A Framework for Identifying (and Avoiding) Fraudulent Financial Reporting*

Abstract

This commentary analyzes the relationship of fraud risk assessments to other risk assessments by auditors. The Public Company Accounting Oversight Board notes that this is a problem area of current practice. Effective detection of fraudulent financial reporting requires an integrative accounting/auditing conceptual framework. As a result, this paper is as much about accounting theory as it is about auditing. To simplify the development of such an integrated framework, this paper uses an expanded risk model. This effectively results in a risk perspective on fraudulent financial reporting. There are many potential implications but the major findings are as follows. First, the study identifies the crucial role of benchmarks based on acceptable levels of risk to help differentiate between intentional and unintentional misstatements. Such differentiation is critical to successfully implementing the American Institute of Certified Public Accountants' Statement on Auditing Standards ( SAS ) No. 99 and international standards ISA Nos. 240 , 540 , and 700 . Second, the paper shows the importance of not allowing the major categories of risks identified here from getting too high. This paper explains the need to set acceptable levels of these risks, either by standard-setters as a matter of broad policy, or by individual practitioners as part of the terms of specific engagements. I propose that a major factor in the concept of "present fairly" be the acceptable levels of accounting risks that are defined here, especially the risks due to intentional forecast errors. Third, this paper clarifies how the fraud risk of SAS No. 99 , and similar international standards, relates to the current audit risk model framework.

Principles‐Based Reasoning about Accounting Estimates

“…The proposed approach is consistent with risk management principles, such as calibration of ranges, as well as risk‐based auditing. This approach is also consistent with the more complete risk model proposed in Smieliauskas for use in auditing. Specifically, here I focus on how to make operational the concept of fairness of presentation of accounting estimates when working with the “reasonable range” concept of CAS No.…”

“…This is a bit more ambiguous than AuG‐41. This increased ambiguity can be addressed via the accounting risk concept discussed in Smieliauskas (). The accounting risk concept assumes the uncertainty within the range also needs to be considered in deciding the total riskiness of a reported estimate in meeting the requirements of CAS 540.16.…”

“…I do this by using the logic and concepts of Smieliauskas () to identify under what conditions estimates from reasonable ranges can be used to assess whether measurements of value are fairly presented in financial reporting. The risk methodology discussed here can be integrated with other risk assessments as discussed in Smieliauskas (). This approach may guide the way for auditors and accountants to be more relevant in today's financial reporting environment.…”

Auditing, Reasoning Systems, Reporting Frameworks, and Accounting Policy Risk: A Response to Alexander

“…Such aggregation can lead easily to aggregate risks much greater than 1, thereby violating basic probability axioms. On this point, a proposal made by Smieliauskas (2008) regarding identification of fraudulent forecasts in financial reporting merits consideration. Smieliauskas (2008) introduced the concept of a benchmark range based on acceptable AccR, proposed a way to properly aggregate audited financial reporting risks, and proposed a general way of constructing ranges of acceptable forecasts for financial reporting.…”

“…On this point, a proposal made by Smieliauskas (2008) regarding identification of fraudulent forecasts in financial reporting merits consideration. Smieliauskas (2008) introduced the concept of a benchmark range based on acceptable AccR, proposed a way to properly aggregate audited financial reporting risks, and proposed a general way of constructing ranges of acceptable forecasts for financial reporting. Any accounting estimate involving assumptions about the future that fall outside the benchmark range is considered unacceptable for the financial reporting framework.…”