CPA Exam — AUDAssessing Risk and Developing a Planned ResponseMedium
A client's management has a strong incentive to overstate earnings due to compensation tied directly to reported net income. The auditor identified several complex accounting estimates involving significant management judgment. This combination of factors is most indicative of which type of fraud risk factor?
- ARationalization
- BIncentive/Pressure
- CAttitude
- DOpportunity
Show answer & explanationAnswer & explanation
Correct answer: B. Incentive/Pressure
The 'fraud triangle' identifies three conditions generally present when fraud occurs: incentive/pressure, opportunity, and rationalization. Management's compensation being tied to reported net income creates a strong 'incentive or pressure' to achieve financial targets, potentially leading to fraudulent financial reporting, especially when combined with opportunities presented by complex estimates.
Why the other options are wrong
- A. Rationalization is the ability to justify the fraudulent act, which is not directly described here.
- C. Attitude refers to a disregard for internal controls or ethical conduct, which is not the primary factor described.
- D. Opportunity relates to circumstances that allow fraud to occur, such as weak internal controls or complex estimates, but the primary factor described is the motivation.
Fraud Triangle - Incentive/Pressure
One of the three conditions of the fraud triangle, representing a reason or motivation for management or employees to commit fraud, often stemming from financial targets, personal financial distress, or internal pressures.
- Motivation for fraud.
- Often financial or performance-based.
- Examples: bonuses tied to earnings, debt covenants.
Memory trick: PIO: Pressure, Opportunity, Rationalization.