Definition of Fraud 1-3

1.
DEFINITION OF FRAUD
As a broad legal concept, fraud describes any intentional deceit meant to deprive another person or
party of their property or rights.
TYPES OF FRAUD
In the context of auditing financial statements, fraud is defined as an intentional misstatement of

financial statements. The two main categories are fraudulent financial reporting and misappropriation of
assets.
Fraudulent financial reporting
Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with

the intent to deceive users. Most cases involve the intentional misstatement of amounts, rather than
disclosures. For example, WorldCom capitalized as fixed assets billions of dollars that should have been
expensed. Omissions of amounts are less common, but a company can overstate income by omitting
accounts payable and other liabilities.
In practice, this type of fraud is done either to increase or decrease assets and/or liabilities owned
intentionally in order to achieve income objectives, this is often referred to as Earning Management.
One of the well-known techniques is called Income Smoothing, a technique of shifting income or
expenses from one period to another, to avoid fluctuating income.
Misappropriation of assets
Misappropriation of assets is fraud that involves theft of an entity’s assets. In many cases, but not all, the
amounts involved are not material to the financial statements. However, the theft of company assets is
often a management concern, regardless of the materiality of the amounts involved, because small
thefts can easily increase in size over time.
The term misappropriation of assets is normally used to refer to theft involving employees and others
internal to the organization. According to estimates of the Association of Certified Fraud Examiners, the
average company loses five percent of its revenues to fraud, although much of this fraud involves
external parties, such as shoplifting by customers and cheating by suppliers.
2. CONDITION FOR FRAUD
Fraud Triangle are three conditions that can lead to fraud, including:
THREE CONDITION FOR FRAUDULENT FINANCIAL REPORTING
Incentives/Pressures A common incentive for companies to manipulate financial statements is a decline

in the company’s financial prospects. For example, a decline in earnings may threaten the company’s
ability to obtain financing. Companies may also manipulate earnings to meet analysts’ forecasts or
benchmarks such as prior-year earnings, to meet debt covenant restrictions, or to artificially inflate stock
prices. In some cases, management may manipulate earnings just to preserve their reputation.
Opportunities Although the financial statements of all companies are potentially subject to
manipulation, the risk is greater for companies in industries where significant judgments and estimates
are involved.
A turnover in accounting personnel or other weaknesses in accounting and information processes can
create an opportunity for misstatement. Many cases of fraudulent financial reporting were caused by
ineffective audit committee and board of director oversight of financial reporting.
Attitudes/Rationalization The attitude of top management toward financial reporting is a critical risk
factor in assessing the likelihood of fraudulent financial statements. If the CEO or other top managers
display a significant disregard for the financial reporting process, such as consistently issuing overly
optimistic forecasts, or they are overly concerned about meeting analysts’ earnings forecasts, fraudulent
financial reporting is more likely. Management’s character or set of ethical values also may make it easier
for them to rationalize a fraudulent act.
THREE CONDITION FOR MISAPPROPRIATION OF ASSETS
Incentives/Pressures Financial pressures are a common incentive for employees who misappropriate
assets. Employees with excessive financial obligations, or those with drug abuse or gambling may steal to
meet their personal needs. In other cases, dissatisffed employees may steal from a sense of entitlement
or as a form of attack against their employers.
Opportunities Opportunities for theft exist in all companies. However, opportunities are greater in
companies with accessible cash or with inventory or other valuable assets, especially if they are small or
easily removed. For example, casinos handle extensive amounts of cash with little formal records of cash
received. Similarly, thefts of laptop computers are much more frequent than thefts of desktop systems.
Weak internal controls create opportunities for theft. Inadequate separation of duties is practically a
license for employees to steal.
Attitudes/Rationalization Management’s attitude toward controls and ethical conduct may allow
employees and managers to rationalize the theft of assets. If management cheats customers through
overcharging for goods or engaging in highpressure sales tactics, employees may feel that it is acceptable
for them to behave in the same fashion by cheating on expense or time reports.
3. ASSESSING THE RISK OF FRAUD

Communications Among Audit Team SAS 99 requires the audit team to conduct discussions to share
insights from more experienced audit team members and to “brainstorm” ideas.
These discussions about fraud risks will likely take place at the same time as discussions about the
susceptibility of the entity’s financial statements to other types of material misstatement
Inquiries of Management SAS 99 requires the auditor to make specific inquiries about fraud in every
audit. Inquiries of management and others within the company provide employees with an opportunity
to tell the auditor information that otherwise might not be communicated. Moreover, their responses to
the auditor’s questions often reveal information on the likelihood of fraud.
Risk Factors SAS 99 requires the auditor to evaluate whether fraud risk factors indicate incentives or
pressures to perpetrate fraud, opportunities to carry out fraud, or attitudes or rationalizations used to
justify a fraudulent action.
Analytical Procedures auditors must perform analytical procedures during the planning and completion
phases of the audit to help identify unusual transactions or events that might indicate the presence of
material misstatements in the financial statements. When results from analytical procedures differ from
the auditor’s expectations, the auditor evaluates those results in light of other information obtained
about the likelihood of fraud to determine if fraud risk is heightened.
Other Information Auditors should consider all information they have obtained in any phase or part of
the audit as they assess the risk of fraud. Many of the risk assessment procedures that the auditor
performs during planning to assess the risk of material misstatement may indicate a heightened risk of
fraud.

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1.

In the context of auditing financial statements, fraud is defined as an intentional misstatement of

Fraudulent financial reporting

Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with

2. CONDITION FOR FRAUD

Incentives/Pressures A common incentive for companies to manipulate financial statements is a decline

THREE CONDITION FOR MISAPPROPRIATION OF ASSETS

3. ASSESSING THE RISK OF FRAUD

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