Seminar on Fraud Detection

1. Seminar on Fraud Detection Presented by Candice Lau on 25 March 2011 T. K. Lo & Company, CPAs

2. What is Fraud? • Crime of cheating somebody in order to get money or goods illegally (Source: Oxford Dictionary) • Intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage (Adapted from HKSA 240 para11(a)) T. K. Lo & Company, CPAs

3. Types of Fraud Relevant to Auditors • Fraudulent financial reporting, and • Misappropriation ofassets Both result in misstatement of financial statements!!! T. K. Lo & Company, CPAs

4. Fraudulent Financial Reporting • Omission of accounts or disclosures in F/S • Often involves management override of controls • Example: By the effort of management to manage earnings in order to deceive F/S users by influencing their perceptions as to the entity’s performance and profitability T. K. Lo & Company, CPAs

5. Fraudulent Financial Reporting (Continued) • Techniques:  fictitious journal entries  inappropriately adjusting assumptions  omitting, advancing or delaying recognition  concealing, or not disclosing, facts  engaging in complex transactions  Altering records and terms T. K. Lo & Company, CPAs

6. Misappropriation of Assets • Theft of entity’s assets • Often involves employees in small and immaterial amounts • Accomplished by:  embezzling receipts  stealing physical assets or intellectual properties  paying for goods or services not received  using entity’s assets for personal loan T. K. Lo & Company, CPAs

7. Who Commits Fraud? • Suppliers • Competitors • Customers • Officers • Managers • Employees • Directors T. K. Lo & Company, CPAs

8. Fraud News from United States Source: 2010 Report to the Nation on Occupation Fraud & Abuse, Association of Certified Fraud Examiners T. K. Lo & Company, CPAs

9. Elements of Fraud Fraud Triangle Pressure / Incentive Opportunity Rationalization T. K. Lo & Company, CPAs

10. Fraud Triangle - Pressure / Incentive Operating conditions: • High degree of competitions • Decline in customer demand • Operating losses • Negative cash flows • New accounting or statutory requirements T. K. Lo & Company, CPAs

11. Fraud Triangle - Pressure / Incentive (Continued) Meeting expectation of third parties • Profitability level expected by investors, creditors, or management • Obtaining additional debt or equity financing • Debt covenant requirements • Business combinations or contract awards T. K. Lo & Company, CPAs

12. Fraud Triangle - Opportunities • Weak internal control • Poor management oversight • Domination of management without compensating controls • Unduly complex organizational structure • High turnover of employees • Low chance of being caught • Small penalty of being caught T. K. Lo & Company, CPAs

13. Fraud Triangle - Rationalization • Believe that committing fraud is the only solution to problems • Label theft as “borrowing” • Because of job dissatisfaction • Does not understand / care about consequence of the action T. K. Lo & Company, CPAs

14. Red Flags • Something different than expected as to time, frequency, place, amount or personality • Difference may be very small, however, when accumulated, often the essence of a sophisticated fraud scheme T. K. Lo & Company, CPAs

15. Operational / Business Red Flags • Loose internal controls • Poor computer file access & password controls • Unrealistic earning targets • Override of normal controls by management-officers T. K. Lo & Company, CPAs

16. Operational / Business Red Flags (Continued) • Significant or unusual changes in customers or suppliers • Significant related party transactions • Highly complex transactions near year end • Significant bank accounts in tax-havens with no apparent business justification T. K. Lo & Company, CPAs

17. Operational / Business Red Flags (Continued) • Transactions which lack documentation or normal approval • Unusually rapid growth or profitability • Inability to generate cash flow • Poor or deteriorating financial position T. K. Lo & Company, CPAs

18. Red Flags – Inventory & Purchase • Excessive inventory • Large inventory adjustments • Deviation from specifications • Delivery location = employee address • Most contracts awarded to a particular supplier • New supplier with P O Box address T. K. Lo & Company, CPAs

19. Red Flags – Accounts Payable • Invoices are duplicates or copies • Altered or missing supporting documents • Unusual payees • Duplicate payments • Vendor address = employee address T. K. Lo & Company, CPAs

20. Red Flags – Cash Receipts & Receivables • Shortage and overages in cash drawers • Excessive voids or refunds • Slow deposits in transit • Increasing debtors / sales ratio • Bad debts all centered on 1 employee • Sudden loss of customers • Customers complained “ I paid” T. K. Lo & Company, CPAs

21. Red Flags – Payroll • Authorization do not match signatures on file • Supervisors fill out time sheets • Excessive overtime • Employees not present to get cheques • Level of wages inconsistent with level of production T. K. Lo & Company, CPAs

22. HKSA 240 • Hong Kong Standard on Auditing 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements (Issued July 2009; revised July 2010) T. K. Lo & Company, CPAs

23. HKSA 240 - Requires Auditors to: • Maintain attitude of professional skepticism • Discuss the susceptibility • Perform procedures to identify and assess risks of material misstatements due to fraud • Determine overall responses to address to the risks • Design and perform audit procedures response to risks of fraud T. K. Lo & Company, CPAs

24. HKSA 240 - Requires Auditors to:(Continued) • Consider whether identified misstatement is indicative of fraud • Obtain written representations relating to fraud • Communicate with management and those charged with governance • Establish documentation requirements T. K. Lo & Company, CPAs

25. Professional Skepticism • Maintain throughout the audit • Recognizing possibility of existence of material misstatement due to fraud • Notwithstanding past experience with the entity • May accept records and documents as genuine unless indications of contrary • Investigation to inconsistencies T. K. Lo & Company, CPAs

26. Discussion among Engagement Team • Discuss susceptibility of client’s financial statements to material misstatement due to fraud • Engagement partner consider matters to be communicated with team members not involved in discussion T. K. Lo & Company, CPAs

27. Risk Assessment Procedures • Make inquiries of management, those charged with governance, and others as appropriate for understanding management’s attitude towards risk of fraud • Consider whether fraud risk factors present • Consider any unusual or unexpected relationships by analytical procedures • Consider other information T. K. Lo & Company, CPAs

28. Risks of Fraud in Revenue Recognition • Risk greater due to pressures from performance measurement or cash sales • Overstatement of revenue: premature revenue recognition, fictitious revenue • Understatement of revenue: improper shifting revenue to a later period) • Above presumption may be rebutted for cases with single type of simple revenue • If presumption not applicable: state reason (para 47) T. K. Lo & Company, CPAs

29. Overall Responses to Assessed Risks • Increase sensitivity in selection of nature and extent of documentation to be examined in support of material transactions • Increase recognition of need to corroborate management explanations or representations concerning material matters T. K. Lo & Company, CPAs

30. Audit Procedures • At assertion level:  Physical observation or inspection of important assets  Substantive testing at or near period end  Increasing sample sizes or performing analytical procedures at a more detailed level T. K. Lo & Company, CPAs

31. Audit Procedures (Continued) • Responsive to Management Override of Controls:  Test the appropriateness of journal entries made at year end  Review accounting estimates  Understand client’s significant transactions which are outside normal courses of business T. K. Lo & Company, CPAs

32. Audit Procedures (Continued) • Evaluation of audit evidence:  Evaluate whether assessment of risks at assertion level remain appropriate  Perform analytical procedures at or near end of audit  Consider whether identified misstatement may be indicative of fraud T. K. Lo & Company, CPAs

33. Audit Procedures (Continued) • Management representations (written):  Acknowledge responsibilities for design and implementation of internal control to prevent and detect fraud  Disclose to auditors results of assessment of risk F/S may be materially misstated as a result of fraud  Disclose to auditors knowledge of actual, suspected or alleged fraud T. K. Lo & Company, CPAs

34. Communicate with Management • If fraud has been identified • If information indicates fraud may exist • Communicate as soon as possible to appropriate level of management T. K. Lo & Company, CPAs

35. Unable to Continuethe Engagement • Client does not take appropriate action regarding fraud • Results of audit tests indicate significant risk of material and pervasive fraud • Significant concern about competence or integrity of management • Consider professional and legal responsibilities (may obtain legal advice) T. K. Lo & Company, CPAs

36. Documentation • Auditor’s understanding of client and its environment • Auditor’s assessment of risks of material misstatement • Decisions reached during discussion among engagement team • Auditor’s responses to assessed risks • Results of audit procedures • Communications about fraud made to management T. K. Lo & Company, CPAs

37. Reference Materials • Hong Kong Standards on Auditing 200, 230, 240, 260, 315, 330, 450, 540, 580, 610 & 700 • Website of Association of Certified Fraud Examiners: www.acfe.com • T. K. Lo’s Engagement Handbook V9_4 (讚！) • ACCA seminar notes: Technical Seminar on “Forensic Accounting” held on 1 Feb 2010 T. K. Lo & Company, CPAs

38. ~ The End ~ Thank You T. K. Lo & Company, CPAs