Question

answer the following questions:

• Evaluate the financial statement fraud scheme.
• Explain how information determined by using the Fraud Exposure Rectangle can help assess the likelihood of financial statement fraud.
• Explain how information obtained through using strategic reasoning can help assess the likelihood of financial statement fraud.

Answer 1

Financial Statement Fraud Scheme

Financial statement typically consists of Income Statement or Profit and Loss Statement, Balance Sheet, Cash Flow Statement and Notes to financial statement. Method of disclosures and computation of account balances and other information in these statements is governed by statutory framework in which the entity operates. However, when financial statement fraud scheme or trend if any is employed by the entity, financial statement depict incorrect picture of financial position of the entity and mislead the users of financial statements. This may be done by various methods; some of which are enlisted below:

• Over or understatement of revenue/ expense/ assets/ liabilities
• Pre booking revenue to inflate the sales performance figures of a financial period
• Not recognizing accrued expenses or incomes
• Booking fictitious expenses by obtaining false invoices
• Non disclosure of any legal cases possibly demanding major penalties in near future
• Deliberate misinterpretation and application of Accounting principles
• Incorrect stock valuation as at end of year specially in case of fictitious sale recorded where sale is recorded but goods have not moved out of company premise

Fraud Exposure Rectangle

Management and Directors	Relationship of company with other entities
Nature of Organization and it's industry	Financial results and operating characteristics

Fraud exposure rectangle as shown above indicate various areas of fraud exposure that must be examined and analyzed by auditors. This brings auditor's attention to non financial parameters as elaborated in brief below; besides the numbers disclosed by financial statement in order to investigate into possible fraudulent reporting.

1. Management and directors - auditor can study their background, work history, education, scope of influence in society, relationship history with company and it's associated entities.
2. Relationship of company with other entities - auditor can look for documentation, communication trails or through other appropriate sources for company's Relationship with other entities like banks, tax consultants, government bodies, Lawyers, local influential people, political parties etc.
3. Nature of Organization and the industry in which it operates - auditor can study the Organization's method of operation, principles followed, work culture and other characteristics of business conducted. Also the industry trends in which it operates and current scenario of the industry can be studied.
4. Financial results and operating Characteristics - Auditors can study the financials based of Specific analysis of above three factors besides regular methods of analysis like ratio analysis, vertical and horizontal analysis.

Fraud Exposure Rectangle can help assess the likelihood of financial statement fraud since it extends auditor's view from just financial analysis to a larger spectrum of factors which would drive a fraud scheme being employed in an entity. This rectangle helps auditor to design and improvise the audit techniques being employed and customize them to each case under study based of findings of using rectangle.

Strategic reasoning

Strategic reasoning or approach to fraud detection implies use of non - generic methods of fraud detection. It a proactive measure that aims to design audit procedures in such a manner that they target specific fraud exposure areas to the particular Organization under audit. It studies the business and looks for fraud symptoms and determine audit procedures that specifically address these issues. Since it helps in applying customized audit procedures it improves chances of fraud detection.