Fraud, Audit Risk & Material Misstatement Presented By: Erin Sullivan-Hogan Roberta Collier Ferguson Siobhan Pardy Overview: Cendant Corporation Formed December 1997 CUC International and HFS Incorporated merged Overview (…cont’d) Cendant Operations Alliance Marketing Travel Real Estate Services Overview (…cont’d) Employees – 40,000 Countries – 100 Customer Contacts – 100 million annually Overview (…cont’d) Merged – December 1997 Press Release – April 1998 (four months after merger) Accused CUC of Fraud 1997 earnings were overstated by $115 Million Overview (…cont’d) Cendant hired Arthur Anderson to Audit Audit Report August 1998 findings: CUC‟s CEO and COO created a culture that accepted fraudulent accounting activities Failure to implement appropriate controls and procedures Overview (…cont’d) Fraud: intentional misstatements 2 types: Misstatements arising from fraudulent financial reporting; and Misstatements arising from misappropriation of assets Overview (…cont’d) Misstatements arising from fraudulent financial reporting include: Manipulation, falsification, or alteration of accounting records or supporting documents from which F/S are prepared Misrepresentation in, or intentional omission from, the F/S of events, transactions, or other significant information Intentional misapplication of accounting principles Management override of internal controls that otherwise may appear to be operating effectively Overview (…cont’d) Misstatements arising from misappropriation of assets involve the theft of an entity‟s assets where the theft causes the F/S to be misstated and they include: Embezzling cash receipts Stealing assets Causing the entity to pay for goods or services not received Overview (…cont’d) Fraudulent financial reporting is committed, usually by management, to deceive F/S users. Misappropriation of assets is committed against the entity, most often by employees. Question a) Discuss the fraud in terms of the three conditions for fraud. Audit Risk and Fraud The determination of audit risk requires considerable judgment on the part of the auditor. The risk of fraud must be evaluated based on criteria and risk assessment procedures set out in the Handbook and through GAAS. The audit must be planned knowing the risk factors for fraud and how they relate to the entity. Fraud Risk Factors Attitudes/ Incentives/Pressures Opportunities Rationalizations • Employees where aware of history • Large multi-national corporation •Pressure on management to meet of earnings inflation • Complex organizational structure analyst expectations • Employees rationalized the inflation • Serious lack of internal controls as necessary to meet analyst • Management had the abilities to •Incentives to keep earnings high to Expectations create and delete accounting entries hide „personal transactions‟ • No moral leadership for employees at will – no monitoring Question b) From the information given, speculate about signs of potential fraud that EY perhaps should have recognized. “The auditor should specifically assess the risk of material misstatement of the F/S due to error or fraud and should consider that assessment in designing the audit procedures”. (p. 84, Auditing & Assurance Services) Example: point #3 EY should have carried out proper procedures to assess the level of risk before beginning the audit. This would have included interviews with management and the employees involved in processing & recording complex or unusual transactions. Example: point #5 Amounts held in reserve accounts are rarely used and when they are it is usually in connection with specific transactions. Unusual or unjustified changes to the reserve accounts each year should have prompted EY to carry out further investigation. Example: point #5 (…cont’d) EY should have examined the unaudited F/S for the first 3 quarters of the year each year. They would have identified the obvious misstatements and had been able to provide CUC with the opportunity to restate (or they could have withdrawn as the auditors). Example: point #6 EY had communicated with CUC with regards to the misstatement but were satisfied when they should not have been. The auditors from EY should have recognized this as a material amount; further investigation of the matter was required. Other potential signs: EY should have recognized that because the company had such a complex organizational structure and had so many subsidiaries, the risk for fraudulent activity would be higher, thus more in- depth planning for audit testing would be needed. Summary This case clearly shows CUC to be guilty of committing fraudulent accounting activities. It is openly evident that it was the intention of CUC to deceive the users of their financial statements. Summary (…cont’d) EY should have taken due care in performing their audit of CUC, even if this resulted in issuing a qualified, adverse or denial of opinion, or removing themselves as auditors for the company. Comments/Questions???