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ISSN 1392-1258. EKONOMIKA 2009 85

THE FRAUD TREE AND ITS INVESTIGATION IN AUDIT

Jonas Mackevičius Laimutė KazlauskienėDepartment of Accounting and Auditing Department of Accounting and AuditingFaculty of Economics Faculty of EconomicsVilnius University Vilnius UniversitySaulėtekio al. 9, LT-10222 Vilnius, Lithuania Saulėtekio al. 9, LT-10222 Vilnius, LithuaniaTel. +370 5 236 61 53 Tel. +370 5 236 61 53E-mail: jonas.mackevicius@ef.vu.lt E-mail: laimaaj@iti.lt

Abstract. The purpose of the present research paper is to introduce a new structure of the Fraud Tree and to suggest certain audit procedures possibly employed in examining its branches. For the purpose of the present paper the authors thereof have referred to the analysis of related research literature, also applied the information comparison and generalization methods. Fraud is being committed in every part of the world, and in every sphere of human activities. Often fraud leads to financial nightmare and collapse of major international corporations which cause spill-off after-effects not only upon corporations and their employees, but also upon other related businesses and organizations, governments and societies. In view of globalization of economy, increasingly dynamic and competitive business fraud has changed in character though has not downscaled in its scope. Today fraudsters elaborate their attempts making use of the most state-of-the-art science achievements and innovative technologies. This largely facilitates the growth of the “Fraud Tree” with its new branches ever springing up. The present article represents an attempt to investigate individual fraud cases and the groups of persons committing this kind of crime. A new concept of “Fraud Tree” has been introduced with the following basic branches: i) material misstatements in financial statements; ii) asset misappropriation; iii) corruption; iv) tax evasion; and v) others. Every branch on the Fraud Tree has several sub-branches, and significant efforts should be devoted in the course of audit to examine the scope, formation conditions of each such sub-branch. The present paper includes guidelines for the principal actions and procedures to be followed by an auditor in view of the risks related to misstatements in financial statements, asset misappropriation, corrup-tion and tax evasion.

Key words: fraud, Fraud Tree, fraud detection, investigation.

Introduction

Fraud has always been present since the times reached by human memory extend-ing up to our days and is highly likely to continue to be committed in the future. Anybody can be exposed to fraud – in-

ternal (corporate managers, sharehold-ers, employees) and external (banks, taxinstitutions, suppliers, purchasers, inves-tors, governmental institutions, financialexperts, auditors and even the society atlarge) users of information. Fraud produc-es detrimental effectnotonlyuponthefi-

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nancial status and performance of compa-nies,itmayruinthecompany’simageanddamageitscompetitiveness.Fraudspecifi-cally creates obstacles to the development of foreign investment.

From time to time the erupting fraud disclosures result in huge financial scan-dals and bankruptcies of largest interna-tionalcorporations.On2December2001,the energy company Enron was declared bankrupt making the lines as the largest ever collapse in the history of the USA. Withaviewtoconcealingitsactualfinan-cial situation, for fouryears themanage-ment of the company was deliberately mis-leading information users by not including its partners’ liabilities into corporate ac-counts and thus recklessly overstating its corporateearningsbyUSD586mor20%(Skandalingas „Enron“... 2002, p. 121).The Enron’s scandal was shortly followed by the collapse of the telecommunications giant WorldCom. The corporation with 85,000 in staff operating in 65 countriesworld-wide was manipulating accounting entries by reporting its stationary costs (pens,pencils,paper,etc.)asitsrevenues.The Company share price was immediate-lydumpedfromUSD60to just20cents(Girdzijauskas, 2007, p. 20). Fraudulentaccounting has brought about absolutely detrimental losses to such global opera-tors as Xerox, Kmart, GlobalCrossing,Adelphia Communications and a number of others.

Despiteitsultimateimportancetoecon-omy globally and to each individual com-pany fraud as a phenomenon has not been thoroughly investigated. Lately though,fraud has become a focus for the Associa-tionofCertifiedFraudExaminers(ACFE)

that has developed a fraud classifier, theso-called ‘Fraud Tree’. Some genuine of the Fraud Tree has been conducted by M.MosqueraandA.Scifo(2004).Arangeof issues related to fraud and forensic in-vestigation has been covered by R. Turpen (1997),R.Vanasco(1998),J.Well (2002)and other authors. The most common fraud cases in Lithuania were examined by R. Bičiulaitis (2001), J. Mackevičius(2001), J. Mackevičius and R. Bartaška(2003), J. Kabašinskas and I. Toliatienė(1998), aswell as by the private compa-ny Pačiolis (Jagminas, 1998). However,with fraud attempts becoming even more sophisticated and employing increasingly hardlydetectable tools andmethods, fur-ther fraud research and investigation have become absolutely necessary.

Fraud: essence and impact

In its most general sense fraud means ac-tions, behaviors and/or oral expressionsdeliberately aimed at deception and / ormisinformation (Dabartinės lietuvių ka-lbos žodynas(TheDictionaryofContem-porary Lithuanian), 1993, p. 21). Fraudmay also be referred to an intentional er-ror conceived in advance. Such errors are often accompanied by certain ac-tions designed to conceal their presence (Mackevičius, 2001, p. 288). Fraud wasdefinedas: anydishonest activity involv-ingtheextractionofvaluefrombusiness,directlyorindirectly,regardlessofwheth-ertheperpetratorbenefitspersonallyfromhisorheractions.(Coram,Ferguson,Mo-roney, 2006). So, the concept of fraud isquiteextensive.Therefore,mostoftenitisdefinedbyreferencetospecificobjectsand

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goalsofaparticularfraud.Namely,fraudisusuallydefinedasasequenceofactivi-tiesperpetratedtoobtainmoney,propertyor services, to avoid payment or loss ofservices,ortosecurepersonalorbusinessadvantages. These acts are not dependant upon the application of threat of violence or of physical force. (International Stand-ards for Professional Practice of Internal Auditing,2002,p.26).

Anactoffraudmaybealsodefinedasa crime in the economic sphere manifest-ed by a theft of somebody else’s property or title to such property by abusing trust (Auditorskijslovar2003,p.81).Someau-thors classify fraud into active and passive fraud. The key feature of active fraud is a supply of false information. Passive fraud involves concealment of certain circum-stanceswhichotherwisehadtobenotified(Osnovyaudita,2000,p.147).

Frauds are committed in all spheres of human activities, notmerely in business,but also in public and financial sectors(Ratlift,1996,p.864).Undercurrentdy-namic and competitive business conditions fraud has also evolved now employing most modern science achievements and innovative technologies. With the intro-duction of computers and other computa-tiontechniquestoperformaseriesofman-agement functions, fraud has declined inscale although it has become increasingly sophisticated.

Instances of fraud produce a tremen-dous effect upon corporate and financialperformance,itscorporateimageandbusi-ness continuity. Fraud ruins the reliabil-ity of financial statements and the valuethereof as a principal source of informa-tion. Therefore the disclosure of frauds,

examination of the underlying motives,tools employed and other related issues has latelyacquiredaspecialsignificance.Andauditorsinthefulfillmentofthistaskare assigned a very special role.

Auditors’ focus is aimed at acts of fraud that cause material misstatements in corporate financial statements. From theaudit viewpoint “fraud” isdefinedas an“intentional act by one or more individuals among management, those charged withgovernance, employees, or third parties,involving the use of deception to obtain an unjust or illegal advantage” (Handbook on InternationalAuditing,Assurance andEthics Pronouncements, 2008 p. 230).Thisdefinitionof fraudemphasizes threeimportantthings:

1)Oneorseveralcorporatemanagers,employees and third parties may be engagedincommitmentoffraud;

2)Fraudisaseriesofdeliberateacts,usuallypreparedinadvance;

3) Fraud is aimed at obtaining unjust orillegalbenefit.

Theauditobjectivityprinciplerequiresfromanauditortoexpresshis/heropiniononanypresenceoffraudinfinancialstate-ments and the impact of such fraud on re-liability of information. The International StandardonAuditing240 emphasizes anauditor’s obligation to examine any mis-statements of information occurring due to:(i)fraudulentfinancialreporting(mis-stated, omitted or undisclosed amounts,intentional overriding of accounting prin-ciples, altering of accounting records),(ii) misappropriation of assets (theft of an entity’stangibleandintangibleassets,em-bezzlingreceipts,causinganentitytopayforgoodsandservicesnot received,etc.)

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(HandbookonInternationalAuditing,As-suranceandEthicsPronouncements,2008p.231). Such misrepresentations of infor-mation may cause the users of such infor-mation to arrive at incorrect conclusions and/orpasswrongdecisions(seeFig.1).

Companies and organizations that arehit with employee fraud, including em-bezzlement, asset misappropriation, andfinancialstatementmanipulationareoftensurprised that the incident occurred. Even more surprising to executives and boards of directors is the fact that their auditors did not find the fraud sooner, or did notfinditatall.Afterall,isn’tthatwhataudi-torsaresupposedtodo?(Coenen,2006)

The risk of not detecting a material misstatement resulting from fraud is high-er than the risk of not detecting a material misstatementresultingfromerror,becausefraud may involve sophisticated and care-

fullyorganizedschemesdesignedtocon-ceal it. Such attempts at concealment may beevenmoredifficult todetectwhenac-companied by collusion. Intents of fraud are specifically difficult for an auditor todetect where they are related to manage-ment decisions concerning accounting estimates and application of accounting principles.

For auditors fraud involving manage-mentismoredifficulttodetectthanfraudinvolving employees. Certain levels of managementmayhaveanunlimitedinflu-encein theentity, theymaybeinaposi-tiontooverridecontrolprocedures,ordi-rect their subordinates to perform certain transactions, conceal facts, or come intoagreement with third parties, etc. Audi-torstendtotrusttheinformation,althoughknowinglymisleading,suppliedbycorpo-rate manager.

Fig. 1: Impact of fraud upon decisions of information usersSource : compiled by the authors

Fraud

Fraud involving management Fraud involving employees

Collusions with external third parties

Informationmisstatementdueto:

Fraudulentfinancialreporting Asset misappropriation

Incorrect conclusions and decisions by information users

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Fraud Tree and Relevance of Research thereof

Fraud cases tend to take a great variety of forms. They depend on a number of fac-tors, such as corporate governance struc-ture, internal control schemes, activitiesperformed (production, commercial, fi-nancial, investment, etc.), the expedienceof persons committing fraud and others. Literatureavailableonaudit(Mackevičius,Bartaška, 2003, p. 39;Atestuoto audito-riaus darbo vadovas,2003;HandbookonInternationalAuditing,AssuranceandEth-ics Pronouncements 2008, p. 231;Well,,2002,p.25–26;Vanasco,1998,p.17–19)specifies the following fraudcasesas themostcommon:

1) Falsification of primary and con-solidatedrecords;

2) Falsification,intentionalmanipula-tion or altering of accounting en-triesusedtopreparefinancialstate-ments;

3) Concealment of transactions, fail-ure to record such transactions in primary documents and failure to enter such transactions in account-ingrecordsandfinancialstatements(intentionalomission);

4) Unauthorized recording of trans-actions in primary documents and entry into accounting records and financialstatements(entryoftrans-actions that have not been actually performed);

5) Intentional misapplication of ac-counting principles relating to amounts,classification,mannerofpresentation,ordisclosure;

6) Deliberatelyincorrectlydevelopedaccountingpolicy;

7) Intentional supply of incorrect in-formation on transactions and/orcorporateoperationalstatus;

8) Deliberatelyinaccurateforecastsandestimatesoffinancialindicators;

9) Asset misappropriation (theft) and embezzlement;

10) Other cases.

It is always a challenge for the audi-tor to foresee any occurrence of any of the above or any other types of fraud in an entity. Therefore the Association of Certi-fiedFraudExaminershasofferedaunifiedprofessional fraud classifier, also knownas “the Fraud Tree” for investigation of frauds.TheAssociationdefines threekeybranchesoftheFraudTree:(i)assetmis-appropriation; (ii) corruption, and (iii)fraudulent reporting.

The International Standard on Auditing 240specifiestheimportanceforanauditorto examine two types of information mis-statement,namely:(i)fraudulentfinancialreporting,and(ii)assetmisappropriation.In termsof the“FraudTree” theory, IAS240 refers to only two branches of the FraudTree.Butinrealityfraudisbecom-ing increasingly sophisticated, elaborate,employing scientifically based methodsandtechnologies,andevolvingintoagrow-ing number of new forms. Tax evasion is becoming one of fast growing crimes and certain illegal acts aimed at VAT avoidance in particular. Thus new branches appear on the Fraud Tree (see Fig. 2).

Every branch on Fraud Tree has several sub-branches (see Table 1).

The size of every branch and sub-branchontheFraudTreeisinfluencedbydifferent conditions and circumstances,goals and motives of persons involved in

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Fig. 2: Fraud TreeSource : compiled by authors

Table 1. Sub-branches of the Key Branches on the Fraud Tree

KeyBranches Sub-branches

1. Asset misappro- priation

2. Corruption

3. Misstatement offinancial statements

4. Tax evasion

5. Other frauds

1. Cash thefts2. Manipulations in securities3. Theft of tangible and intangible property4.Deliberatelyinappropriateuseoftangibleandintangibleproperty5. Concealment of income related to receipt of cash

1.Bribery2. Extortion3.Conflictsofinterests4. Illegal gratuities

1.Falsificationofdocumentsandaccountingrecordsandtheillegalusethereof2. Failure to enter the actually performed transactions into accounting records3. Entrance of actually unperformed transactions into accounting records4.Illegaloverstatementorunderstatementofassetsand/orrevenues5.Illegaloverstatementorunderstatementofexpensesand/orliabilities

1. Concealment of revenues2. Failure to submit VAT returns3.Falsificationofexportrecords4. Incorporation of shell companies

Other different frauds, undisclosed and non-described in relevant literature,although committed in practice.

Source : compiledbyauthors

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the designing of the crimes. Three basic circumstances/preconditionsmaybedis-tinguishedhowever,uponthepresenceofwhichafraudmaybecommitted:

1)Management and/orother employ-ees in a company are induced or forcedtocommitfraud;

2) Opportunities (e.g. weak internal controls) conducive to commitment offraud;

3) Persons intending to commit fraud have relevant unethical attitude and features of character.

Butinrealitythepresenceofallthreeabove preconditions is not indispensable for commitment of an act of fraud. How-ever, even otherwise honest individualscan commit fraud in an environment that imposes sufficient pressure on them.Themore intense is the pressure or encour-agement,thehigheristheprobabilitythatthe person will commit fraud. Most com-monly, frauds are driven by a strive togainbenefit (Mackevičius,2001,p.299),other motives being jealousy, anger, re-venge, greed, blind belief in something,hatred,pride,mistrust, laziness,mockery,acknowledgement of being a loser, lackofknowledge,sickness,pain,fearofloss,uncertainty,etc. (Kabašinskas,Toliatienė,1997, p. 169).An auditormust take anyand all measures and perform all possible procedures in order to disclose and inves-tigate frauds properly.

Auditor’s actions in investigating the “Fraud Tree”: detection of a risk of fraud

An auditor’s possibilities to detect an act of fraud depends on his/her professionalcompetence, practical skills and experi-

ence, incidence rate and scope of fraudcases, scale of collusions involved andmany other factors. Audits and reviews are procedures performed on financial state-ments of a company, for the purpose ofdetermining whether financial statementsinclude any material misstatements. Mis-statements are essentially wrong numbers due to numerical errors, fraud, or errorsin interpreting accounting rules. Mis-statements arematerial, if they are largeenough tomakeadifference to auseroffinancialstatementssuchasbankorinves-tor. So how doesfraudfitintoideaofma-terial misstatements? Misstatements can be caused by either error or fraud. Audi-tors have some responsibility for detection of both errors and frauds that are mate-rial,butthisresponsibilityisnotabsolute.(Coenen,2006).

Fraud by it’s nature is something that canbeextremelydifficulttodetectto.Us-ersoffinancialstatementcansometimesbemistakenwhentheythinkthatunqualifiedopinionissuedbytheauditoronfinancialstatements always means that these state-ments are one hundred percent accurate and their systems are totally robust – this is not necessarily the case. Auditors should therefore ensure that their letters of engage-ment emphasise that the nature of the audit is such that a material misstatement may notberevealedduringtheaudit.However,this is not designed as a ‘get out of jail’ card for not doing appropriate audit test-ing in terms of fraud. Auditors must ensure that their audit work supports the opinion they give on financial statements and anefficient audit would normally detect amaterial misstatement whether caused by fraud or error.

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The auditor must seek for as much as possible scrutinized examination of cir-cumstances and events creating conditions favourable for the commitment of fraud,fraud detection of methods and motives,aswellastools,throughwhichsuchfraudhasbeencommitted, i.e.asmanyaspos-sible risk factors involved. Fraud-related riskfactorsareoverlynumerous,thereforeit is expedient to classify them into certain categories (See Fig. 3) and consider them properly and consistently.

Investigating the risks of material mis-statementsinfinancialstatements,anaudi-tor must focus on analysis of management characteristics and their effect upon thecontrol environment within an entity. The auditormustfindout such circumstancesas management inclination to inappro-priately understate declarable revenues

overstate corporate share value,manage-ment’s commitment to fulfill apparentlyunrealistic or history of negligent attitude towardsinternalcontrols,orignoringanyrequirementssetbyexternalregulatoryin-stitutions,etc.Theauditormustnoticetheefficiency of the corporate organizationalstructure, rotation of managers, board orcouncilmembers, any claims against theentity or its management for fraud or other incompliance,etc.

The auditor must examine also the keysector-specificfraudriskfactors(e.g.,fierce competition within the sector, de-clining industry, numerous bankruptcies,rapidchangesinindustry,rapidlydevelop-ingtechnologies,etc.).

A special attention must be paid to fraud risk factors related to corporate operations featuresandfinancialstability.Firstly,the

Management’s properties and impact on the con-trol environment.Sector-specificconditions.

Peculiaritiesofcompany’soperationsandfinan-cial stability

Possibilities for asset misappropriation Asset control.

Corruption schemes.

Concealment of proceeds.Engagement in import and export operations.Failure to supply VAT returns.Use of shell companies.

Fig. 3. Examination and evaluation of fraud risk factors.Source : compiledbyauthors

Misstatement of financialstatements

Asset mis sapropriation

Corruption

Tax evasion

Fraud risk factors

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auditor has to evaluate company’s abil-itytogenerateitscashflows,performtheanalysisofkeyrelevantfinancialindicators(solvency,profitability,assetturnover,costlevelandothers),findoutwhetherornotthe company has been engaged in unusual or overly complex transactions, whetheror not it is engaged in unduly aggressive sales promotion or profit enhancementprograms,etc.

In investigating asset misappropriation risk factors the auditor must make every effort to detect possibilities for such as-setmisappropriationtotakeplace.He/shemustpayattentiontothefollowingfactors:whether the company keeps high amounts ofcash,oranumberoffine,butespeciallymarketable and valuable things and easily exchangeable items in the entity. Thor-oughly assess the features of the property concerned,propertytypesandpossibilitiesfor stealing.The auditor shall be specifi-cally thorough in assessing asset security control system.

Corruption cases always pose a great-est challenge to the auditor. Corruption is anattempttogainsomeunjustbenefitbyabusingone’sofficialposition,orbriberyofanofficialorapublicfigure(Dabartinėslietuvių kalbos žodynas), 1993, p. 327).Corruption schemes may take a huge va-riety of forms, as a rule involving thirdparties. Most common types of corrup-tion inLithuania are bribery and conflictofinterests.Inanactofbribery,apersonisengagedinoffering,givingortaking,orintermediatesinoffering,givingortakingsomething valuable, so that certain laws,resolutions or business decisions would be replaced without any knowledge of certain related persons.

Inschemesofconflictsofinterests,man-agers or employees of companies have cer-tainpersonalfinancialoreconomicintereststhrough economic operations that have most immediateeffectupon theperformanceofthecompany.Asarule,theaforementionedand some other corruption schemes (extor-tion, illegal gratuities, etc.) are related toother fraud schemes (e.g. stealing of prop-erty, concealing of sales revenues, etc.).Therefore corruption schemes during audit may be detected only after identifying and examining other fraud schemes.

There are many ways of fraud seeking toseizeVAT,andtheyhappentobeveryinventive. Among most popular types of fraud are revenue concealment, perform-anceofexportandimportoperations,fail-ure to supply VAT returns and incorpora-tion of shell companies. When seeking to conceal revenues goods or raw materials obtainedarewritten-offasconsumed,butactually they are sold where the proceeds arenotrequiredtobeenteredintoacash-register, or where no accounting docu-mentsareissued,e.g.inthestreetmarket.Ordinarily this is the way to market some highly demanded consumer goods.

In performance of export operations,anexportoperationisactuallyperformed,butincorrectdataonthevalue,quantitiesand/orpurchasersofgoodsareenteredinrelevantdocuments,exportdocumentsareforged,andgoodsarenotactuallyexport-ed. In performance of import operations,such imports of goods are not declared (smuggling),someothergoodsaredefinedin relevant documentation, or goods areactually imported, but incorrect data ontheir value, quantities or consignors aredeclared in relevant documentation.

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Investigating cases of failure to supply VAT returns, an auditormust pay an ap-propriate attention to the fact that this may bethewayofseekingto:

1) Conceal performed activities and avoidtaxpayment;

2) Avoid payment of VAT to the budg-et by implementing any of illegal activity models, where such un-paid VAT is included into the VAT returns and/or recovered from thebudget by other companies partici-pating in such criminal activities.

To avoid VAT payment to the state budget,corporatemanagerssometimesuseshellcompanies.Theterm‘fictitious/shellcompanies’ is usually applied to the com-panies,which are used not for economicactivities,but ratherseekingselfish inter-ests or as a cover in performance of any other activities than provided in incorpo-ration documents of such companies. As a rule,suchcompaniesareincorporatedwiththeuseofforgeddocumentsand/oronbe-half of a dummy (usually, some sociallyexcludedperson),whoisnotactuallypar-ticipating in activities of such incorporated company and sometimes even unaware of such company. Shell companies may be also invented companies, in the name ofwhichsalesdocumentsofgoods/providedservices may be issued (name and legal de-tails of such invented company, or nameoflegallyexistingcompany,butinventedlegaldetails,orlegaldetailsbysomeothercompany may be provided in the docu-ments).

Shell companies engaged in sales of goods or provision of services transactions failtopayVATtotheStatebudget,whereasother companies taking part in such trans-

actions declare VAT on their VAT returns and recover VAT from the State budget.

As soon as an auditor notices certain fraudrisk factors,he / she, takingproperconsideration of their character and signif-icance,must decidewhether the plannedauditproceduresaresufficientinthispar-ticular case, or their character, time andscope have to be changed with a possible applicationofadditional,moreelaboratedprocedures.

Afterqualifiedevaluationofthefraudrisk factors, an auditor may identify thesituations where a case of fraud may be present.Besides,theauditperformanceit-selfmay prevent themanagement and/oremployeesofthecompany,aswellasthirdparties engaged in certain illegal agree-ment from commitment of fraud. It should bestressedout,however, that theauditoris not responsible for the performance of fraud prevention.

As soon as an auditor detects signifi-cant informationdistortionsdue to fraud,he/she must notify this to the corporatemanagementandseniormanagers,andinsome cases even to the law enforcement and prosecution officials. It is extremelyimportant to notify on due time for the management to undertake appropriate measures. It is important to notify even if theactoffraudisinsignificant,e.g.asmallamount of cash appropriated by a lower rankofficial in the company.Sometimes,auditors face the questionwhich rank ofthe management he/she has to notify ofhis/her obtained evidence of possible oractual fraud. This depends on possibility ofexistingofanyillegalagreement,orthemanagement’s involvement in the case of fraud.Asarule,auditorsshouldnotifythe

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managers of a rank higher than that of the persons allegedly involved in the fraud.

Managers has the responsibility for the maintenance of adequate accountingrecords and internal controls, preventionand detection of fraud and errors, safe-guardingofassets, selectionandapplica-tion of suitable accounting policies and appropriate disclosure of financial infor-mationinfinancialstatements.Preventionand detection of fraud is a big challenge. Inordertoreduceitsincidence,companymanagement, boards of directors, regula-tors and auditors all must share responsi-bility.(Watson,2002).Inmostcasesinter-nal audit is dedicated to determining what improvements would be needed to fraud management processes and how to make thosechangesquicklyandefficiently.

Conclusions

A fraud is deliberate actions by one or sev-eralmanagersand/oremployeesinacom-pany,or thirdparties, committedwith anaimtobenefitundulyandillegally.Fraudsoften induce huge financial scandals andcollapses of largest international corpora-tions. They cause lots of negative after-ef-fectsnotonlytocompaniesandtheirstaff,but also to other related corporations and organizations,governmentsandsocieties.Frauds are detrimental to the reliability of financial statements and may lead infor-mation users to arriving at incorrect con-clusions or passing wrong business deci-sions.

As a rule, frauds encompass complexand carefully prepared schemes for con-cealment thereof. It is especially difficultto detect frauds in cases of collusions with

external third parties. Auditors face a real challenge in detecting frauds committed by management that is much higher than in case of fraud involving employees, asmanagers are in a position to exercise sig-nificant influence in the company, havebetterpossibilitiestoconcealcertainfacts,enter into agreements with third parties,etc.

As cases of frauds may be numerous andversatile,auditorsaresuggestedtousethe ‘Fraud Tree’ theory in order to facilitate detection of such frauds. According to the theory,allfraudsareclassifiedintocertaincategories. The authors of the present ar-ticle suggest to apply the new structure of theFraudTreebydistinguishingfivekeybranches: (i) asset misappropriation; (ii)materialmisstatements of financial state-ments; (iii) corruption; (iv) tax evasion;(v) other undetected frauds. Every main branch on the Fraud Tree has several sub-branches.Thesizeofeachbranchandsub-branch on the fraud tree is determined by differentcircumstances,goalsandmotivesof the persons committing the fraud.

Auditorsshouldtakeeveryeffortinasscrutinizedaspossibleexaminationofcir-cumstances and events creating conditions conducive to the commitment of fraud,identifying the ways, tools and motivesof such commitment. To facilitate disclo-sure and evaluation of fraud risk factors,wesuggesttheclassificationaccordingtothe main branches on the fraud tree with distinguishing most important risk factors related to each of them. For investigation ofsuchriskfactors,wesuggestusingauditprocedures,changingthecharacter,timingand scope of audit procedures.

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