During the planning of the audit, the auditor becomes aware of the situations described here.

Required:

For each of the situations described:

a. What is the risk associated with the scenario?

b. Indicate how the auditor would have uncovered the information (e.g., during the planning portion of the audit).

c. What should the auditor do to gather more persuasive evidence about the existence and extent of the fraud risk?

d. Assuming the auditor concludes that the specific risk is present, identify the specific audit steps that should be taken because of the risk identified.

Scenarios:

1. Divisional management is compensated with a base salary plus a year-end bonus.

The bonus applies to operational management and the controller of the division.

The bonus often exceeds 100 percent of the base salary and is calculated solely on reported divisional income. If managers are successful, they often receive promotions to larger divisions.

2. The company is dominated by a charismatic top manager who seems able to convince everyone that he can sell more products even though financial results are deteriorating and the company’s products seem to be falling behind the industry leaders in technology. Management, however, is confident that the company has achieved a technological breakthrough and will be offering a new product in the fourth quarter. Everyone in the company believes the new product will solve most of the company’s problems.

3. The company is suffering from severe solvency problems. Company management has asked the auditor for advice on structuring transactions so that more of the company’s financing is “off the balance sheet.” The off-the-balance-sheet treatment appears to be acceptable, although not necessarily good accounting.

4, The company is experiencing rapid growth and is continually introducing new products. The accounting system seems to be lagging behind the growth of the rest of the company. Although the auditor recommended that the company start an internal audit department last year, it decided it could not afford to do so.

5. The company has an audit committee composed mostly of outside directors. However, the president attends all the meetings and clearly has a dominating presence. The auditor has not had major problems with the company in the past, but discussions about accounts that are material to the financial statements are increasing.

Most involve judgments, such as allowance for doubtful accounts or warranty expense estimates. Disagreements between the auditor and management regarding these accounts are increasing.

6. The company has been acquired as part of a hostile takeover and is now being run by a management that has earned its reputation as financial wizards. This management group has handled similar acquisitions by selling off assets, slashing payroll, increasing reported profits through aggressive accounting choices, and then selling the entity to another party in a relatively short period of time. Management is very aggressive in its financial accounting posturing and places a great deal of emphasis on quarterly financial results. Although the auditor has not dealt directly with this management team previously, she is aware that it does not have a good reputation in the business community; but she is unaware of any record of management dishonesty.