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  • Jennifer M Mueller-Phillips
    Evaluating the Intentionality of Identified Misstatements:...
    research summary last edited February 28, 2017 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment 
    Title:
    Evaluating the Intentionality of Identified Misstatements: How Perspective Can Help Auditors in Distinguishing Errors from Fraud
    Practical Implications:

    This study contributes by providing evidence regarding a type of reasoning process that appears to help auditors assess the risk that a misstatement identified during audit fieldwork was caused intentionally. In addition to considering fraud risks at the company level, auditors should also consider fraud risks that are specific to an operating location or individual manager. By considering a client manager’s perspective, auditors presumably gain insight into whether the manager perceived misstating to be personally beneficial and reasonably easy to perpetrate and conceal, assisting in the evaluation of the manager’s intentions. 

    Citation:

    Hamilton, E. L. 2016. Evaluating the Intentionality of Identified Misstatements: How Perspective Can Help Auditors in Distinguishing Errors from Fraud. Auditing: A Journal of Practice and Theory 35 (4): 57 – 78.

    Keywords:
    perspective taking, fraud risk, fraud detection, misstatement, and audit quality.
    Purpose of the Study:

    Although auditors are responsible for detecting misstatements arising from either error or fraud, the auditing standards require very different audit responses when a misstatement is believed to be the result of an intentional act. Specifically, auditors are instructed to perform additional audit procedures, reassess overall fraud risk and the integrity of management, and communicate potential concerns to the audit committee if they suspect intentional misstatement; thus, if the auditors fail to recognize and respond to information indicating a misstatement was caused intentionally, then audit quality may be impaired. The author uses this study to investigate whether auditors who consider the perspective of the manager responsible for a misstatement’s occurrence are more sensitive to circumstances indicating the misstatement was intentional. 

    Design/Method/ Approach:

     The author creates an experiment utilizing auditor participants at the manager level and above with a case describing an identified misstatement that resulted from the actions of a client manager and ask them to assess the likelihood that it was caused intentionally. 

    Findings:
    • The author finds that auditors who considered the client manager’s perspective, compared to those who did not, assessed the misstatement as significantly more likely to be intentional, but only when such increased skepticism was warranted.
    • The author finds that, while auditors who considered manager’s perspective assessed the misstatement’s intentionality higher in the high-fraud-risk condition than in the low-fraud-risk condition, auditors who did not consider the manager’s perspective assessed the misstatement’s intentionality the same regardless of whether the circumstances surrounding the misstatement were indicative of high or low fraud risk.
    • The author finds that auditors who consider management’s perspective respond to the identified misstatement more appropriately. 
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    A Field Survey of Contemporary Brainstorming Practices
    research summary posted February 20, 2017 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.07 SAS No. 99 Brainstorming – process, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.04 Auditors’ Professional Skepticism, 10.0 Engagement Management, 10.03 Interaction among Team Members 
    Title:
    A Field Survey of Contemporary Brainstorming Practices
    Practical Implications:

    Understanding that auditors allocate greater resources to fraud brainstorming when engagement risk is significant fosters brainstorming of a superior caliber corresponds to stronger regulatory compliance.  Auditors report that engagement teams are holding fraud brainstorming sessions earlier in the audit, document more detailed risk assessments, plan more specific procedures, and retain more documentation.  These characteristics contribute to adequately addressing increased PCAOB regulatory scrutiny.  Additionally, brainstorming sessions are highly regarded when they occur in a face-to-face fashion and are attended by multiple levels of firm personnel—whether that is “core” or “non-core” professionals.  Fraud brainstorming sessions are executed less mechanically (as determined by PCAOB inspectors) by using fewer checklists and increase the amount of time auditors prepare for brainstorming sessions.  

    Citation:

    Dennis, S. A., and K. M. Johnstone. 2016. A Field Survey of Contemporary Brainstorming Practices. Accounting Horizons 30 (4): 449–472. 

    Keywords:
    audit planning; engagement risk; field survey; fraud brainstorming; professional skepticism
    Purpose of the Study:

    The purpose of this study is to further understand current fraud brainstorming practices minding regulatory climate and its impression of brainstorming practices.  The authors seek to understand the auditing profession’s existing framework to effectively brainstorm by evaluating audit team characteristics; attendance and communication; structure, timing, effort; and brainstorming quality.  Fraud brainstorming environment is considered with respect to client characteristics; particularly, inherent, fraud, and engagement risks, and if the client is publicly traded or privately held.  The authors refer to the characteristics as “partitions”.  The partitions allow the study to better examine how each characteristic effects the deployment of resources in response to risk levels and trading status. 

                The study poses further exploration into the implementation of Statement of Auditing Standards No. 99 and its effect on fraud brainstorming practices.  Particularly addressing the Public Company Accounting Oversight Board’s report suggesting auditing professionals were “mechanically” addressing fraud-related auditing standards.  SAS 99 sought to blend experienced audit professionals—those with greater client experience—with less-seasoned auditors to brainstorm how a fraud could occur specific to the client.  As part of the brainstorming framework, the study seeks to understand if senior-level auditors (partners and managers) and seniors and staff members, along with “non-core” professionals, cultivate meaningful brainstorming sessions. 

    Design/Method/ Approach:

    The authors collected field data from audits conducted between March 2013 and January 2014, per a survey of 77 audit engagements.  Information pertaining to the client, audit team, and brainstorming sessions were called upon in the survey.  The majority (93 percent) of observations were obtained by two Big 4 firms—7 percent from one non-Big 4 global firm.  Each engagement’s partner received instructions for the distribution of the survey to lead managers and lead seniors on the respective engagement while the partner withheld that the survey was for research purposes.  A total of 75 managers and 73 seniors participated.  

    Findings:
    • Surveyed auditors rarely interacted with engagements where fraud in financial reporting was identified.
    • When fraud risk and inherent risk are both elevated for a particular engagement, perceived professional skepticism is also elevated.
    • Risk-based resource deployment is consistent when considering high- versus low-risk clients—particularly, when inherent risk is elevated, audit team size is also greater.
    • Public clients cultivate larger audit teams where managers and seniors have more client experience.
    • With respect to contributions made at brainstorming sessions, the audit partner and manager make the greatest contributions along with forensic specialists and audit seniors.  Interestingly, when fraud brainstorming is more important with respect to the engagement, seniors make lower relative contributions. 
    • Media richness theory is robustly at work with respect to attendance patterns at brainstorming sessions.  Specifically, when engagement risk is elevated, staff and seniors are more likely to attend face-to-face. 
    • Fraud brainstorming sessions are most commonly open-discussion (86 percent) where the session is held during the planning stage of the engagement (87 percent).
    • Results propose that audit partners are open-minded to suggestions made during fraud brainstorming.
    • Fraud risk assessments appear to be independent from brainstorming tactics; however, when inherent risk is elevated and if the client is public versus private, audit teams exert more effort.  
    Category:
    Auditing Procedures - Nature - Timing and Extent, Engagement Management, Risk & Risk Management - Including Fraud Risk, Standard Setting
    Sub-category:
    Auditors’ Professional Skepticism, Changes in Audit Standards, Fraud Risk Assessment, Interaction among Team Members, SAS No. 99 Brainstorming – process
  • Jennifer M Mueller-Phillips
    Broadening the Fraud Triangle: Instrumental Climate and...
    research summary posted November 15, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.02 Fraud Risk Models 
    Title:
    Broadening the Fraud Triangle: Instrumental Climate and Fraud
    Practical Implications:

    This paper incorporates important organizational theory into the fraud literature by reporting the presence of an instrumental climate when fraud is being perpetrated within an organization. Internal auditors and those charged with governance could adapt this climate measure as a red flag for potential fraud. 

    Citation:

    Murphy, P. R. and C. Free. 2016. Broadening the Fraud Triangle: Instrumental Climate and Fraud. Behavioral Research in Accounting 28 (1): 41-56.

    Keywords:
    organizational climate, instrumental climate, fraud, fraud triangle, rationalization
    Purpose of the Study:

    Many papers focus on investigating organizations in which management’s tone exemplifies high ethical standards, combined with a climate that support and encourages ethical behavior in an effort to examine if this organization is less vulnerable to fraud. However, this paper takes a different approach. It examines the “flip side” of organizations, those that are associated with fraud instead of those associated with preventing fraud. By doing this, the authors also hope to delve into the effectiveness of the fraud triangle. For years, the fraud triangle has been the dominant fraud framework but recently it has been called into question for its narrow interpretation and lack of comprehensiveness. Thus, the goal of this research is not only to identify an organizational climate that exists in the presence of fraud but also to broaden the interpretation of the fraud triangle by explicitly identifying fraud triangle elements related to such a climate. 

    Design/Method/ Approach:

    The authors created and administered a survey to three groups of individuals having fraud experience: (1) prisoners who are incarcerated for committing fraud within an organization, (2) individuals who audited or investigated fraud within an organization, and (3) individuals who witnessed fraud within their organization. 

    Findings:
    • The authors find that 39 percent of the respondents agreed or strongly agreed that an instrumental climate was present when fraud occurred within the organization.
    • The authors find that an instrumental climate is significantly associated with a malevolent work environment and social incentives and pressures.
    • The authors find that the use of externally oriented rationalizations are very common with instrumental climates, especially the claim of helping the company.
    • The authors find that an instrumental climate is not associated with conventional attitude variables (prior history of white-collar crime, character, ethical values of the perpetrator), internally oriented rationalizations (minimizing or ignoring the consequences of the fraud, or entitlement) or individual greed or need. 
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Fraud Risk Models
  • Jennifer M Mueller-Phillips
    Auditing Related Party Transactions: A Literature Overview...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 13.0 Governance 
    Title:
    Auditing Related Party Transactions: A Literature Overview and Research Synthesis.
    Practical Implications:

    In this paper, the authors link academic research and other pertinent literature to issues raised in the PCAOB briefing paper on auditing related party transactions. Overall, the authors believe that the findings in academic research and the significance of related party transactions in recent prominent fraud cases are consistent with the PCAOB’s reconsideration of auditing of related party transactions.

    Citation:

    Gordon, E. A., E. Henry, T. J. Louwers, and B. J. Reed. 2007. Auditing Related Party Transactions: A Literature Overview and Research Synthesis. Accounting Horizons 21 (1): 81-102.

    Keywords:
    related party transactions, arm’s length transactions, corporate governance, financial disclosure
    Purpose of the Study:

    Related party transactions are difficult to audit for a number of reasons.  

    • Related parties and transactions warranting examination may be difficult to identify.
    • Auditors must rely on management to provide detailed information on related parties and related party transactions.
    • Despite the increased internal control requirements imposed by the Sarbanes-Oxley Act of 2002, internal controls have difficulty tracking related party transactions. This difficulty arises because of the wide variety of parties and types of transactions and because some transactions may not be given accounting recognition, e.g., receipt of free services from a related party.

    The authors examine research relevant to auditing related party transactions to contribute to the PCAOB project on this topic and to provide other policy makers, auditors, and academics with an overview of relevant literature. Specifically, they report on the challenges associated with the identification, examination, and disclosure of related party transactions. Additionally, they address issues and research evidence related to nondisclosure and reliance on management assertions, risk assessment, materiality, fraud detection, the effect of related party transactions on corporate governance, and international auditing issues.

    Design/Method/ Approach:

    To prepare PCAOB Standing Advisory Group (SAG) members for discussion of these issues, the PCAOB staff prepared a briefing paper posing 13 broad questions for consideration by the SAG. The authors contribute to the PCAOB project by reviewing pertinent literature and providing appropriate insights from academic research relevant to auditing related party transactions. They highlight instances where existing research addresses the questions raised in the briefing paper. 

    Findings:

    The primary conclusions from the literature review are:

    • The definition of related parties varies across regulatory bodies.
    • Related party transaction disclosures are present in the Securities and Exchange Commission (SEC) filings of most publicly held companies.
    • While listed as a fraud risk factor in authoritative literature, related party transactions do not appear to be more common in companies committing fraud than in companies in which no fraud has been detected. Accordingly, but in opposition to authoritative guidance, survey research indicates that the presence of related party transactions alone does not appear to significantly increase external auditors’ client risk assessments.
    • Although related party transactions in isolation may not be a significant indicator of fraud, when fraud does exist, the presence of related party transactions is one of the top reasons cited for audit failures. The willingness of auditors to tolerate greater misstatement in footnotes may help partially explain this apparent contradiction.
    • Related party transactions should be assessed in the context of the company’s overall governance structure, particularly given the importance of managements’ assertions about the existence and nature of these transactions.
    • Related party transactions often impact the corporate governance of the company by creating gray directors, i.e., directors who are neither insiders nor totally independent of the company. Whether gray directors differentially impact a board’s monitoring effectiveness may depend on the specific board committee (audit, compensation) or may depend on the specific type of gray director.
    Category:
    Governance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Financial Statement Fraud: Insights from the Academic...
    research summary posted March 31, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment 
    Title:
    Financial Statement Fraud: Insights from the Academic Literature.
    Practical Implications:

    The research summarized above will provide valuable input to the accounting profession and standard-setters, and there are several areas in which additional research is needed. Despite existing auditing standards and authoritative guidance on an auditor’s responsibility for discovering and reporting financial statement fraud, there remains an expectation gap between what investors believe the auditor’s responsibility should be in detecting financial fraud and what auditors are willing to assume as responsibility in this area.

    Citation:

    Hogan, C. E., Z. Rezaee, J. A. Riley, and U. K. Velury. 2008. Financial Statement Fraud: Insights from the Academic Literature. Auditing: A Journal of Practice & Theory 27 (2): 231-252.

    Keywords:
    audit planning, audit procedures, financial statement fraud, fraud detection, fraud triangle, high-risk audit areas
    Purpose of the Study:

    Over the past several decades, a significant amount of academic research has been focused on fraud in general and financial statement fraud in particular. These studies address the trends, determinants, and consequences of financial fraud, as well as the responsibility for preventing, detecting, and remediating that fraud. To facilitate the development of auditing standards and to inform regulators of insights from the academic auditing literature, the Auditing Section of the American Accounting Association (AAA) has decided to develop a series of literature syntheses for the Public Company Accounting Oversight Board (PCAOB). The authors summarize relevant academic research findings and to offer insights and conclusions relevant to academics, standard setters, and practitioners. They discuss the characteristics of firms committing financial statement fraud, as identified in the literature, and research related to the fraud triangle. The authors then discuss research related to the procedures and abilities of auditors to detect fraud, and how fraud risk assessments impact audit planning and testing. In addition, they discuss several “high risk” areas and other issues as identified by the PCAOB. 

    Design/Method/ Approach:

    Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement Audit, states that three conditions are generally present when fraud occurs. These conditions collectively are known as the fraud triangle. The authors reviewed the academic findings related to the presence of these conditions in cases of financial statement fraud. This helps provide a basis for understanding the development of the questionnaires and checklists in SAS No. 82 and SAS No. 99.

    Findings:

    The primary conclusions from the review of the literature on fraudulent financial reporting are as follows.

    • There is a significant amount of literature on the characteristics of fraud firms, providing support for the fraud triangle classifications and the list of “red flags” used in both SAS No. 82 and SAS No. 99.
    • Evidence on the usefulness of checklists as a fraud detection tool is mixed. While there is some research that supports the use of checklists as a decision tool, there is more evidence that suggests the use of checklists is dysfunctional in that auditors fail to expand their thinking beyond the checklist.
    • Research supports a need by auditors to align management incentives to the types of risks that should be evaluated as high.
    • There is evidence that suggests auditors do not make significant adjustments to audit plans as a result of higher fraud risk assessments.
    • Research supports further exploration into the use of additional fraud detection tools such as regression analysis, the use of nonfinancial information, digital analysis, and neural network models.
    • Research supports the identification of revenue recognition, significant or unusual accruals, and related parties as areas with increased risk of fraudulent financial reporting activity.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    An Examination of the Effects of Managerial Procedural...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 14.0 Corporate Matters, 14.02 Corporate Whistle Blowers 
    Title:
    An Examination of the Effects of Managerial Procedural Safeguards, Managerial Likeability, and Type of Fraudulent Act on Intentions to Report Fraud to a Manager.
    Practical Implications:

    This study provides evidence that whistleblowers take report recipient individual differences (i.e., managerial likeability) into account when making reporting decisions. In addition, this is despite that fact that, eventually, the investigation and resolution will involve multiple organizational members. Further, the results highlight the benefits of managerial likeability: employees have higher reporting intentions when faced with a likeable manager than one who is unlikeable.

    Secondly, this study finds that employees have higher reporting intentions when the fraud involves misappropriation of assets as opposed to fraudulent financial reporting, possibly because employees see fraudulent financial reporting as benefiting the organization as a whole, while misappropriation of assets benefits a single employee to the detriment of the organization.

    Finally, the authors suggest that findings indicating that the strength of managerial procedural safeguards to not influence reporting intent could be a result of poor manipulations and need to be further investigated.

    Citation:

    Kaplan, S. E., K. R. Pope, and J. A. Samuels. 2015. An Examination of the Effects of Managerial Procedural Safeguards, Managerial Likeability, and Type of Fraudulent Act on Intentions to Report Fraud to a Manager. Behavioral Research in Accounting 27 (2): 77-94.

    Keywords:
    managerial procedural safeguards, managerial likeability, fraud, reporting intentions
    Purpose of the Study:

    Because only a fraction of employees who discover fraud actually report it, the authors endeavor to obtain a better understanding of factors influencing individuals' intentions to report fraud, particularly to a non-anonymous recipient such as a manager (as opposed to an anonymous recipient, such as a hotline). The authors predict that reporting intentions to a manager will be influenced by 3 factors:

    • Attributes of the firm (i.e., strong managerial procedural safeguards will result in stronger reporting intentions than will weak managerial procedural safeguards)
    • Report recipient (i.e., a likeable manager will result in stronger reporting intentions than will an unlikeable manager)  
    • Type of fraud (i.e., managers are more likely to report misappropriation of assets than fraudulent financial reporting)

    Results indicate that managerial likeability and the type of fraud, but not managerial procedural safeguards or the interaction with managerial likeability, significantly influence reporting intentions to a manager.

    The authors contend that participants are influenced by managerial likeability because it provides specific information about the manager and acts as a signal about how the manager will likely handle a fraud report. In addition, these results suggest that participants make stronger attributions to a person engaging in misappropriation of assets compared to a person engaging in fraudulent financial reporting.

    Design/Method/ Approach:

    The authors execute a 2 x 2 x 2 between-subjects experiment, engaging 171 professional accountants and managers and randomly assigning each to one of eight experimental conditions. Participants had an average of over 26 years of work experience and almost half (47.5%) reported having had discovered a person of greater authority than themselves engaging in questionable or wrongful behavior. Participants were presented with a scenario in which an employee identifies an apparent fraudulent act by his immediate supervisor and asked about their intentions to report the fraud to a manager.

    Findings:
    • Attributes of the firm: Findings do not indicate that variances in managerial procedural safeguards (strong or weak) impact participant intention to report a fraud.
    • Report recipient: Findings indicate that reporting intentions were significantly higher when the manager was described as likeable (as opposed to unlikeable).
      • The authors suggest that this is because likeable managers are perceived as being more approachable, and will be expected to perform well as a recipient of a fraud report.
    • Type of fraud: Findings indicate that participants have significantly higher reporting intentions when the fraud involves a misappropriation of assets (i.e., employees taking company assets) versus when the fraud involved fraudulent financial reporting (i.e., misreporting financial results or financial position).
      • This, the authors posit, is because misappropriation of assets is seen as benefiting the employee only at the expense of the company and its shareholders, while fraudulent financial reporting might be seen as benefiting the company.
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Corporate Whistle Blowers, Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Accounting Variables, Deception, and a Bag of Words:...
    research summary posted October 20, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.02 Fraud Risk Models 
    Title:
    Accounting Variables, Deception, and a Bag of Words: Assessing the Tools of Fraud Detection.
    Practical Implications:

    This paper presents a fraud-detection tool developed based on textual analysis of the MD&A sections in public companies’ annual and quarterly reports. This tool correctly classifies reports into truthful and fraudulent more than 82% of the time. Compared with other fraud-detection approaches documented in prior literature, this tool has the highest predictive power for both annual reports and quarterly reports. Using the tool to analyze a sequence of reports of a company further increases the accuracy of predictions. This paper provides insights for regulators and practitioners in designing fraud-detection tools. As the tool is “trained” using the AAER database, one limitation is the tool may not detect fraudulent reports if the SEC fails to discover certain types of frauds and/or has bias in selecting firms to investigate.     

    Citation:

    Purda, L. and D. Skillicorn. 2015. Accounting Variables, Deception, and a Bag of Words: Assessing the Tools of Fraud Detection. Contemporary Accounting Research 32 (3): 11931223.

    Keywords:
    corporate fraud, financial disclosure, textual analysis
    Purpose of the Study:

    There are many tools developed by academia, audit firms and regulators to detect accounting frauds in the U.S. This paper is to demonstrate that the changes in writing and presentation style in the management discussion and analysis (MD&A) section as captured by a data-generated language tool has high predictive power over frauds. Another purpose of this study is to compare the effectiveness of various fraud-detection tools, including the financial, language-based, and nonfinancial fraud-detection tools, and to analyze the correlations among them. The findings will help investors, regulators and practitioners to select effective tools and use the tools in optimal ways.

    Design/Method/ Approach:

    The authors adopt a bag of word methodology to develop the fraud-detection tool. In contrast to other language-based tools developed through the same methodology, this tool does not use a list of ex-ante identified predictive words. Rather, the authors use data to generate a bag of words. First, the authors extract a sample of annual and quarterly reports for the period from 1999 to 2006 from the EDGAR database. Second, they use the SEC’s AAER bulletins to identify which reports are fraudulent. The truthful and fraudulent reports comprise a database which is used to “train” the tool to identify the subtle relationships between words in the MD&A sections and the fraudulent reports. Third, the authors use the decision tree approach to create a list of top 200 words ranked by their abilities to identify fraudulent reports. Based on the list, they build a model to calculate the probability of truthful reporting for each report.

    Findings:
    • The Receiver Operating Characteristic (ROC) area is a statistic number range from 0 to 1 and is used to assess the overall ability of a model to correctly differentiate truth from false. The ROC area of this tool is 0.89, which is significantly higher than the 0.5 benchmark and is also higher than the ROC areas of alternative fraud-detection tools.  
    • The F-score from Dechow et al. (2011) is the second best fraud-detection tool in terms of the ROC area. The authors find the F-score, a financial-based tool, can be used as complements to their language-based tool.
    • The authors find their tool has an advantage to predict fraudulent interim reports. Through time-series analysis, the authors find a decline in probability of truthful reporting in the two quarters preceding the fraud. They also find including the change in probability significantly increase the predictive power of the model.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Fraud Risk Models
  • Jennifer M Mueller-Phillips
    Effects of Decomposition and Categorization on Fraud-Risk...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment 
    Title:
    Effects of Decomposition and Categorization on Fraud-Risk Assessments.
    Practical Implications:

    The results of the experiment show that auditors who decompose fraud assessments make overall and component fraud-risk assessments that are more appropriate in response to changes in opportunity and incentive cues than auditors who only categorize fraud-risk factors. This study also adds to the body of research that examined the linkage between judgment and decision; more specifically, in fraud judgment. The results of the experiment show that auditors who assess fraud with decomposition perceive a higher (or lower) need to revise audit plans and to increase (or decrease) the extent of testing than auditors who make categorical judgments prior to an overall assessment, in response to increase (or decrease) in fraud risk.

    Citation:

    Favere-Marchesi, M. 2013. Effects of Decomposition and Categorization on Fraud-Risk Assessments. Auditing: A Journal of Practice & Theory 32 (4): 201-219.

    Keywords:
    categorization, decomposition, fraud-risk assessments
    Purpose of the Study:

    Risk assessment is a fundamental part of the audit process. Public Company Accounting Oversight Board (PCAOB) standards highlight auditors’ responsibilities for considering the risk of fraud as a central part of this process. The current auditing standards categorize fraud factors along three dimensions: management’s attitude or character, opportunities, and incentives. Regulators, practitioners, and researchers have all expressed concerns that auditors rely heavily on their perception of management’s attitude when this perception suggests low fraud risk, not realizing the difficulty of accurately perceiving management’s attitude or not understanding the unreliable nature of such perceptions. The potential drawback is that when auditors perceive management’s attitude as indicative of low fraud risk, they may overlook incentive and/or opportunity risks indicative of high fraud risk in overall fraud-risk assessments.

    This study examines two issues related to the decomposition of fraud-risk assessments. First, it investigates whether there is a significant difference in the fraud-risk assessment of auditors who decompose the fraud judgment from that of auditors who merely categorize fraud-risk factors. Second, it examines whether the perceived need to modify the audit plan and the extent of testing in response to the fraud-risk assessment is significantly influenced by the decomposition of the fraud judgment.

    Design/Method/ Approach:

    A total of 60 managers from two of the Big 4 accounting firms in offices throughout Canada and the United States participated in this study. Managers were split evenly over the firms and, on average, had 8.4 years (standard deviation 2.2) of audit experience. The case, using modified WZ materials, was designed to simulate what audit managers review during the planning phase of an audit when assessing fraud risk. The evidence was gathered prior to June 2011.

    Findings:

    The results of this study indicate that auditors who decompose fraud-risk judgments have significantly different fraud-risk assessments than those of auditors who simply categorize fraud cues. When management’s attitude cues are indicative of a low fraud risk, decomposition auditors are significantly more sensitive to changes in incentive and opportunity cues than categorization auditors. Further, auditors who decompose fraud-risk assessments perceive a significantly higher need to revise audit plans and to increase the extent of audit testing.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment
  • Jennifer M Mueller-Phillips
    Fraud dynamics and controls in organizations.
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 06.02 Fraud Risk Models, 06.04 Management Integrity 
    Title:
    Fraud dynamics and controls in organizations.
    Practical Implications:

    The findings have important implications for auditors and other individuals responsible for assessing fraud risk and detecting and preventing fraud. First, for certain types of organizations aggregate fraud levels can vary tremendously over time. Furthermore, the effectiveness of mechanisms to prevent and detect fraud can be contingent on the type of organization and related individual susceptibilities to social influence. Therefore, it may be inappropriate for auditors to evaluate fraud prevention and detection mechanisms in a uniform manner. The results suggest that the same fraud prevention and detection mechanisms implemented in a similar manner in two different organizations cannot be expected to be equally effective without considering the average susceptibilities to social influence of the individuals therein.

    Citation:

    Davis, J. S., and H. L. Pesch. 2013. Fraud dynamics and controls in organizations. Accounting, Organizations & Society 38 (6/7): 469-483.

    Keywords:
    fraud, fraud dynamics, impact of fraud in organizations, fraud risk assessment, management integrity
    Purpose of the Study:

    Fraud has become a popular area of inquiry among accounting academics because of the magnitude of losses (estimated by the Association of Certified Fraud Examiners in 2010 to be US$2.9 trillion worldwide) and requirements imposed on auditors to explicitly address the problem. To date, very little work has attempted to explicitly link individual behaviors in the organization to organizational outcomes within the fraud context. Understanding the individualorganization link is important because a focus on either individual behavior or the organization in isolation turns a blind eye to the social process through which individuals’ behaviors are influenced by the organization as a whole and vice versa. In other words, a narrow focus on individual behaviors or on the organization ignores the organization’s sociology, which can have profound effects on fraud outcomes and the efficacy of fraud prevention mechanisms.

    The authors develop a model of fraud in organizations that allows an evaluation of the relative efficacy of mechanisms designed to prevent fraud while explicitly recognizing the social processes underlying the formation of organizational norms. To develop the model, the authors use a method that is relatively new in accounting research: agent-based modeling (ABM). Designed to study the emergence of macro-level phenomena from micro-level interactions, ABM is well suited to address questions involving organizational outcomes (e.g., a culture of fraud) resulting from the interactions between individuals within an organization and organizational variables. The use of ABM allows the authors to gain insights into fraud even when data in organizations are censored.

    Design/Method/ Approach:

    The authors develop an agent-based model to examine the emergent dynamic characteristics of fraud in organizations. In the model, individual heterogeneous agents, each of whom can have motive and opportunity to commit fraud and a pro-fraud attitude, interact with each other. This interaction provides a mechanism for cultural transmission through which attitudes regarding fraud can spread.

    Findings:
    • When average susceptibility is low, the number of fraudsters in the organization tends toward a specific level and remains relatively stable over time.
    • When average susceptibility is moderate to high the authors observe a very different pattern in which the number of fraudsters in the organization vacillates over time between extremes; either virtually no one in the organization is a fraudster or virtually everyone is.
    • The impact of mechanisms to prevent fraud is contingent on average susceptibility to social influence within the organization.
    • A reduction in perceived opportunity or the introduction of influential, honest managers (tone at the top) reduces the number of fraudsters, but neither change to their model is effective in eliminating outbreaks of fraud when susceptibility is moderate or high.
    • Allowing honest employees to be more influential than fraudsters has no qualitative effect when susceptibility is low; however, it transforms behavior when average susceptibility is moderate to high, reducing the number of fraudsters to near zero and eliminating fraud outbreaks.
    • Efforts to remove fraudsters can effectively reduce the number of fraudsters to near zero regardless of the level of susceptibility, but such efforts do not eliminate fraud outbreaks when susceptibility is moderate to high.
    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Fraud Risk Assessment, Fraud Risk Models, Management Integrity
  • Jennifer M Mueller-Phillips
    Are Fraud Specialists Relatively More Effective than...
    research summary posted July 22, 2015 by Jennifer M Mueller-Phillips, tagged 05.0 Audit Team Composition, 05.01 Use of Specialists e.g., financial instruments, actuaries, valuation, 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 10.0 Engagement Management, 10.01 Budgeting and Audit Time Management 
    Title:
    Are Fraud Specialists Relatively More Effective than Auditors at Modifying Audit Programs in the Presence of Fraud Risk?
    Practical Implications:

    Although both auditors and fraud specialists added non-standard procedures to the audit program, auditors cut the budgets for some standard procedures, making room in the overall audit budget for non-standard additional procedures. In contrast, fraud specialists added standard procedures, but they were not more effective than those selected by auditors, and also provided less budget room for those procedures. The involvement of fraud specialists in planning an audit engagement where fraud risk is present is likely to lead to additional audit effort and cost, possibly without commensurate benefit. However, considering the potential consequences to the auditor of undiscovered fraud, it may be cost-effective to include additional non-standard procedures in an audit program if they improve the probability of discovering a fraud.

    Citation:

    Boritz, J. E., Kochetova-Kozloski, N., & Robinson, L. 2015. Are Fraud Specialists Relatively More Effective than Auditors at Modifying Audit Programs in the Presence of Fraud Risk? Accounting Review 90 (3): 881-915.

    Keywords:
    audit planning, audit procedures, fraud, specialists
    Purpose of the Study:

    Since the passage of Statement on Auditing Standards (SAS) 99 and the Sarbanes-Oxley Act of 2002, policy-makers and regulators have promulgated additional guidance aimed at improving auditors’ performance in assessing and responding to fraud risks of audit clients. Auditors are expected to address fraud risk through the design of their audit methods and programs and by involving specialists. The authors study whether fraud specialists are relatively more effective than auditors in designing an audit program that will address elevated fraud risk. The goal is to examine whether the expertise of fraud specialists can directly contribute to planning the nature and extent of audit procedures, and whether the mix of procedures that such specialists recommend is likely to be more effective and efficient than the procedures proposed by auditors in a setting where ex ante fraud risk is rated at above a low level. By directly examining fraud specialists’ recommendations for an audit plan under conditions of an elevated fraud risk, the authors seek to clarify whether there are benefits in requesting fraud specialists to participate in audit program design.

    Design/Method/ Approach:

    Participants completed an audit case based on an actual company that had issued fraudulent financial statements. Thirty-two fraud specialists and sixteen auditors completed the case  On average, the fraud specialists were 41 years old, had 12 years of specialized fraud-related experience, and six years of auditing experience. The auditors were, on average, 36 years old, had 13.25 years of auditing experience, but no specialized fraud experience. The evidence was gathered prior to November 2010.

    Findings:
    • In a situation with elevated fraud risk, fraud specialists did not select more procedures from a standard audit program than financial statement auditors; nor were the selected procedures more effective than those selected by auditors. This suggests that the benefits of involving fraud specialists in audit planning do not lie in their ability to identify more effective standard audit procedures.
    • When the risk of fraud is other than low, the fraud specialists proposed more additional procedures than did auditors, and the specialist-proposed additional procedures were marginally more effective, but significantly less efficient, than the additional procedures proposed by auditors. This suggests that involving fraud specialists in audit planning can carry benefits for engagements where fraud risk is not low by helping to identify a larger set of effective procedures than even very experienced auditors are able to do.
    • Fraud specialists increased time budgets to reflect the additional effort that they proposed via extensive non-standard procedures. However, although they proposed significantly more additional procedures than did auditors, their proposed time budget increases for those procedures were significantly lower than adjustments proposed by the auditors. 
    Category:
    Audit Team Composition, Engagement Management, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Budgeting & Audit Time Management, Fraud Risk Assessment, Use of Specialists (e.g. financial instruments – actuaries - valuation)

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