Solutions for Chapter 2
True/False Questions
2-1 F
2-2 F
2-3 T
2-4 F
2-5 T
2-6 T
2-7 F
2-8 T
2-9 F
2-10 T
2-11 T
2-12 F
Multiple Choice Questions
2-13 B
2-14 B
2-15 B
2-16 E
2-17 D
2-18 C
,2-19 C
2-20 D
2-21 A
2-22 D
2-23 E
2-24 B
Review and Short Case Questions
2-25
Fraud is an intentional act involving the use of deception that results in a material misstatement of the
financial statements. Two types of misstatements are relevant to auditors’ consideration of fraud (a)
misstatements arising from misappropriation of assets and (b) misstatements arising from fraudulent
financial reporting. Intent to deceive is what distinguishes fraud from errors.
2-26
Three common ways that fraudulent financial reporting can be perpetrated include:
Manipulation, falsification or alteration of accounting records or supporting documents
Misrepresentation or omission of events, transactions, or other significant information
, Intentional misapplication of accounting principles
2-27
The reporter’s statement makes sense. Asset misappropriations are much easier to accomplish in
small organizations that don’t have sophisticated systems of internal control. Fraudulent financial
reporting is more likely to occur in large organizations because management often has ownership
of or rights to vast amounts of the company’s stock. As the stock price goes up, management’s
worth also increases. However, the reporter may have the mistaken sense that financial fraud only
occurs rarely in smaller businesses. That is not the case. Many smaller organizations are also
motivated to misstate their financial statements in order to (a) prop up the value of the
organization for potential sale, (b) obtain continuing financing from a bank or other financial
institution, or (c) to present a picture of an organization that is healthy when it may be susceptible
to not remaining a going concern. Finally, smaller organizations may conduct a fraud of a different
sort, i.e. misstating earnings by understating revenue or masking owner distributions as expenses.
This is often done to minimize taxes. It would also be a mistake to think that asset
misappropriations do not happen in larger organizations. Whenever controls are weak, there is an
opportunity for asset misappropriation. When the opportunity is coupled with motivation and a
belief that the fraud could be covered up, some of those opportunities will result in asset
misappropriation.
2-28
a. A Ponzi scheme occurs when the deposits of current investors are used to pay returns on the deposits of
previous investors; no real investment is happening.
b. The key elements of the Bernie Madoff fraud include:
Fabricated “gains” of almost $65 billion
Defrauded thousands of investors
Took advantage of his high profile investment leader status to establish trust in his victims
Accomplished the scheme by keeping all the fraudulent transactions off the real financial
statements of the company
, Employed a CPA who conducted a sham audit
Led to the PCAOB now having oversight of the audits of SEC-registered brokers and dealers
c. The Bernie Madoff fraud is primarily a case of asset misappropriation. However, it is important to
note that asset misappropriation then led Madoff to commit fraudulent financial reporting to hide
the asset misappropriation.
2-29
a. Management perpetrated the fraud by filling inside containers with water in the larger containers
filled with oil. Further, they transferred the oil from tank to tank in the order in which they knew
the auditors would proceed through the location.
b. The goal was to overstate inventory assets, thereby understanding cost of goods sold and
overstating income.
c. The Great Salad Oil Swindle is primarily a case of fraudulent financial reporting.
2-30
Incentives relate to the rationale for the fraud, e.g., need for money, desire to enhance stock price.
Opportunities relate to the ability of the fraudster to actually accomplish the fraud, e.g., through
weak internal controls. Rationalization is the psychological process of justifying the fraud.
2-31
The fraud triangle recognizes that when these three factors appear together the likelihood of fraud
increases. For example, an individual needs to have an opportunity to commit the fraud, such as a
weakness in internal controls. Second, there must be some pressure or incentive to conduct the
fraud, e.g. there is a real or perceived economic problem. Third, the perpetrator must be able to
True/False Questions
2-1 F
2-2 F
2-3 T
2-4 F
2-5 T
2-6 T
2-7 F
2-8 T
2-9 F
2-10 T
2-11 T
2-12 F
Multiple Choice Questions
2-13 B
2-14 B
2-15 B
2-16 E
2-17 D
2-18 C
,2-19 C
2-20 D
2-21 A
2-22 D
2-23 E
2-24 B
Review and Short Case Questions
2-25
Fraud is an intentional act involving the use of deception that results in a material misstatement of the
financial statements. Two types of misstatements are relevant to auditors’ consideration of fraud (a)
misstatements arising from misappropriation of assets and (b) misstatements arising from fraudulent
financial reporting. Intent to deceive is what distinguishes fraud from errors.
2-26
Three common ways that fraudulent financial reporting can be perpetrated include:
Manipulation, falsification or alteration of accounting records or supporting documents
Misrepresentation or omission of events, transactions, or other significant information
, Intentional misapplication of accounting principles
2-27
The reporter’s statement makes sense. Asset misappropriations are much easier to accomplish in
small organizations that don’t have sophisticated systems of internal control. Fraudulent financial
reporting is more likely to occur in large organizations because management often has ownership
of or rights to vast amounts of the company’s stock. As the stock price goes up, management’s
worth also increases. However, the reporter may have the mistaken sense that financial fraud only
occurs rarely in smaller businesses. That is not the case. Many smaller organizations are also
motivated to misstate their financial statements in order to (a) prop up the value of the
organization for potential sale, (b) obtain continuing financing from a bank or other financial
institution, or (c) to present a picture of an organization that is healthy when it may be susceptible
to not remaining a going concern. Finally, smaller organizations may conduct a fraud of a different
sort, i.e. misstating earnings by understating revenue or masking owner distributions as expenses.
This is often done to minimize taxes. It would also be a mistake to think that asset
misappropriations do not happen in larger organizations. Whenever controls are weak, there is an
opportunity for asset misappropriation. When the opportunity is coupled with motivation and a
belief that the fraud could be covered up, some of those opportunities will result in asset
misappropriation.
2-28
a. A Ponzi scheme occurs when the deposits of current investors are used to pay returns on the deposits of
previous investors; no real investment is happening.
b. The key elements of the Bernie Madoff fraud include:
Fabricated “gains” of almost $65 billion
Defrauded thousands of investors
Took advantage of his high profile investment leader status to establish trust in his victims
Accomplished the scheme by keeping all the fraudulent transactions off the real financial
statements of the company
, Employed a CPA who conducted a sham audit
Led to the PCAOB now having oversight of the audits of SEC-registered brokers and dealers
c. The Bernie Madoff fraud is primarily a case of asset misappropriation. However, it is important to
note that asset misappropriation then led Madoff to commit fraudulent financial reporting to hide
the asset misappropriation.
2-29
a. Management perpetrated the fraud by filling inside containers with water in the larger containers
filled with oil. Further, they transferred the oil from tank to tank in the order in which they knew
the auditors would proceed through the location.
b. The goal was to overstate inventory assets, thereby understanding cost of goods sold and
overstating income.
c. The Great Salad Oil Swindle is primarily a case of fraudulent financial reporting.
2-30
Incentives relate to the rationale for the fraud, e.g., need for money, desire to enhance stock price.
Opportunities relate to the ability of the fraudster to actually accomplish the fraud, e.g., through
weak internal controls. Rationalization is the psychological process of justifying the fraud.
2-31
The fraud triangle recognizes that when these three factors appear together the likelihood of fraud
increases. For example, an individual needs to have an opportunity to commit the fraud, such as a
weakness in internal controls. Second, there must be some pressure or incentive to conduct the
fraud, e.g. there is a real or perceived economic problem. Third, the perpetrator must be able to
