Case Study 3

Module Overview

Misstatements

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Misstatements in financial statements are the result of either errors or fraud. Errors are unintentional mistakes, while fraud results from an intentional act. The AICPA is concerned with errors or fraud that result in material misstatements in a company’s financial statements (AICPA, 2012). Company management and others in the corporate governance system are primarily responsible for the prevention and detection of fraud as well as creating and maintaining an ethical corporate environment. Auditors must realize that although the risk of fraud can be reduced, it cannot be eliminated. Therefore, auditors must understand the nature of fraud and be aware of potential fraud schemes that are characteristic of the industry for each company they audit. In addition, acts such as collusion make it difficult to detect the existence of fraud.

The Fraud Triangle

Donald Cressey (1952) developed the framework for understanding how fraud occurs, now called the fraud triangle. Three conditions need to be present in order for the fraud to take place: incentive or pressure to commit the fraud, opportunity, and rationalization for the fraud. Without each component of the fraud triangle, fraud could not occur. The AICPA has adopted the theory of the fraud triangle in AU 240, Consideration of Fraud in a Financial Statement Audit. Examples of illustrations of risk factors for each component of the fraud triangle are shown in Exhibit 5.3 of the textbook (Mintz & Morris, 2013). Additionally, AU 240 lists 10 areas auditors can consider to increase the detection of fraud during an audit.

This document also discusses the difficulties of detecting fraud when management overrides the internal controls that are in place or colludes with others to conceal fraud. Revenue recognition is the area that has produced the greatest fraud losses. Because of their position, management is able to manipulate revenue through estimates and allowances.

Internal Controls

The studies performed by the Committee of the Sponsoring Organizations of the Treadway Commission (COSO) and its resulting reports have served as the framework for the development of an effective internal control system. Additionally, its reports have stressed the significance in top management’s role in misleading financial statements, whether in actually perpetrating the fraud or shopping for an audit firm willing to support management’s decisions (Mintz & Morris, 2013).

Understanding the psychological components of fraud as depicted in the fraud triangle and being aware of red flags that may signal fraud can greatly assist auditors and accountants. Auditors have missed many of these fraud indicators in the past. Following audit standards and applying the fraud triangle increases auditors’ ability to evaluate the risk of fraud. Users of financial information rely on auditors’ reports to make decisions, and auditors must keep this responsibility in mind at all times.

References

American Institute of Certified Public Accountants (AICPA). (2012). AU-C Section 240:Consideration of fraud in a financial statement audit. New York, NY: AICPA.

Cressey, D. (1952). Application and verification of the differential association theory. Journal of Criminal Law & Criminology, 43(1), 43–52.

Mintz, S., & Morris, R. (2013). Ethical obligations and decision making in accounting (3rd ed.). New York, NY: McGraw-Hill.

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