Official© Solutions Manual for Auditing A Risk Based Approach Johnstone,11e

Financial Statement Auditing: A Risk-Based Approach, 11e




Solutions for Chapter 2

Answers to Check Your Basic Knowledge
Questions



2-1 F
2-2 F
2-3 b
2-4 b
2-5 T
2-6 F
2-7 b
2-8 e
2-9 T
2-10 T
2-11 d
2-12 c
2-13 F
2-14 F
2-15 c
2-16 d
2-17 F
2-18 T
2-19 a
2-20 d
2-21 T
2-22 T
2-23 a
2-24 b

,Review Questions and Short Cases



2-1



Fraud is an intentional act involving the use of deception that results in a 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.



2-2



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



Common types of fraudulent financial reporting include:



 Improper revenue recognition

 Improper deferral of costs and expenses

 Improper asset valuation

 Concealed liabilities

 Misrepresentations or omissions in financial statement footnotes of MD&A



2-3

,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 approach is often used 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.



2-4



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 the following actions Madoff
perpetrated, which led to the PCAOB now having oversight of the audits of SEC-registered
brokers and dealers:



 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



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.



2-5



a. Management perpetrated the fraud by filling large containers with water and placing a layer
of salad oil on top. Furthermore, 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 understating cost of goods sold and
overstating income.



c. The Great Salad Oil Swindle is primarily a case of fraudulent financial reporting.



2-6



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, complex transactions. Rationalization is the psychological process of
justifying the fraud.



2-7



Common incentives for fraudulent financial reporting include:
 Management compensation schemes