Chapter 10 Fraud Auditing

10.1 Learning Objective 10-1

1) Which of the following best defines fraud in a financial statement auditing context?
A) Fraud is an unintentional misstatement of the financial statements.
B) Fraud is an intentional misstatement of the financial statements.
C) Fraud is either an intentional or unintentional misstatement of the financial statements,
depending on materiality.
D) Fraud is either an intentional or unintentional misstatement of the financial statements,
depending on consistency.
2) Companies may intentionally understate earnings when income is high to create ________
that may be used in future years to increase earnings.
A) income smoothing
B) cookie jar reserves
C) cash
D) sales
3) Which of the following is a category of fraud?
A)
Fraudulent financial reporting Misappropriation of assets
Yes Yes

B)
Fraudulent financial reporting Misappropriation of assets
No No

C)
Fraudulent financial reporting Misappropriation of assets
Yes No

D)
Fraudulent financial reporting Misappropriation of assets
No Yes
4) Most cases of fraudulent reporting involve
A) inadequate disclosures.
B) an overstatement of income.
C) an overstatement of liabilities.
D) an overstatement of expenses.

5) ________ is fraud that involves theft of an entity's assets.

A) Fraudulent financial reporting
B) A "cookie jar" reserve
C) Misappropriation of assets
D) Income smoothing

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6) Which of the following is a form of earnings management in which revenues and expenses are
shifted between periods to reduce fluctuations in earnings?
A) fraudulent financial reporting
B) expense smoothing
C) income smoothing
D) Each of the above is correct.

7) Misappropriation of assets is normally perpetrated by

A) members of the board of directors.
B) employees at lower levels of the organization.
C) management of the company.
D) the internal auditors.

8) Fraudulent financial reporting

A) always involves inadequate disclosures.
B) can be intentional or unintentional.
C) can involve understating net income in order to reduce income taxes.
D) all of the above

9) According to the Association of Certified Fraud Examiners, the average company loses
________ percent of its revenues to fraud.
A) one
B) five
C) ten
D) fifteen
10) Which of the following is an accurate statement regarding the misappropriation of assets?
A) In most cases, the amounts involved are material to the financial statements.
B) Misappropriation of assets can easily increase in size over time and can lead to significant
reputational harm.
C) Management should not be concerned about minor misappropriations.
D) Asset misappropriation schemes are less common than fraudulent financial statement
schemes.

11) Define fraud and distinguish between the two main categories of fraud.

True false questions

12) Fraudulent financial reporting is an intentional misstatement or omission of amounts or
disclosures with the intent to deceive users. T

13) The two main categories of fraud are fraudulent financial reporting and misappropriation of
assets. T

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14) "Cookie jar reserves" are often created by companies whenever their earnings are low to
create reserves for future periods when earnings need to be "boosted" upward. F

15) Misappropriation of assets is normally perpetrated at the lowest levels of the organization
hierarchy. T

16) Fraudulent financial reporting usually involves manipulation of amounts rather than
disclosures. T

17) According to the Association of Certified Fraud Examiners, losses from misappropriation
schemes are higher than losses from financial statement frauds. F
10.2 Learning Objective 10-2

1) Which of the following are elements of the fraud triangle?

A)
Attitudes/rationalization Risk Factors Opportunities
Yes No Yes

B)
Attitudes/rationalization Risk Factors Opportunities
No Yes Yes

C)
Attitudes/rationalization Risk Factors Opportunities
Yes No No

D)
Attitudes/rationalization Risk Factors Opportunities
No Yes No

2) Although the financial statements of all companies are potentially subject to manipulation, the
risk is greater for companies that
A) are heavily regulated.
B) have low amounts of debt.
C) have to make significant judgments for accounting estimates.
D) operate in stable economic environments.

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3) Which of the following is not a factor that relates to opportunities to commit fraudulent
financial reporting?
A) lack of controls related to the calculation and approval of accounting estimates
B) ineffective oversight of financial reporting by the board of directors
C) management's set of ethical values
D) high turnover of accounting, internal audit, and information technology staff
4) Fraud is more prevalent in smaller businesses and not-for-profit organizations because it is
more difficult for them to maintain
A) adequate separation of duties.
B) adequate compensation.
C) adequate financial reporting standards.
D) adequate supervisory boards.

6) Which of the following is a factor that relates to attitudes or rationalization to misappropriate

assets?
A) significant accounting estimates involving subjective judgments
B) excessive pressure for management to meet debt repayment requirements
C) a sense of superiority by executives
D) high turnover of accounting, internal audit and information technology staff
7) Which of the following is not a factor that relates to opportunities to misappropriate assets?
A) inadequate internal controls over assets
B) presence of large amounts of cash on hand
C) inappropriate segregation of duties or independent checks on performance
D) adverse relationships between management and employees
8) Which of the following is a factor that relates to incentives/pressures to misappropriate assets?
A) weak internal controls
B) significant personal financial obligations
C) management's practice of making overly aggressive forecasts
D) anger and fear

9) According to a KPMG survey, most fraud perpetrators

A) are over the age of 65.
B) work on the assembly line.
C) have worked for the company for over ten years.
D) are female.

10) In the fraud triangle, fraudulent financial reporting and misappropriation of assets
A) share little in common.
B) share most of the same risk factors.
C) share the same three conditions of the fraud triangle.
D) share most of the same conditions. of the fraud triangle.
11) Which of the following would the auditor be most concerned about regarding a heightened
risk of intentional misstatement?
A) Senior management emphasizes that it is very important to beat analyst estimates of earnings
every reporting period.
B) Senior management emphasizes that budgeted amounts for expenses are to be achieved for
each reporting period or explained in the variance analysis report.
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C) Senior management emphasizes that job rotation is a worthwhile corporate objective.
D) Senior management emphasizes that job evaluations are based on performance.
12) Which of the following is a risk factor related to opportunities and financial statement fraud?
A) ineffective communication of company values
B) promotions inconsistent with expectations
C) significant related-party transactions
D) adverse relationships between management and employees

13) Relating to opportunities, why do most people commit fraud?

A) They need to fund an extravagant lifestyle.
B) They feel a sense of superiority.
C) There are weak internal controls.
D) They need to meet pre-specified business targets.

14) List and briefly describe the three conditions for fraud.
15) List and briefly describe examples of risk factors for each condition of fraud for fraudulent
financial reporting.

True false questions

16) Incentives and opportunities are two conditions that are generally present when financial
statement fraud occurs. T
17) Fraud is more prevalent in large businesses than small businesses and not-for-profit
organizations. F

18) Turnover in accounting personnel can create a rationalization for misstatement. F

19) A lack of controls over payments to vendors can cause revenue fraud. F
20) Ineffective oversight by the board of directors over financial reporting is an example of an
incentives/pressures risk factor. F

21) A common incentive for companies to manipulate financial statements is a decline in the
company's financial prospects. T

22) The pressure to do "whatever it takes" to meet goals is one of the main reasons why financial
statement fraud occurs. T

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23) In the fraud triangle, fraudulent financial reporting and misappropriation of assets share the
same conditions and risk factors. F

10.3 Learning Objective 10-3

1) Which of the following is true statement regarding professional skepticism?

A) Auditors reject most potential clients perceived as lacking honesty and integrity.
B) If the auditor has past experience with a client, they can assume the client is honest.
C) Material frauds occur in most of the audits of financial statements.
D) Professional skepticism is required only during the planning phase.
2) Upon discovering information that indicates a material misstatement due to fraud may have
occurred, auditors should
A) acquire additional evidence as needed.
B) thoroughly probe the issues.
C) consult with other team members.
D) all of the above
3) As part of the brainstorming sessions, auditors are directed to emphasize
A)
How management could perpetrate
and conceal fraudulent financial The audit team's response to
reporting potential fraud risks
Yes Yes

B)
How management could perpetrate
and conceal fraudulent financial The audit team's response to
reporting potential fraud risks
No No

C)
How management could perpetrate
and conceal fraudulent financial The audit team's response to
reporting potential fraud risks
Yes No

D)
How management could perpetrate
and conceal fraudulent financial The audit team's response to
reporting potential fraud risks
No Yes

4) Which of the following questions is the auditor not required to ask company management
when assessing fraud risk?
A) Does management have knowledge of any fraud or suspected fraud within the company?
B) What is the nature of the fraud risks identified by management?
C) Is management using all assets effectively?
D) What internal controls have been implemented to address the fraud risks?
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5) When assessing the risk for fraud, the auditor must be cognizant of the fact that
A) the existence of fraud risk factors means fraud exists.
B) analytical procedures must be performed on revenue accounts.
C) horizontal analysis is not useful in helping to determine unusual financial statement
relationships.
D) the auditor cannot make inquiries about fraud to company personnel who have no financial
statement responsibilities.

6) Which of the following is not a likely source of information to assess fraud risks?
A) communications among audit team members
B) inquiries of management
C) analytical procedures
D) consideration of fraud risks discovered during recent audits of other clients

7) When assessing fraud risk,

A) fraud risk is assessed only at the overall financial statement level.
B) the auditor's assessment of fraud risk should be ongoing throughout the audit.
C) if the auditor concludes that there is a risk of material misstatement due to fraud, auditing
standards require that the risks be treated as pervasive.
D) auditing standards require that the auditor presume there is a risk of fraud in the inventory
account.

8) Discuss the need for maintaining professional skepticism during an audit.

9) Briefly discuss the brainstorming session required by current auditing standards. Be sure to
include a list of ideas that should be addressed in the session.
10) Describe the five sources of information gathered to assess fraud risks.

True false questions

11) In vertical analysis, the account balance is compared to the previous period, and the
percentage change for the period is calculated. F
12)
13) Upon discovering information that indicates a material misstatement due to fraud, the auditor
must assume that the misstatement is an isolated incident.

14) The presence of fraud risk factors increases the likelihood of fraud and may suggest that
fraud is being perpetrated.

15) When the auditor receives inconsistent responses from management and others within the
organization, the auditor should obtain additional audit evidence to resolve the inconsistency.

16) Auditing standards require that the auditor presume that there is a risk of fraud in revenue
recognition.

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17) For significant risks, including fraud risks, the auditor should obtain an understanding of the
internal controls related to the risks.

10.4 Learning Objective 10-4

1) Which of the following is the best reason for management to emphasize fraud prevention and
deterrence?
A) It is often more effective and economical for companies to focus on fraud prevention and
deterrence rather than on fraud detection.
B) Collusion is impossible to detect.
C) The AICPA requires management to implement a fraud prevention program.
D) All of the above are equally valid reasons.

2) Which of the following parties is responsible for implementing internal controls to minimize
the likelihood of fraud?
A) external auditors
B) audit committee members
C) management
D) Committee of Sponsoring Organizations

3) Research indicates that the most effective way to prevent and deter fraud is to
A) implement programs and controls that are based on core values embraced by the company.
B) hire highly ethical employees.
C) communicate expectations to all employees on an annual basis.
D) terminate employees who are suspected of committing fraud.
4) Fraud awareness training should be
A) broad and all-encompassing.
B) extensive and include details for all functional areas.
C) specifically related to the employee's job responsibility.
D) focused on employees understanding the importance of ethics.
5) Which party has the primary responsibility to oversee an organization's financial reporting and
internal control process?
A) the board of directors
B) the audit committee
C) management of the company
D) the financial statement auditors
6) Management is responsible for
A)
Identifying and measuring fraud Taking steps to mitigate identified
risks risks
Yes Yes

B)
Identifying and measuring fraud Taking steps to mitigate identified
risks risks
No No

C)

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 Identifying and measuring fraud Taking steps to mitigate identified
risks risks
Yes No

D)
Identifying and measuring fraud Taking steps to mitigate identified
risks risks
No Yes

7) Which of the following is not one of the elements to prevent, deter, and detect fraud according
to the AICPA?
A) performing analytical procedures
B) culture of honesty and high ethics
C) management's responsibility to evaluate risks of fraud
D) audit committee oversight
8) Who is responsible for setting the "tone at the top"?
A) management
B) PCAOB
C) audit committee
D) SEC

9) An effective code of conduct should contain the company's policies regarding

A) conflicts of interests.
B) kickbacks.
C) gifts and entertainment.
D) all of the above.

10) The "tone at the top" provides a foundation upon which a more detailed code of conduct can
be developed to provide specific guidance for the organization and its employees. Components
of a code of conduct may include sections on 1) general employee conduct, 2) relationships with
clients and suppliers and 3) conflicts of interest. Give a narrative description of what might be
included in each of the above components of a code of conduct.
11) Senior management is responsible for promoting a culture of honesty and ethics. Describe
what that implies for the organization.

True false questions

12) Management and the board of directors are responsible for setting the "tone at the top."

13) If employees have positive feelings about their employers, they are less likely to commit
fraud.

14) Management must recognize that almost any employee is capable of committing a dishonest
act under the right circumstances.

15) Audit committee oversight also serves as a deterrent to fraud by senior management.

10.5 Learning Objective 10-5

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1) As part of designing and performing procedures to address management override of controls,
auditors must perform which of the following procedures?
A)
Examine journal entries for evidence
of possible misstatements due to Review accounting estimates for
fraud biases
Yes Yes

B)
Examine journal entries for evidence
of possible misstatements due to Review accounting estimates for
fraud biases
No No

C)
Examine journal entries for evidence
of possible misstatements due to Review accounting estimates for
fraud biases
Yes No

D)
Examine journal entries for evidence
of possible misstatements due to Review accounting estimates for
fraud biases
No Yes

2) Auditors may identify conditions during fieldwork that change or support a judgment about
the initial assessment of fraud risks. Which of the following is not a condition which should alert
an auditor that the initial assessment should be changed?
A) The subsidiary ledger agrees with the general ledger.
B) discrepancies in the accounting records
C) unusual relationships between the auditor and management
D) missing or conflicting evidence

3) When the auditor identifies risk at the assertion level,

A) the auditor may need to obtain audit evidence that is more reliable and relevant.
B) the auditor may choose to conduct substantive testing during interim periods rather than at the
end of the period.
C) the auditor may decrease the sample size.
D) both a and b

4) Auditors are required to perform certain procedures in every audit to address the risk of
management override of internal controls. What are these procedures?

True false questions

5) Because fraud perpetrators are often knowledgeable about audit procedures, auditors should
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incorporate unpredictability into the audit plan.

6) The auditors should pay careful attention to accounting principles that involve subjective
measurements or complex transactions.

10.6 Learning Objective 10-6

1) Auditing standards specifically require auditors to identify ________ as a fraud risk in most
audits.
A) overstated assets
B) understated liabilities
C) revenue recognition
D) overstated expenses
2) Company management is often under pressure to increase revenue and/or net income. One
approach is to use a "bill and hold" arrangement. This is an example of which of the following?
A) significant accounting estimates
B) fictitious revenue recorded
C) premature revenue recognized
D) alteration of cutoff documents

3) A company is concerned with the theft of cash after the sale has been recorded. One way in
which fraudsters conceal the theft is by a process called "lapping." Which of the following best
describes lapping?
A) reduce the customer's account by recording a sales return
B) write off the customer's account
C) apply the payment from another customer to the customer's account
D) reduce the customer's account by recording a sales allowance
4) Analytical procedures can be very effective in detecting inventory fraud. Which of the
following analytical procedures would not be useful in detecting fraud?
A) gross margin percentage
B) inventory turnover
C) cost of sales percentage
D) accounts receivable turnover

5) When dealing with revenue frauds,

A) the most egregious form of revenue fraud involves premature revenue recognition.
B) premature revenue recognition involves recognizing the revenue after the accounting
standards requirements have been met.
C) premature revenue recognition is the same as cutoff errors.
D) side agreements can modify the terms of the sales transaction and should be analyzed
carefully.
6) Two of the most useful warning signals that can indicate that revenue fraud is occurring are
A) analytical procedures and documentary discrepancies.
B) analytical procedures and misappropriation of assets.
C) documentary discrepancies and vague responses to inquiries.
D) missing audit evidence and vague responses to inquiries.

7) Fictitious revenues
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A) increase accounts receivable turnover.
B) understate the gross margin percentage.
C) lower accounts receivable turnover.
D) have no impact on the gross margin percentage.

8) Which of the following is a correct statement regarding the misappropriation of receipts

involving revenue?
A) One of the easiest frauds to detect is when a sale is not recorded and the cash from the sale is
stolen.
B) If a customer's payment is stolen, regular billing of unpaid accounts can uncover the fraud
unless the fraud perpetrator does something to hide the theft.
C) Misappropriation of cash receipts is generally as material as fraudulent reporting of revenues.
D) Analytical procedures can detect relatively small thefts of sales and related cash receipts.

9) When analyzing accounts for fraud risk,

A) companies will generally attempt to overstate accounts payable and net income.
B) the inventory account is generally not susceptible to fraud since the auditor must verify the
existence of the inventory.
C) payroll is rarely a significant risk for fraudulent financial reporting.
D) fixed assets are rarely stolen because of their large size.
10) When dealing with fraudulent financial reporting risk for accounts payable,
A) companies will generally tend to overstate accounts payable.
B) it is difficult for the auditor to verify if all liabilities have been recorded if prenumbered
receiving reports are used.
C) companies have used fictitious reductions to accounts payable to overstate net income.
D) accounts payable is rarely a significant risk area for fraudulent financial reporting.
11) Which of the following is an accurate statement regarding assets and fraud risk?
A) Companies will often capitalize repairs as fixed assets.
B) Since fixed assets are often large, there is little theft of fixed assets.
C) Intangible assets are recorded at cost and valuation issues therefore are not a fraud risk.
D) Since companies have few fixed assets, there is no need for them to be periodically
inventoried.

12) List the three main types of revenue manipulations employed to commit fraudulent financial
reporting and give an example for each type.

13) The most common fraud in the acquisition and payment cycle is for the perpetrator to issue
payments to fictitious vendors and deposit the cash in fictitious accounts. What procedures could
the company take to prevent this type of fraud?

True false questions

14) When the allowance for doubtful accounts is understated, bad debt expense is understated
and net income is also understated.

15) Fictitious revenue transactions have the same level of documentary evidence as legitimate
transactions.

16) Auditors should rely on original, rather than duplicate, copies of documents.
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17) The two most common areas of fraud in payroll are the creation of fictitious employees and
the overstatement of individual payroll hours.

10.7 Learning Objective 10-7

1) To address heightened risks of fraud, the auditor can do all of the following except
A) use specialists to assist in evaluating the accuracy and reasonableness of management's key
estimates.
B) decrease the amount of substantive tests.
C) use ACL or IDEA to search for fictitious revenue transactions.
D) use EXCEL to perform analytical procedures at the disaggregated level.
2) Which of the following is least likely to uncover fraud?
A) external auditors
B) internal auditors
C) internal controls
D) management
3) Which of the following is not a category of inquiry used by auditors?
A) assessment inquiry
B) declarative inquiry
C) interrogative inquiry
D) informational inquiry

4) ________ inquiry is used to obtain information about facts and details that the auditor does
not have, usually about past or current events or processes.
A) Assessment
B) Declarative
C) Interrogative
D) Informational

5) An auditor uses ________ inquiry to corroborate or contradict prior information.

A) assessment
B) declarative
C) interrogative
D) informational

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6) When the auditor suspects that fraud may be present, auditing standards require the auditor to
A) terminate the engagement with sufficient notice given to the client.
B) issue an adverse opinion or a disclaimer of opinion.
C) obtain additional evidence to determine whether material fraud has occurred.
D) re-issue the engagement letter.

7) With whom should the auditor communicate whenever he or she determines that senior
management fraud may be present, even if the matter might be considered inconsequential?
A) PCAOB
B) audit committee
C) an appropriate level of management that is at least one level above those involved
D) the internal auditors

8) Most frauds are detected by

A) a confession by the fraudster.
B) IT controls.
C) law enforcement.
D) a tip.

9) What types of inquiry techniques might an auditor use when making inquiries of client
personnel? What are the uses of each technique?

True false questions

10) The auditor has a responsibility to notify law enforcement when fraud is suspected.

11) Most frauds are discovered by accident.

12) Interrogative inquiry is often confrontational.

13) Auditors may expand other substantive procedures to address the heightened risks of fraud.

10.8 Learning Objective 10-8

1) Auditing standards require that auditors document

A) specific risks of fraud identified at the financial statement level, but not at the assertion level.
B) all conversations with management.
C) results of the procedures performed to address the risk of management override of controls.
D) all of the above.

2) If auditors determine that there is not a significant risk of material improper revenue
recognition, no documentation of this decision is required.

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