Forensic AccountingBy Mary-Jo Kranacher, CPA/CFF, CFE Chapter 7 Fraud Detection: Red Flags and Targeted Risk Assessment LEARNING OBJECTIVES 7-1 7-2 7-3 7-4 7-5 7-6 7-7 7-8 7-9 7-10 Describe management’s primary responsibilities. Discuss methods used to address management override and collusion. Define the ‘‘expectations gap.’’ Describe the role of the external auditor in the financial reporting process. Explain the concept of materiality. Compare and contrast earnings management and fraud. Recognize red flags for fraud. Identify behavioral red flags. Explain what is meant by an anomaly and give examples of certain types of anomalies. Discuss the components that frame the fraud risk assessment process. True/False Answer: 7-T/F #1. Management must design, implement, and maintain internal controls and financial reporting processes to produce timely financial and nonfinancial information that reflects the underlying economics of the business. T Answer: 7-T/F #2. Management need not develop a methodology to measure their performance since this is done with the released annual financial statements. F Answer: 7-T/F #3. In very few cases will a company fall under the purview of more than one set of regulations or taxing authorities influences. F Answer: 7-T/F #4. Even though independent auditors are “independent,” management is still responsible for cooperation in order for them to complete their work. T Page 1 of 17 ” T Answer: 7-T/F #8. and alleged illegal acts. T Answer: 7-T/F #10. suppliers. customers. F Answer: 7-T/F #7. The company should communicate its expectations and commitment to honest and ethical behavior to vendors. An independent auditor’s “adverse” opinion on financial statements indicates the auditors have completed their work and are concerned with the “going concern” aspects of the audited entity. concerns about the financial reporting process. T Answer: 7-T/F #12. Illegal acts have materiality thresholds and require that auditors pay close attention to their nature and corresponding consequences to the company. “One-time” transactions of large values should be scrutinized to ensure they have an appropriate underlying business rationale because generally such transactions will be fraudulent. A major difference between auditors and fraud examiners is that most auditors match documents to numbers to see whether support exists and is adequate. FASB 2 defines materiality as the “magnitude of an omission or misstatement of accounting information that.Answer: 7-T/F #5. in the light of surrounding circumstances. Most audit committees have the authority to investigate any matters within the scope of their responsibility. F Answer: 7-T/F #6. suspected corruption. contractors. and others who do business with the organization. makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.. T Answer: 7-T/F #11. F Answer: 7-T/F #9. whereas fraud examiners determine whether the documents are real or fraudulent. Earnings management below a threshold value may be judged immaterial. including internal control deficiencies. T Page 2 of 17 . T Answer: 7-T/F #14. as well as between subsidiaries and decentralized divisions. F Multiple Choice 7-M/C #1. F Answer: 7-T/F #17.” F Answer: 7-T/F #18. managers.Answer: 7-T/F #13. The Statement of Auditing Standards (SAS) No 1 states (select the most correct answer): Page 3 of 17 . The first step in the ten-step approach to targeted fraud risk assessment is “Identify the business processes and consider differences in those processes in foreign operations. F Answer: 7-T/F #15. Most of a company’s information systems feed directly into the general ledger and other aspects of the accounting system. F Answer: 7-T/F #16. or monthly. T Answer: 7-T/F #19. Data mining software such as Access. Unusual behaviors such as irritability or the inability to relax are examples of analytical anomalies. A fraudster. F 7-T/F #20. weekly. or IDEA allow a large amount of data to be evaluated quickly for symptoms of fraud and provide evidence of the fraud act or concealment of the fraud. CAATTS (computer-aided auditing tools and techniques) are used primarily to select samples and detect collusion . ACL. Common tipsters for fraud are employees. Electronic storage Answer: of entity financial and nonfinancial records is expensive and access to the information in data warehouses is limited to data mining activities. can easily minimize the amount of information captured concerning his nefarious activities... and outside colleagues who interact with the fraudster daily. aided by the digital age. co-workers. C Answer: 7-M/C #3. and owners’ equity. management must design. an internal controls program to protect entity assets. should verify all journal entries and values associated with consolidations which resulted for work within spreadsheets. In searching for breakdowns of internal controls by collusion and fraud. D. management is responsible for adopting sound accounting principles which will result in accurate and proper financial statements. B. B. All of the choices are correct. C 7-M/C #4. C. C. an accounting system that is in full compliance with U. the fear of detection is usually more than adequate to stop fraud by senior management. Page 4 of 17 .S. D. GAAP accounting principles.A. Overall. D. internal controls and financial reporting processes to produce timely financial and nonfinancial information that reflects the underlying economics of the business. internal and external auditors must design procedures to detect such activity. All of the choices are correct. A Answer: 7-M/C #2. B. C. weekends. liabilities. C. should obtain an understanding of the internal control processes regarding journal entries and other adjustments. and late at night. auditors: A. Answer: management is responsible for adopting sound accounting policies and for establishing and maintaining internal control consistent with management’s assertions embodied in the financial statements. implement. B. management is responsible for all acts of fraud. should check all journal entries made on holidays. management is responsible for adopting sound accounting policies which will result in adequate protection of entrusted assets. D. In a collusive environment: A. should discuss with employees any journal entry which has been made to reduce liabilities or increase owners’ equity. and maintain: A. management is responsible for adopting sound internal control policies which will protect entity assets from reasonable loss and damage. is that: A. D. “unqualified” indicates that there are major problems with the financial statements presented by management. an independent auditor’s responsibility is to provide reasonable assurance that the financial statements are free from material misstatement whether by error or fraud. C. the materiality of the value involved.” B.Answer: D 7-M/C #5. GAAP. As a result of its significant concern with financial statement fraud. and misstated financial statements. D. C. D. Page 5 of 17 . The public perception of independent auditors. B. significant changes in estimating procedures are prohibited. B. corruption. C. Answer: D.S. guidance to overcome the “expectation gap” held by the public. A. The difference between fraud and errors is: A. particularly with regard to asset misappropriation. 1 – Consideration of Fraud in a Financial Statement Audit. audited financial statements are free of estimates and misstatements. “unqualified” indicates that the independent auditors believe the financial statements presented by management are fairly presented. B Answer: 7-M/C #8. the accounting profession responded in 2002 with: A. All of the choices are correct. the concealment of fraud through estimates is hard since all estimates can be directly tied to the individual responsible for them. B. All of the choices are correct. the creation of the Public Company Accounting Oversight Board (PCAOB). SAS No. C. C Answer: 7-M/C #7. “qualified” indicates that the independent auditors believe the financial statements presented by management meet the guidance of U. independent auditors are responsible for fraud detection. Answer: 7-M/C #6. independent auditors have overcome the “expectations gap. B 7-M/C #9. 99 – Consideration of Fraud in a Financial Statement Audit. An auditor’s opinion of: A. A With regard to the review of accounting estimates: prior years’ estimates should be examined for consistency.. SAS No. decrease current period net income. D. As such: A. All of the choices are correct. increase current period net income. C. omission of events. All of the following are correctly stated except: A. the type of account and its related financial statement plays an important role in materiality. Auditors are required to report all fraud to an appropriate level of management. whether it affects owners’ equity or not. the amount of stockholders’ equity is used as a base. D. Answer: 7-M/C #10. A Answer: 7-M/C #12. 99 lists several steps in considering the risk of fraud in a financial statement audit. All of the choices are correct. intentional misapplication of accounting principles that guide the disclosure of financial information. D Page 6 of 17 . may involve “consuming” prior period reserves for current period performance. B. C. B. D Answer: 7-M/C #11. Auditors must determine the types of fraud risks that exist. C. B. alteration of the underlying accounting data. Fraud can be committed by: A. transactions. D. C. Auditors must evaluate the audit evidence throughout the audit and respond to any identified misstatements. B intent of those involved. Materiality is relative. D. Auditors must brainstorm with the key personnel of both the internal and independent audit teams to plan a strategy to detect fraud. B Answer: 7-M/C #13. All of the choices are correct. Earnings management may: A.Answer: B. SAS No. D. net income is more critical than total revenues or total expenses. C. or other significant information in the notes related to the financial statements. materiality threshold values should be increased where management barely qualifies for bonuses and other short-term compensation. B. is the threat of getting caught. external audit committee. internal auditors: Page 7 of 17 . B. retain legal counsel. B. remains the external audit team. B. D. preclude using GAAP compliant alternatives to manage income. were designed to provide some degree of choice to management. president/CEO. and forensic accountants. retain nonauditor accountants. retain other professional advisors as necessary to carry out their duties. B Answer: 7-M/C #17. C Answer: 7-M/C #18. Upon discovering fraud. the internal auditors evaluate: A. is the effectiveness of the SEC and FBI investigators. D. take testimony of employees under oath. D. board of directors and/or the audit committee if one exists. D 7-M/C #19. investigators. D. B. C. All of the choices are correct. D Answer: 7-M/C #16. independent auditors. C. The primary responsibility to oversee management and direct the internal audit and the external auditor with regard to the organization’s internal controls over financial reporting and the company’s internal control processes rests with the: A. C. None of the choices are correct. segment profitability. product line profitability. division profitability. Accounting principles and policies: A.Answer: 7-M/C #14. The main deterrent for fraud in the corporate environment: A. B. C. remains the internal audit team. D. As related to operations. A Answer: 7-M/C #15. are”one-size-fits-all” to ensure comparability between companies. C. Audit committees generally have the right to all of the following except: A. The second step to develop an approach to fraud detection is to: Page 8 of 17 . values. D. and time periods affected. III. C. Both “A” and “C” are correct. D. I. II and III. damage. II. B. Red flags that ultimately point to problems underlying the foundation upon which transactions are recorded. Anomalies are: A. methods. should only continue their investigation if the fraud is in the present or immediately previous period. 7-M/C #22. C. build an understanding of the organization and the environment in which it operates. II.A. The major approaches to fraud detection are through: I. have an obligation to notify management or the board of directors when the incidence of significant fraud has been established to a reasonable degree of certainty. I and III. D. Whistleblowers. C I and II. B 7-M/C #21. The first step to detecting fraud is to: A. Answer: Answer: A. build an internal control system. and recommend possible action. and III. C 7-M/C #20. seek out red flag transactions and possible anomalies. part of the day-to-day operations for most companies. seldom seen in companies with good internal controls and procedures. C. Targeted risk assessment. establish an audit committee and identify its authority. C. B. value. must provide the audit committee and the board of directors with a preliminary written statement detailing the known facts and presenting reasonable suspicions as to perpetrators. B. most often red flags that indicate fraud is present. Answer: Answer: must fully investigate it and determine perpetrator(s). B. D 7-M/C #23. D. All of the choices are correct.4 percent. shows that tips and internal controls are the two largest identifiers for fraudulent activities. A develop an understanding of the control environment. C. D. C Answer: 7-M/C #25. The 2008 biennial ACFE Report to the Nation: A. C. C. there is not supporting evidence of fraud. excessive purchases. explained cash shortages. B. B Answer: 7-M/C #27. transactions too small or too large for normal activity. B. D. the red flags are not associated with financial statement preparation. C. the audit committee is involved in other investigations. excessive debit and credit memos. B. of the frauds are detected by accident. there are many red flags in day-to-day operations that are not fraud indicators. C. Answer: 7-M/C #24. 46. entries made by accounting personnel. shows that frauds detected or exposed by tips and accident total almost 55 percent of the frauds discovered. symptoms of fraud. Some of the analytical anomalies include all of the following except: A. identify the members of internal audit and the audit committee.Answer: A. entries made by members of senior management. B. B. Journal entries of concern include: A. define the authority of the audit committee. D.2 percent. C Answer: 7-M/C #26. Red flags. shows that almost half. B Page 9 of 17 . develop a system of internal controls. routine accrual entries prepared at year-end. shows that fraud exposed by accident has increased in the last two years from 20 percent to approximately 25. often go unnoticed or are not vigorously pursued because: A. D. D. and fraud prosecution. fraud prevention. C. The foundation behind the use of nonfinancial information for fraud detection is that: A. fraud elimination. the observance of an individual living above his income. requires a top down approach. every accounting event has a quantity of units associated with it. When using red flags as a basis for further investigation: A. each fraud has common elements making identification easier. Targeted fraud risk assessment starts with: A. B. puts considerable emphasis on the system of internal controls. Three of the various objectives of an internal control program are: A. All of the choices are correct. and fraud mitigation. fraud detection. D. B Answer: 7-M/C #30. fraud prevention. B. in particular section 404: A. each fraud will have some unique attributes. D. ensures that vendors are paid accurately. C 7-M/C #33. a hotline or anonymous tip. B. fraud deterrence. and fraud detection. Page 10 of 17 . the more data available. skill. D. D. D. C. fraud deterrence. C. C Answer: 7-M/C #29. the discovery of fraudulent documents within a particular department. D Answer: 7-M/C #31.Answer: 7-M/C #28. fraud deterrence. B. C. fraud deterrence. the world revolves around quantities and prices. prenumbered forms function as fraud deterrents. and ability in fraud detection and investigation. red flags prove of very limited value due to their massive number in dayto-day operations. A Answer: 7-M/C #32. Targeted fraud risk assessment is consistent with the PCAOB’s Auditing Standard No. ensures that customers receive accurate and timely invoices. a solid knowledge. The Sarbanes-Oxley Act of 2002. the harder it is to conceal fraud. C. and fraud mitigation. 5 (AS5) which: A. All of the choices are correct. B. or IDEA. 7-SAE #2. and rationalization to align at any time. A requires the audit team to hold a brainstorming session at the beginning of each investigation to determine who has the ability to commit the potential fraud. a continuous process. each of which requires further investigation. and detection cannot be overstated. and fraud detection and identify issues of timing. etc which will enable prosecution. ACL. today. today.B. and internal controls. Information systems: A. usually provide weak evidence trails due to their digital nature. Page 11 of 17 . yesterday. generate small amounts of red flags. requires the audit committee report directly to the independent auditor. fraud deterrence. a targeted approach. opportunity. ethics programs. B Short Answer Essay Answer: 7-SAE #1. C. Answer: D. a results-driven approach. B. requires the board of directors to review the internal controls of the entity when fraud of a material amount is detected. the activity. The key to successful fraud detection and investigation using digital tools and techniques requires: A. C. and tomorrow focused on not allowing the three legs of the fraud triangle – pressure. B. Answer: 7-M/C #34. Fraud deterrence is similar to fraud prevention. rather than focused on internal factors with the fraudster. can be used to reconstruct actual data flow of considerable value to the fraud specialist. Provide at least five examples of typical internal control weaknesses. and tomorrow however. C. C Answer: 7-M/C #35. yesterday. a systems-type approach. as a mechanism for fraud prevention. D. focused on environmental factors such as whistleblower hotlines. the value. Fraud detection is after the fact and requires identification of the fraudster. access to data warehouses and data mining tools such as Access. D. the timing. deterrence. Fraud prevention is a continuous process. Define the terms fraud prevention. and paying employees will seldom generate red flags. 6. (Answers will vary but should generally follow the concept as stated in the text. paying creditors. Explain why and provide examples of how. If one hundred cans of red paint are purchased for five dollars each as initial inventory. Answer: Answer: 7-SAE #3. A warehouse concept with eight part-time employees would be an issue to investigate if the site recorded (8 workers × 40 hours) three hundred and twenty hours worked each weekly pay period. when a customer requests a credit on his account for damaged goods or the warehouse reports merchandise damaged or destroyed in a movement digital systems commonly portray these as abnormal. 9. red flag. for sale at nine dollars each and eight are documented as sold. This additional payment may appear as a red flag. When vendors are paid late or debit memos are issued to vendors additional red flag events may be recorded. Override of existing internal controls. Red flags are considered trouble signs in almost any environment and yet there seem to be many red flags in normal business operations which can reduce their value in finding fraudulent activities. Additionally. Inadequate surprise audits. If ninety-four or ninety are in the physical inventory count extended inventory values of ($5 × 92) four hundred and sixty dollars is not justified and the declaration of sales of ($9 × 8) seventy-two dollars comes under suspicion. Lack of proper authorization. 4. 7-SAE #4.Answer: 1. Explain how this may happen.) Typical internal control weaknesses include: Lack of segregation of duties. third. (Answers will vary but should generally follow the concept as stated in the text. Inadequate accounting system. selling. Lack of independent checks. 10. events. 2. Page 12 of 17 . (Answers may include weaknesses not identified here. 5. 11.) Businesses frequently deal in quantities with extended costs or price for many events.) The normal business events of purchasing. Inadequate whistleblower opportunities and protection. 7. and fourth quarters and four times in the second quarter of a non-leap year. Lack of physical safeguards. payables that are due every thirty days starting on January 1. ninety-two should be remaining. 3. It is said the nonfinancial numbers are powerful tools for the fraud examiner. However. Inadequate employee education (expectations). will be paid three times in the first. Lack of proper documentation and other records. 8. Reactive fraud detection approach. The fraud examiner categorizes schemes in three ways. Fill the 4 gallon bucket up a third time and top off the 9 gallon bucket. Category 2. and/or financial statement fraud) Category 3—Wrongdoing perpetrated by an outside third party against the organization with the principal benefit to the third party (examples include the sales of inferior goods that do not meet contract specifications) Critical Thinking Exercise A scientist has an unlimited water supply and two buckets. one-person. What are the primary responsibilities of management? Management is first and foremost responsible for ensuring that a corporation meets is strategic. Dump the 3 gallons of water from the 4 gallon bucket into the 9 gallon bucket.” More specifically. corruption. processes and procedures necessary to safeguard the resources of the entity and ensure relevant and reliable financial reporting. This leaves 3 gallons in the 4 gallon bucket. these latter obligations require management to design and implement a system of internal controls. 1 states that “Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will. among other things. initiate. Category 1—Wrongdoing perpetrated by an insider acting alone with the principal benefit to the individual (examples include simple. record. authorize. 7-TRQ #2. Text Review Questions Answer: 7-TRQ #1. The 9 gallon bucket now has 7 gallons of water. Dump out the 9 gallon bucket. Category 1. By using nothing but the buckets and water. how is the problem of management override and collusion addressed? Page 13 of 17 . Statement on Auditing Standards (SAS) No.Answer: 7-SAE #5. Fill up the 4 gallon bucket a 4th time and dump all of the 4 gallons into the 9 gallon bucket. Generally. process and report transactions (as well as events and conditions) consistent with management’s assertions embodied in the financial statements. how can she accurately measure seven gallons of water? Answer: Use the 4 gallon bucket to fill the 9 gallon bucket up to the 8 gallon mark. one holds four gallons and the other holds nine gallons. Explain each category. gardenvariety embezzlement schemes) Category 2—Wrongdoing perpetrated by more than one individual acting collusively (possibly with individuals outside the company) with the principal benefit to the individual perpetrators or the organization (examples include sophisticated asset misappropriation. and Category 3. operational and performance objectives. 7-TRQ #5. external confirmations. auditors rely not only on financial assessments. the principal internal control procedures will be centered on detection. makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement. inquiries. they also consider various qualitative factors such as whether they have discovered fraud in prior audits or there are Page 14 of 17 . the auditor must apply judgment related to materiality and that judgment has an impact on the information presented in the financial statements. How is materiality determined? FASB 2 defines materiality as the “magnitude of an omission or misstatement of accounting information that. Further. Thus. When auditors have completed their work. fraud examiners. auditors also rely on high-level analytical procedures as well as interviews. particularly with regard to asset misappropriation. inspections. is that independent auditors are responsible for fraud detection. physical inventories and other audit procedures to determine if the financial statements are free from material misstatement. Since prevention (segregation of duties. The difference between the public’s perception of the auditor’s role and the role that audit professionals actually serve has led to an “expectations gap. internal and external auditors. Auditors do not examine 100% of the recorded transactions. internal controls cannot prevent management override or collusive behavior by and among senior management. corruption and misstated financial statements. an auditor’s responsibility is to provide reasonable assurance that the financial statements are free from material misstatement whether caused by error or fraud. instead. in the light of surrounding circumstances. What is the role of the external auditor in the financial reporting process? The auditor’s role is to attest to the fairness of management’s presentation of the financial information as well as the assertions inherent in the financial statements. 7-TRQ #3. The fear of detection may be an effective deterrence mechanism. Further.” 7-TRQ #4. they report their findings in an audit report. but that does not eliminate the concern that traditionally designed internal control systems centered on prevention will not be effective when management override or collusion is present.Answer: Answer: Answer: Answer: Depending on the individuals involved. However. they rely on sampling a portion of the transactions to determine the probability of whether or not the transactions are recorded properly. and forensic accounting professionals must design procedures to detect such activity. approvals and authorizations) is not possible in a collusive environment.” Thus. What is the “expectations gap”? The perception of the public. signs of management override (by carefully examining journal entries. defensiveness. inability to look people in the eye. 7-TRQ #9. clothing and other material possession of which they could not or should not be able to afford. in fact. been managed. for private gain. behavioral red flags. Answer: Answer: Answer: Answer: 7-TRQ #6. analytical anomalies. confession to a trusted confidant. belligerence. The underlying cause may be guilt or fear but either way. That stress then causes changes in the person’s behavior. Generally. (excessive or starting) smoking and other anxiety-based symptoms. alcohol abuse. Analytical anomalies are transaction or financial statement relationships that do not make sense. irritability. The primary issue is whether the independent auditor or forensic accountant has clear and convincing evidence that demonstrates that earnings have. and unusual transactions). such as: Page 15 of 17 . argumentativeness. stress is created. paranoia. Also. illegal acts have no materiality threshold and require that auditors pay close attention to their nature and corresponding consequences to the company. homes. pointing failure at others (scapegoats). Such changes include insomnia. Managing earnings can be fraud. Is earnings management considered fraud? Earnings management involves deliberate actions by management to meet specific earnings objectives. and those performing the work should use their heightened sense of professional skepticism to be aware of other choices made by management. 7-TRQ #8. 7-TRQ #7. What are the similarities and differences between analytical and accounting anomalies? Anomalies are based on patterns or breaks in patterns. and signs of collusion among the executive ranks. generally. Any sign of deliberate efforts to manage earnings should be considered a red flag. estimates.allegations of illegal acts or fraud. Lifestyle symptoms can be observed through cars. whether or not material. the fear of getting caught and the ramifications associated with that cause the person to exhibit unusual behaviors. There is no perfect advice for auditors and forensic accountants in this regard except that management may find itself on a slippery slope—an earnings management in one period may lead to fraud in the next. drug abuse. What are some red flags that may indicate that fraud is occurring? The red flags that can lead to a formal fraud investigation include tips and complaints. accounting anomalies and internal control irregularities and weaknesses. jewelry. What is meant by behavioral red flags? Behavioral anomalies are exhibited in lifestyles and unusual behaviors. signs of embarrassment. inability to relax. boats. What are the main components of the fraud risk assessment process? An overview of the fraud risk assessment process includes the following components: Page 16 of 17 . a fraud examiner may notice transactions being recorded in odd ways or at odd times during the month. Unexplained cash shortages Unexplained inventory shortages Deviations from specifications Increased scrap Excessive purchases Too many debit memos Too many credit memos Significant unexpected changes in account balances Excessive late charges Unreasonable expenses Unusual expense reimbursements Accounting anomalies are unusual activities that seem to violate normal expectations for the accounting system. Some irregularities in documentation may include: Missing documents Old items being carried on bank and other account reconciliations from one period to the next period Excessive voids or credit memos Common names. addresses or phone numbers of payees or customers Names. For example. addresses or phone numbers that are the same as those of employees Increases in past due accounts receivables Increases in the number and amount of reconciling items Alterations on documents Duplicate payments Second endorsements on checks Breaks in check. invoice. purchase order and other document number sequences Questionable handwriting Photocopied documents Answer: 7-TRQ #10. Evaluate the fraud risk factors Identify possible fraud schemes and scenarios Prioritize individual fraud risks Evaluate mitigating controls for those fraud schemes that are reasonably possible or probable of occurrence and are more than inconsequential or material. Page 17 of 17 .
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