In this video, we walk through 5 AUD practice questions teaching about fraud risk factors. These questions are from AUD content area 2 on the AICPA CPA exam blueprints: Assessing Risk and Developing a Planned Response.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Fraud Risk Factors
Fraud in financial reporting and asset misappropriation presents a significant risk to businesses and stakeholders. The likelihood of fraud increases when there is a combination of pressure, opportunity, and rationalization, commonly referred to as the fraud triangle. Auditors must assess these factors to determine the risk of material misstatement and implement appropriate procedures to detect fraud.
Fraudulent Financial Reporting
Fraudulent financial reporting involves intentional misstatements or omissions designed to mislead users of financial statements. This type of fraud is typically committed by management, as they have the ability to manipulate financial data. Common indicators include an overly complex organizational structure, an inability to generate cash flow despite reported earnings growth, and excessive focus on stock price performance.
For example, if a company reports strong revenue growth but consistently struggles with cash flow, auditors should investigate whether revenue is being artificially inflated.
Misappropriation of Assets
Misappropriation of assets, also known as employee fraud, occurs when an individual steals or misuses company resources. This could involve theft of cash, fraudulent expense reimbursements, or unauthorized use of company property.
Auditors should be particularly concerned when there is a lack of independent checks on financial transactions and large amounts of liquid assets that are easily converted to cash. A company with minimal oversight over petty cash or accounts payable may be at higher risk for asset misappropriation.
Pressures and Incentives for Fraud
Pressure or incentive is one of the key drivers of fraudulent behavior. Employees or executives may feel pressure to meet financial targets, secure bonuses, or prevent layoffs.
For instance, a CFO who faces termination if earnings targets are not met may feel compelled to manipulate financial statements. While external business challenges, such as competition, can create financial strain, fraud risk increases when those pressures translate into personal financial consequences for employees.
Opportunity to Commit Fraud
The opportunity to commit fraud arises when internal controls are weak or ineffective. Management has the greatest ability to exploit these weaknesses, especially if they can override controls.
For example, if senior executives have the power to approve and record journal entries without independent review, they have a direct opportunity to manipulate financial reporting. On the other hand, while complex financial transactions may create room for errors, they do not necessarily provide an opportunity for fraud unless controls are lacking.
Rationalization of Fraudulent Behavior
Rationalization allows individuals to justify fraudulent actions. This might include beliefs such as “I’m just helping the company through a tough time” or “I’ll correct this next quarter.”
For example, a long-tenured controller might justify premature revenue recognition by believing the business will recover and no harm will be done. Without this mental justification, even those facing pressure and opportunity might not engage in fraud.
Conclusion
Assessing the pressures, opportunities, and rationalizations for fraud is essential in identifying risks that could lead to material misstatements. By recognizing the red flags—such as management override of controls, high-pressure financial environments, and rationalizations for improper accounting—auditors can take steps to detect and prevent fraud before it significantly impacts financial reporting.
