Kent, CPA, is the engagement partner on the financial statement audit of Super Computer Services Co. (SCS) for the year ended April 30, 2011. On May 6, 2011, Smith, the senior auditor assigned to the engagement, had the following conversation with Kent concerning the planning phase of the audit:

Kent: Do you have all the audit programs updated yet for the SCS engagement?

Smith: Mostly. I still have work to do on the fraud risk assessment.

Kent: Why? Our errors and irregularities program from last year is still OK. It has passed peer review several times. Besides, we dont have specific duties regarding fraud. If we find it, well deal with it then.

Smith: I dont think so. That new CEO, Mint, has almost no salary, mostly bonuses and stock options. Doesnt that concern you?

Kent: No. Mints employment contract was approved by the Board of Directors just three months ago. It was passed unanimously.

Smith: I guess so, but Mint told those stock analysts that SCSs earnings would increase 30 percent next year. Can Mint deliver numbers like that?

Kent: Who knows? Were auditing the 2011 financial statements, not 2012. Mint will probably amend that forecast every month between now and next May.

Smith: Sure, but all this may change our other audit programs.

Kent: No, it wont. The programs are fine as is. If you find fraud in any of your tests, just let me know. Maybe well have to extend the tests. Or maybe well just report it to the audit committee.

Smith: What would they do? Green is the audit committees chair, and remember, Green hired Mint. Theyve been best friends for years. Besides, Mint is calling all the shots now. Brown, the old CEO, is still on the Board, but Browns never around. Browns even been skipping the Board meetings. Nobody in management or on the Board would stand up to Mint.

Kent: Thats nothing new. Brown was like that years ago. Brown caused frequent disputes with Jones, CPA, the predecessor auditor. Three years ago, Jones told Brown how ineffective the internal audit department was then. Next thing you know, Jones is out and Im in. Why bother? Im just as happy that those understaffed internal auditors dont get in our way. Just remember, the bottom line is are the financial statements fairly presented? And they always have been. We dont provide any assurances about fraud. Thats managements job.

Smith: But what about the lack of segregation of duties in the cash disbursements department? That clerk could write a check for anything.

Kent: Sure. Thats a material weakness every year and probably will be again this year. But were talking cost-effectiveness here, not fraud. We just have to do lots of testing on cash disbursements and report it again.

Smith: What about the big layoffs coming up next month? Its more than a rumor. Even the employees know its going to happen, and theyre real uptight about it.

Kent: I know, its the worst kept secret at SCS, but we dont have to consider that now. Even if it happens, it will only improve next years financial results. Brown should have let these people go years ago. Lets face it, how else can Mint even come close to the 30 percent earnings increase next year?

Required

a. Describe the fraud risk factors that are indicated in the dialogue above.

b. Describe Kents misconceptions regarding the consideration of fraud in the audit of SCSs financial statements that are contained in the preceding dialogue, and explain why each is a misconception.

c. Describe an auditors audit documentation requirements regarding the assessment of the risk of material misstatement due to fraud.

TABLE 11-2 Examples of Risk Factors for Misappropriation of Assets

THREE CONDITIONS OF FRAUD
Incentives/Pressures	Opportunities	Attitudes/Rationalization
Management or other employees have incentives or pressures to misappropriate material assets.	Circumstances provide an opportunity for management or employees to misappropriate assets.	An attitude, character, or set of ethical values exists that allows management or employees to intentionally commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.
Examples of Risk Factors	Examples of Risk Factors	Examples of Risk Factors
Personal financial obligations create pressure for those with access to cash or other assets susceptible to theft to misappropriate those assets. Adverse relationships between management and employees with access to assets susceptible to theft motivate employees to misappropriate those assets. Examples include the following: Known or expected employee layoffs. Promotions, compensation, or other rewards inconsistent with expectations.	Presence of large amounts of cash on hand or inventory items that are small, of high value, or are in high demand. Inadequate internal control over assets due to lack of the following: Appropriate segregation of duties or independent checks. Job applicant screening for employees with access to assets. Mandatory vacations for employees with access to assets.	Disregard for the need to monitor or reduce risk of misappropriating assets. Disregard for internal controls by overriding existing controls or failing to correct known internal control deficiencies.