Delve into a Deeper Understanding: Financial Reporting Fraud Risk Statement

The new fraud auditing standards require you to bring a “deeper understanding” of potential fraud schemes into audit planning and execution. The last two months we focused on what this means in when considering asset misappropriation. Over the next few months, we will focus on financial reporting.

What makes financial reporting fraud different than asset misappropriation?

At the most fundamental level, asset misappropriation concerns stolen assets, whereas financial statement reporting focuses on whether the financial statements are presented fairly in conformity with the applicable financial reporting framework. The audit of financial statements must conform to the applicable auditing standards. In this blog, we are discussing the search for intentional efforts to misstate the financial statements.

To build our fraud risk model, we must remember that the fraud risk universe starts with the primary category. The three categories most literature discusses are asset misappropriation, financial reporting and corruption. Within each primary category there is secondary categories, fraud risk statements and the fraud scenarios. The fraud risk statement in each primary category has the same five elements: person committing, entity, action, impact and financial conversion. So, what differs? The importance of each element differs within each primary category. However, what I have learned is that each primary category has unique nuances. Let me illustrate:

In a corruption scheme, the entity is also the person committing the scheme. All corruption schemes involve collusion.

In financial reporting, the action statement has multiple parts, whereas in asset misappropriation schemes, the action statement typically has only one part.

Last month,  we discussed a ghost employee scheme. The action statement had one part: paid for services not performed.

Identifying Financial Reporting Fraud Risk Statements

In creating your fraud risk statement, you must be able to describe the following elements:

1.    Direction of Misstatement: In financial reporting, the misstatement could be an overstatement of an account balance or an understatement of an account balance.  
2.    General ledger account: The general ledger account containing the fraud risk statement. 
3.    Where the transaction is recorded: the fraudulent transaction is recorded in a source journal or a general journal.
4.    The transaction based on a false transaction or a real transaction. A false entity of a real entity
5.    GAAP Consideration: Remember fraud in a financial statement is an intentional error in GAAP. Whether the error is based on the fundamentals of GAAP or a specific FASB or for international IFRS. 

Illustrations of Financial Reporting Fraud Risk Statements

Controller intentionally overstates assets by recording a real operating
expense incurred from a real vendor through the purchase journal as
a capitalized expenditure causing the capitalized advertising expenditures
to be materially misstated.

Or

Controller intentionally overstates assets by recording a real advertising
expense incurred from a real vendor recorded through the purchase journal as
a capitalized expenditure causing the capitalized advertising expenditures
to be materially misstated based on ASC 340-20. ( refers to the U.S. GAAP guidance for Capitalized Advertising Costs)

Next Step, link your risk model to financial statement assertions

In representing that the financial statements are presented fairly in conformity with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding the recognition, measurement, presentation, and disclosure of the various elements of financial statements and related disclosures. Those assertions can be classified into the following categories:

• Existence or occurrence—Assets or liabilities of the company exist at a given date, and recorded transactions have occurred during a given period.
• Completeness—All transactions and accounts that should be presented in the financial statements are so included.
• Valuation or allocation—Asset, liability, equity, revenue, and expense components have been included in the financial statements at appropriate amounts.
• Rights and obligations—The company holds or controls rights to the assets, and liabilities are obligations of the company at a given date.
• Presentation and disclosure—The components of the financial statements are properly classified, described, and disclosed.

When you link the previous fraud risk statement to the financial assertions, you realize that the fraud risk statement allows management to violate the existence and valuation assertion of the financial statements.

Your obligation is to have a “deeper understanding” of how the financial statements can be materially misleading.

Let's assume that capitalized advertising costs are a material account balance on the financial statements. Here is the question you must ask yourself: Do you understand how management can materially misstate capitalized advertising costs and conceal the fact from your audit? Is your audit program designed to detect such a material misstatement? Is your audit team sufficiently aware of how to assess for this type of error? Do you truly have a deeper understanding of the fraud risk?

Fraud Trivia

Topic: Dr. Donald Cressey

1. How many works did he solely publish on criminology?

2. In what year did he coin the phrase “fraud triangle’.

3. Other People's Money: A Study in the Social Psychology of Embezzlement. What year was it published?

4. Dr. Cressy had three occupations; can you name them?
5. What was the focus of much of his writing?

Answers to Last Month's Marathon Trivia

1. In which country & city does the marathon cross two continents? Istanbul, Turkey.
2. What was my son’s place in the 2012 Boston Marathon? 56^th.
3. What is the oldest annual marathon? Boston, started in 1897
4. What is the folklore that started the marathon? The marathon is a celebration of the legendary Greek soldier Pheidippides. He is said to have run over 25 miles from the battle of Marathon to Athens to deliver news of a Greek victory, only to promptly collapse and die.
5. What is the age of the oldest person to run a marathon? At 100 years old, Fauja Singh became the oldest person to run a marathon in 2011, when he completed the Toronto Waterfront Marathon in 8:25:16! And incredibly, at age 3, Budhia Singh became the youngest to complete a marathon.
6. Why is the Marathon 26.2 miles? The 1908 London Olympics was the first time an Olympic marathon was 26.2 miles. The Queen requested a route extension so that her kids could watch the race. It wasn't until 1924 that 26.2 miles became the standard.