNING PHASE In adition to inquiries of management, PSA 240 provides additional requirements for auditors to: 1.) Assess the risk of material misstatements due to fraud 2.) Consider those assessments in designing audit procedures to be performed

TESTING PHASE 1.) The auditor should perform procedures (under each doubtful circumstance) he may deem necessary to determine whether misstatements exist 2.) The auditor should classify whether the misstatement is a result of an error or a fraud

TESTING PHASE If the misstatement is a result of fraud but NOT material, the auditor should: 1.) Refer the matter to the appropriate level of management atleast ONE LEVEL ABOVE THOSE INVOLVED 2.) Be satisfied that the fraud has no other implications or those implications have been adequately considered

TESTING PHASE If the misstatement is a result of fraud that is MATERIAL, the auditor should: 1.) Evaluate the reliability of managements representations 2.) Discuss the matter and approach for further investigation with an appropriate level of ONE LEVEL ABOVE those involved 3.) Attempt to obtain factual evidence 4.) Suggest the client consult legal counsel about questions of law

COMPLETION PHASE The auditor should: 1.) Obtain a written representation from the client's management that: a. It acknowledges its responsibility for the implementation of accounting and internal control systems that are designed to prevent fraud and error b. It believes the effects of the FS misstatements are immaterial c. It has disclosed to the auditor all significant facts relating to fraud or suspected fraud

CONSIDER THE EFFECT ON THE AUDITOR'S REPORT

If the auditor believes that material error of fraud exists, he should: 1.) Request the management to revise the financial statements, otherwise, the auditor will express a qualified opinion If the auditor is unable to evaluate the effect of the fraud on the FS due to his limitation of scope, he shall qualify or disclaim his opinion on the FS

CAQ identifies 3 ways in which individuals involved in the financial reporting process can mitigate the risk of fraudulent financial reporting:

1) Need to acknowledge that there needs to exist a strong highly ethical tone at the top of an organization that permeates the corporate culture

2) Need to continually exercise professional skepticism. 3) Need to remember that strong communication among those involved in the financial reporting process is critical.

It is clear that the general public expects that auditors have a responsibility to detect and report on material frauds. CAQ states that the responsibility of detecting error and fraud is not the responsibility of the auditor alone, but the all individuals involved in the financial reporting process

Objective: To combat corporate fraud and protect shareholders' interests  Action Taken: Provided new rules for; 1.) Publicly traded companies 2.) Audit firms 3.) Created the Public Company Oversight Board (PCAOB) 

Rules for companies:

CEO and CFO must certify the truthfulness and accuracy of the FS - They are criminally liable in case of FS misstatements due to fraud  Company must assess the effectiveness of it's internal controls 

Rules for audit firms:     

Implement quality control if the client is a public company A second audit partner, review and approve audit reports Lead partner and reviewing partner must rotate out for every 5 years Must assess the effectiveness of the client's internal controls (Sec. 404) Prohibition of providing non-audit services to audit clients (e.g. consulting and audit for the same client at the same time

Creation of the Public Company Oversight Board (PCAOB)  Regulated

the auditing industry  Eliminated the self-regulating power of audit firms  Responsibilities: Registration Monitoring Standard-setting Enforcement

CORPORATE GOVERNANCE

OWNERS Governance Stakeholders

Management and the board have responsibilities to act within the laws of society and to meet various requirements of creditors and employees and other stakeholders.

Principles of Effective Corporate Governance

The Principles Related to Boards and Management include:

1) 2) 3) 4) 5)

The board’s fundamental objective Successful corporate governance Effective corporate governance Transparency Independence and objectivity

NYSE Mandated certain corporate governance guidelines that registrants must follow: 1) Boards need to consist of a majority of independent directors. 2) Boards need to hold regular executive sessions of independent directors without management present.

3) Boards must have a nominating/corporate governance committee composed entirely of independent directors. 4) The nominating/corporate governance committee must have a written charter that addresses the committee’s purpose and responsibilities and there must be an annual performance evaluation of the committee.

5) Boards must have a compensation committee composed entirely of independent directors. 6) The compensation committee must have a written charter that addresses the committee’s purpose and responsibilities, which must include the responsibility to review and approve corporate goals relevant to CEO compensation, to make recommendations to the Board about nonCEO compensation and incentive based compensation plans,

And to produce a report on executive compensation; there must also be an annual performance evaluation of the committee. 7) Boards must have an audit committee with a minimum of three independent members.

8) The audit committee must have a written charter that addresses the committee’s purpose and responsibilities, and the committee must produce an audit committee report; there must also be an annual performance evaluation of the committee.

9) Companies must adopt and disclose corporate governance guidelines addressing director qualifications standards, director responsibilities, director access to management and independent advisors, director compensation, director continuing education, management succession, and an annual performance evaluation of the Board.

10) Companies must adopt and disclose a code of business conduct and ethics for directors, officers, and employees. 11) Foreign companies must disclose how their corporate governance practices differ from those followed by domestic companies.

12) CEOs must provide an annual certification of compliance with corporate governance standards. 13) Companies must have internal audit function, whether housed internally or outsourced.

Effective governance is important to the conduct of an audit.