CHAPTER 14

1. Distinguish between the terms errors and fraud.

- The distinguishing factor between fraud and error is whether the underlying action that results
in the misstatement in the financial statements is intentional or unintentional. Unlike error,
fraud is intentional and usually involves deliberate concealment of the facts. Error refers to an
unintentional misstatement in the financial statements, including the omission of an amount or
disclosure.
2. Distinguish between fraudulent financial reporting and
misappropriation of assets. Discuss likely difference between these
two types of fraud on the fair presentation of financial statements.
- Misappropriation of assets represents the theft of assets by employees.
while Fraudulent financial reporting is the intentional misstatement of
financial information by management or a theft of assets by
management, which is covered up by misstating financial statements.
Misappropriation of assets ordinarily occurs either because of
inadequate internal controls or a violation of existing controls. The best
way to prevent theft of assets is through adequate internal controls that
function effectively. Many times theft of assets is relatively small in peso
amounts and will have no effect on the fair presentation of financial
statements, although there are some cases of material theft of assets
which may reallyaffect the fair presentation of financial statements.
Fraudulent financial reporting is inherently difficult to uncover because
it is possible for one or more members of management to override
internal controls. In many cases the amounts are extremely large and
may affect the fair presentation of financial statements.
3. Define fraud, and explain the two types of misstatements that are
relevant to auditor’s consideration of fraud.

Fraud refers to the intentional act by one or more individuals amongh

the management, those charge with governance, employees, or third parties.
involving the use of deception to obtain an unjust or illegal advantage. There
are two types of misstatements, the fraudulent financial reporting is about
 the intentional misstatements or omissions of amounts or disclosures in the
Financial statement to deceive users, this is also known as management
fraud. while the second misstatement is Misappropriation of asset this
involves theft of entity’s assets committed by an employee, this is also
known employee fraud,

4. What are the most common approaches that perpetrators use to

commit fraudulent financial reporting?
There most common ways in which fraudulent financial reporting can take
place include:
 Manipulation, falsification or alteration of accounting records or
supporting documents
 Omission or misrepresentation of events, transactions or other
significant information
 Intentional misapplication of accounting principles.
 Recording of transaction without substance.
5. You are asked to be interviewed by a student newspaper regarding
the nature of accounting fraud. The reporter says, “As I understand
it, assets misappropriations are more likely to be found are more
likely to be found in small organizations, but not in large
organization. On the other hand, fraudulent financial reporting is
more likely to be found in larger organizations.’’ How would you
respond to the reporter’s observation?

This assumption is more likely drawn to the fact that misstatement

arising from fraudulent financial reporting seek gain through the rise in the
stock price which large business have rather than small businesses that can
either be a partnership or sole-proprietorship that doesn’t have stock prices.
And perpetrators for small business can easily do asset misappropriation if
the owner has trusted them with handling the money. However, I think both
are likely to happen in any business if perpetrators have entered the business
and had the chance to do it. I suggest that the business must be always
vigilant in their asset and the financial reports. The business should also have
 a good human resource management so that ever member employed is
trusted and in one with the goal of the business.

6. The fraud triangle identifies incentives, opportunities, and

rationalization as the three elements associated with most fraud.
Describe how each of these elements is necessary for fraud to occur.
 Incentives – The greater the incentive or pressure, the more likely an
individual will be able to rationalize the acceptability of committing
fraud.
 Opportunities – Circumstances exist—for example, the absence of
controls, ineffective controls, or the ability of management to override
controls—that provide an opportunity for a fraud to be perpetrated
 Rationalization – individuals may be able to rationalize committing
fraudulent act. Some individuals possess an attitude, character or set
of ethical values that allow them knowingly and intentionally to commit
a dishonest act. However, even otherwise honest individuals can
commit fraud in an environment that imposes sufficient pressure on
them.
7. If one of the 3 elements of the fraud triangle is not present, can
fraud still be perpetrated? Explain.

According to the Fraud Triangle theory all three elements must be

present for the fraud in workplace occurs. All those elements have a part in
the actualization of fraud. Incentive or Pressure becomes the motive of the
perpetrator it could be anything like, personal gains and greed. Opportunities
are necessary to commit fraud because this is the event where they take
advantage of anything weak in the control of the business transaction so
business must have strong internal control or complexities in every
transaction so that any employee would not have that opportunity even
though they have their motives. And lastly, Rationalization serves as the
mind-set that the fraud that will be done would be justified. This mind-set
would be the fraudster stand and justification to his/her acts. All these three
has different roles in motivating the perpetrator to commit fraud and that
made them equally important in the situation.
8. Identify factors (red flags) that would be strong indicators of
opportunities to commit fraud.
Some of the opportunities to commit fraud that the top management should
consider include the following:
 Significant related-party transactions
 A company’s industry position, such as the ability to dictate
terms or conditions to suppliers or customers that might allow
individuals to structure fraudulent transactions
 Management’s inconsistency involving subjective judgements
regarding assets or accounting estimates
 Simple transactions that are made to understand transactions,
such as financial derivatives or special-purpose entities
 Ineffective monitoring of management by the board
 Complex organizational structure
 Weak internal controls
9. Is the ability to rationalize the fraud an important aspect to consider
when analysing a potentially fraudulent situation? What are some of
the common rationalizations used by fraud perpetrators?
Rationalization is an important aspect to consider a potentially fraudulent
situation because an auditor that thinks critically will easily identify or detect
different justifications a perpetrator may commit from its rationalization and
the auditor could be better prepared and equipped to prevent the fraudulent
act.
Some of the common rationalizations used by fraud perpetrators include the
following:
 “This is a one-time thing to get us through the current crisis and
survive until things get better”
 Personal situations such as needing the money for a family emergency
 An employee believing they are “owed” because they are underpaid
or undervalued in some way
 Debt covenants
 No help is available from outside
 Having the mind-set of “borrowing” the money and paying back later
10. Define and illustrate kiting. What controls should the client
institute to prevent it?
Kiting is done by making transfers near year end from one bank
account to another bank account, recording the deposit in the second
account but not recording the disbursement on the first division’s account
until the next fiscal period. The client institute should have a bank transfer
schedule to be able to prevent kiting. The schedule lists the details of all
transfers to and from a client’s banks, as well as between the client’s banks.
Withdrawal and deposit dates should have been recorded in the same
reporting period to avoid the double counting of cash.