TABLE 6-1 The Three SAS 82 Categories of Risk Factors for Fraudulent Financial Reporting Three Examples of Each CATEGORY 1 CATEGORY 2 CATEGORY 3 Management's Characteristics and influence over the Operating Characteristics Control environment Industry Conditions and Financial Stability These pertain to management 's hese involve the economic and These pertain to the nature and complexity of abilities, pressures, style, and attitude regulatory environment in which the the entity and its transactions, financial relating to internal control and the entity operates. condition, and profitability financial reporting process Examples of risk Factors Examples of risk factors Examples of Risk factors A motivation for management to New accounting statutory,of Significant pressure to obtain engage in fraudulent financial regulatory requirements that could additional capital necessary to stay reporting such as an excessive nterest impair the financ ial stability or competitive considering the financ ial by management to maintain or increase profitabil ity of the entity position of the entity. the entity's stock price or earnings Declining industry with increasing Significant, unusual, or highly trend through the use of unusuall business failures and significant complex transactions, especially those aggressive accounting practices declines in customer demand close to yearend, that pose difficult A failure by management to display Rapid changes in the industry, such substance over form'questions and communicate an approprate as high vulnerabil ity to rapidly Overly complex organizational attitude regarding internal control and changing technology or rapid product structure involving numerous or the financial reporting process, such as unusual legal entities, managerial lines domination of management by a single of authority, or contractual person or small group without arrangements without apparent compensating controls busi High turnover of senior management. counsel or board members Arens, Loebbecke; Auditing, 8/E @2000 Prentice Hall. InArens, Loebbecke; Auditing, 8/E ©2000 Prentice Hall, Inc. CATEGORY 1 Management’s Characteristics and Influence over the Control Environment These pertain to management’s abilities, pressures, style, and attitude relating to internal control and the financial reporting process. CATEGORY 2 Industry Conditions These involve the economic and regulatory environment in which the entity operates. CATEGORY 3 Operating Characteristics and Financial Stability These pertain to the nature and complexity of the entity and its transactions, financial condition, and profitability Examples of Risk Factors • A motivation for management to engage in fraudulent financial reporting, such as an excessive interest by management to maintain or increase the entity’s stock price or earnings trend through the use of unusually aggressive accounting practices. • A failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process, such as domination of management by a single person or small group without compensating controls. • High turnover of senior management, counsel, or board members. Examples of Risk Factors • New accounting, statutory, or regulatory requirements that could impair the financial stability or profitability of the entity. • Declining industry with increasing business failures and significant declines in customer demand. • Rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence. Examples of Risk Factors • Significant pressure to obtain additional capital necessary to stay competitive considering the financial position of the entity. • Significant, unusual, or highly complex transactions, especially those close to yearend, that pose difficult “substance over form” questions. • Overly complex organizational structure involving numerous or unusual legal entities, managerial lines of authority, or contractual arrangements without apparent business purpose. TABLE 6-1 The Three SAS 82 Categories of Risk Factors for Fraudulent Financial Reporting & Three Examples of Each