In every audit engagement, the auditors should identify fraud risks that may require an audit response. Described below are four circumstances or factors that may create an increased risk of material misstatement of the financial statements due to fraud.
1. The compensation of management of a subsidiary of the client is heavily dependent on the net income of the subsidiary and controls over subsidiary management are weak.
2. The compensation of management of a telecommunications firm is significantly tied to revenue, and analytical procedures indicate that revenue may be overstated. The company engages in complex sales agreements.
3. Futures traders in an energy company are compensated based on the performance of their purchases and sales of energy futures contracts. The markets for these contracts have few participants, resulting in the need to value contracts on hand at year-end based on complex valuation models applied by the traders.
4. A chain of discount markets has inconsistent profit margins across stores as indicated by analytical procedures.
a. For each of the four circumstances, indicate the fraud risk that the auditors should consider.
b. For each of the four circumstances, indicate a possible appropriate response by the auditors.