Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan
HIRONORI F UKUKAWA*

THEODORE J. MOCKRAJENDRA P. SRIVASTAVA

Graduate School ofCommerce and Management,
HITOTSUBASHI UNIVERSITY

School of Business Administration,
UNIVERSITY OF C ALIFORNIA, RIVERSIDESchool of Business,
THE UNIVERSITY OF KANSAS

ABSTRACTThis paper introduces an approach to the assessment of financial statement fraud risk
and audit program planning and illustrates its application by simulating its use in the1999 audit of Olympus. The approach incorporates a rigorous approach to assessing
risk and current standards and conventions to fraud risk assessment not in practiceduring the period when a substantial financial statement fraud occurred at Olympus.
The approach described in this paper illustrates a ‘what-if’ analysis that suggests thepossible effectiveness of using updated standards, practice and research on detecting
financial statement fraud.
In the proposed approach, which is based on the Theory of Belief Functions, auditors
follow three steps: (1) fraud risk assessment at the overall financial statement level, (2)fraud risk assessment at an account level, and (3) assessment of account, transactionand evidence schemes used to perpetrate fraud. In the evidential network, formal
auditor belief assessments concerning evidence obtained in each audit step are
aggregated by using Dempster’s rule. High aggregated assessments of belief-in-fraud
or plausibility-of-fraud which exceed the thresholds established by the audit firm
requires the auditors to engage in further investigation, to heighten the level ofprofessional skepticism, and, where appropriate, to adopt a forensic audit approach.
The results of analyzing the 1999 audit of Olympus demonstrate that the applicationsof current standards applied jointly with our approach would have likely both indicateda high plausibility and belief that fraud existed and would have likely directed the audit
team to effective forensic audit procedures.
JEL Classificatoin: D81; M42; M48
Key Words: Financial Statement Fraud; Forensic Audit Procedures; Design Science;
Theory of Belief Functions*

Corresponding Author. Address Graduate School of Commerce and Management, Hitotsubashi University, 2-1 Naka,
Kunitachi, Tokyo, JAPAN. Telephone +81-42-580-8468
E-mail h.fukukawa@r.hit-u.ac.jp
Received October 29, 2013; available online February 12, 2014 (Advance publication by J-STAGE)
DOI: 10.11640/tjar.4.2014.01

Copyright©2014 Research Institute for Economics & Business Administration - Kobe University.

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1. Introduction
The main objective of this paper is to apply a modification of a fraud risk (FR) assessment
framework developed by Gao (2005)1 and designed for assessing the risk of fraud to the specifics
present in the Olympus financial statement fraud case. The objectives include demonstrating theapplication of a structured, three-phased approach to fraud risk assessment and evaluating its use
in complex fraud settings.
The research approach used is that of design science (March and Smith 1995; Hevner et al.
2004; Perols 2011, 2012) which has the primary goals of creating novel frameworks (‘artifacts’)and evaluating their utility in analyzing complex problems. The assessment of financial statement
fraud is clearly a complex problem that the audit profession and audit researchers have been
grappling with for many years (e.g., Weil 2004).
The FR assessment framework uses an evidential reasoning approach to assess fraud risk andpoint to appropriate (forensic) audit procedures. The framework is evaluated by completing thethree general steps sketched in Table 1 and Figure 1.
TABLE 1: BASIC FRAUD RISK ASSESSMENT STEPS AND AVAILABLE EVIDENCE
Fraud Risk (FR)Assessment Step

Key Categories and Items of Evidence[Evidence shown as (Bel-in-fraud; Bel-in-no-fraud) with ambiguity and plausibility implicit]

Prior
Based on 1998
audit

E1.1: Prior fraud risk assessment: Based on posterior at the end of 1998 audit. At the end of 1998 audit (andthus prior for 1999 audit), belief-in-fraud very low and plausibility-of-fraud less than threshold. Assumed tobe (0.001, 0.95) thus at the beginning of 1999 audit, plausibility of fraud starts at 0.05 and belief at 0.001.

Step 1:
Compilation of
overall 1999
evidence for
initialassessment of FR

E1.2: Overall-level evidence gained from research into the general economic environment and other client
engagement continuance considerations. Assume nothing relevant to fraud risk beyond those linked directly
to fraud triangle identified. (0.0, 0.0)
Overall-level fraud triangle assessment (e.g., based on BAC 2013, JICPA Statement 240, ISA 240 and SAS 99
guidance): Based on assumed implementation of formal assessment of the three elements as part of initial
analytical procedures; Engagement team discussion regarding risk of material misstatement due to fraud;Inquiries of management regarding fraud and assessment of management characteristics including integrity.
Evidence specific to particular accounts considered in Step 2:
EI1.n: Evidence interpreted in terms of implications concerning ‘Incentive’ :EI1.1 Poor F/S Performance (0.1, 0.0)
EO1.n: Evidence interpreted in terms of implications concerning ‘Opportunity’:EO1.1 Ineffective Monitoring by BOD (0.1, 0.0); EO1.2 Organizational Culture (0.05, 0.0);
EO1.3 Authority Concentration (0.05, 0.0); EO1.4 Lack of Job Rotation (0.05, 0.0)
EA1.n: Evidence interpreted in terms of implications concerning ‘Attitude’:EA1.1 Restrained Information Disclosure (0.05, 0.0); EA1.2 Possible Lack of Objectivity (0.05, 0.0)

Step 2:Compilation of
specific accountlevel evidence for
FR assessment
and updating ofoverallassessment

Specific consideration of evidence related to fraud triangle factors applied at the account level to all significant
accounts; Ranking of FR by account (Illustration based on ‘Short-term Investments’ account):
EI2.n: Evidence interpreted in terms of implications concerning ‘Incentive’:
EI2.1 Change in External Environment (0.1, 0.0)
EI2.2 Change in Accounting Standards (0.2, 0.0)
EI2.3 Amount of Short-term Investments (0.05, 0.0)
EO2.n: Evidence interpreted in terms of implications concerning ‘Opportunity’:EO2.1 Lack of Financial Expertise (0.05, 0.0)
EA2.n: Evidence interpreted in terms of implications concerning ‘Attitude’: (none)

Step 3:
Account,transaction andevidence scheme
analysis1

Evaluation of specific evidence related to account schemes used to perpetrate fraud and for accounting schemes
to depose of (overvalued) assets without recognizing loss:
EAS1.1 Detection of Loss Transfer Transactions (0.3, 0.0)
EAS1.2 No Similar Loss Transfer Transaction (0.0, 0.7)

See also Gao and Srivastava (2011) and Gao et al. (2011, 2013).

Evidence related
to specificEvidence
Scheme EV2 for
Account Scheme
B1

3

I.
IncentiveA.
Attitude

Evidence related to specific Account
Scheme B2

EI2 Items of evidence pertaining toincentives of management to commit fraudat specific Account B

EA2 Items of evidence pertaining toattitude of management to commit fraudat specific Account B

O.
Opportunity

EI1 Items of evidence pertaining toIncentives of management to commit
fraud at the Overall Level

A.
AttitudeR3

EA1 Items of evidence pertaining toAttitude of management to commit fraud
at the Overall Level

R2
O.
OpportunityAND

E1.1 Baseline assessment of fraud risk at
the overall level

F. Fraud at
the Overall
Level

R1

EO2 Items of evidence pertaining toopportunities of management to commit
fraud at specific Account B

I.
Incentive

R2

R3

AND

Step 2

R1

OR
Fraud inAccount B

Fraud using
Account
Scheme B1

Fraud using
Account
Scheme B2

OR

Fraud using
Evidence
Scheme EV2
for Account
Scheme B1

Fraud using
Evidence
Scheme EV1
for Account
Scheme B1

Evidence related to specific Account
Scheme B1

Step 1FIGURE 1: OVERALL EVIDENTIAL NETWORK FRAUD RISK ASSESSMENT

Step 3Evidence related
to specificEvidence
Scheme EV1 for
Account Scheme
B1

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

EO1 Items of evidence pertaining toOpportunities of management to commit
fraud at the Overall Level

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The Japanese Accounting Review, 4 (2014), 1-25

Figure 1 presents a general evidential diagram for assessing fraud risk (FR). A key feature of
our approach is three general steps2 that are expected to result in a more complete and moreaccurate assessment of fraud risk than that occurs with less structured approaches. These steps are
represented by the three columns in Table 1. The following sketches the approach which isapplied in this case study:
1. Step 1 represents an initial overall assessment of FR based on evidence that relates to thefinancial statements as a whole, primarily evidence collected and considered in the initialstages in an audit. An example is evidence of general economic conditions that makes it
difficult for a client to meet profit targets or evidence of inexperience in the client’s
accounting department. These factors may provide incentive and opportunity for
management to intentionally misstate.
2. Step 2 represents an assessment of FR at the account level based on evidence that relates
to specific accounts and transaction streams. For example, evidence of significantly
greater sales growth than competitors may indicate possible sales reporting fraud. In
addition, Step 2 involves ordering of the accounts by FR to see which accounts represent
a FR level that requires additional fraud investigation effort and heightened professional
skepticism. For these accounts, Step 3 will be conducted.
3. Step 3 is performed for those accounts with significant FR and involves an evaluation of
specific evidence related to account and accounting (transaction recording) schemes used
to perpetrate fraud and involves an evaluation of specific evidence related to evidence
schemes used to disguise, mask and conceal fraud such as creating fictitious documents.
Again, Step 3 should be performed with heightened professional skepticism.
Three symbols are used to indicate the particular type of variable in Figure 1: oval-shapedboxes represent assertions, rectangular boxes represent items of audit evidence, and hexagonalboxes represent relational nodes connecting assertions and sub-assertions. The symbols outlinedwith dashed line indicate items that need to be completed during the audit process. Usually this isdone in the indicated sequence, although cycling back to earlier steps is normal as additional
evidence becomes available.
All of the evidence obtained at each step is used to update beliefs and estimate fraud risk
using a belief function calculus. This information is used to plan effective (forensic) procedures,
effective as they are based on knowledge concerning the account, transaction recording andevidence schemes that are most likely.
The framework as applied to Olympus explicitly assesses 15 items of evidence (see Table 1)
to obtain an updated assessment of FR (see Figures 1 through 4). These may be categorized into
six groups which are important determinants of fraud risk:
1. A ‘prior’ or baseline assessment based upon the prior-year audit if the client is not new,2

As each of these steps is completed, particularly steps 2 and 3, current audit standards dictate that professional
skepticism be applied. In cases where fraud risk is significant, skepticism should be heightened. We illustrate in thefollowing how this may be formally implemented.

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan5

on general audit firm knowledge concerning financial statement fraud frequency and on
knowledge gained from academic (e.g., Messier et al. 2010) and professional research(e.g., Deloitte Forensic Center 2009). For Olympus, this would be based largely on theprior-year (1998) audit.
2. Current year general evidence at the overall financial statement level which results in a
general assessment of fraud risk [Step 1]
3. Evidence related to the likelihood of the fraud risk factors Incentives, Attitude, andOpportunities at the overall financial statement level [Step 1]
4. Evidence related to the likelihood of the fraud risk factors Incentives, Attitude, andOpportunities being present specific to particular accounts [Step 2]
5. Evidence related to the account-based or transaction-recording-based fraud schemes
which are used to manipulate account balances or financial performance results [Step 3]
6. Evidence related to the evidence-based fraud schemes which are used to deceive auditorsand conceal fraud (Gao and Srivastava 2011) by creating fictitious evidence ormanipulating evidence [Step 3]3
Importantly, the framework provides a way to assess in which accounts fraud could havebeen perpetrated and concealed by tying the presence of opportunities, incentives and an attitude
that permits fraud to be rationalized to potential fraud schemes. The framework is flexible andcan be adapted to the specifics of each engagement setting. Thus, the framework can be used byaudit teams as a guide to assess fraud risk and can be incorporated into firm training to educate
auditors about linking planning-phase fraud risk assessments, fraud schemes, and various items ofevidence.
The paper is organized as follows. Section 2 reviews prior professional and academic
literature. Section 3 presents the general evidential reasoning framework for fraud risk assessment
and applies it to the general context which existed during the initial years of the Olympus fraud.
Section 4 illustrates how Olympus auditors could have used the framework to perform fraud risk
assessment, to plan an appropriate audit program, and to evaluate audit results. Section 5
concludes with a discussion of contributions and suggested future research.
To attempt to evaluate the effects of applying the framework sketched in Figure 1, we
simulate what a plausible assessment of fraud risk might have been if the actual Olympus auditors
had first completed their assessment of fraud risk the year prior to the actual discovery of thefraud and then incrementally had applied the key elements of our framework. Thus we ask theresearch question:
RQ: “What if” the Olympus auditors had completed the three steps for enhanced
fraud risk assessment suggested by our framework?
3

In some cases, frequency information may be available to guide the FR assessment. Gao et al. (2013) utilize thisapproach and a ‘conditional OR’ to weight evidence based on frequency knowledge.

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2. Relevant Literature
In this section, we first provide background on the Dempster-Shafer (DS) theory of belief
functions and then on Olympus. Although there are several publications available in the literaturethat provide good introductions to DS theory (e.g., see Srivastava 1993; Srivastava and Mock2000, 2002, 2005; Srivastava and Shafer 1992), for the convenience of readers, we introduce thebasic concepts of DS theory relevant to the current paper. There are three basic functions, thebasic belief mass function, the belief function, and the plausibility function, which are important alongwith Dempster’s rule of combination.

2.1 Belief functions and Dempster’s rule
DS theory (Shafer 1976) is a framework for representing and managing uncertainty (risk)
and for assessing the effect of obtained evidence on uncertainty. In this paper, it is applied to theassessment of fraud risk. It is a broader framework than probability theory and in certain
situations reduces to probability theory.
Consider a situation (i.e., a question such as ‘Is there significant financial statement fraud?’)with ‘n’ possible mutually exclusive and exhaustive outcomes (i.e., answers): a1, a2, a3, . . . an.
This set of outcomes is known as the frame of discernment, , with  = { a1, a2, a3, . . . an }.
Suppose that we have (audit) evidence that provides knowledge that supports or disconfirms
the possibilities or, is mixed in its support. Under probability theory, this situation may be
expressed as probability distribution over the entire frame by assigning probabilities to eachnoutcome: P(a1), P(a2), . . . P(an), where 1P(ai)0, and P(ai) = 1. There is no provision in
i =1

probability theory to assign probabilities to more than one element, that is, to combinations of
the assumed mutually exclusive elements.
Under DS theory, however, we express the knowledge gained from available evidence interms of a basic belief mass function. This function assigns m-values to all the subsets of the frame
and to the entire frame, i.e., to all the single elements: m(a1), m(a2), … m(an); all the subsetswith two elements, m({a1, a2}), m({a1, a3}), . .; all the subsets with three elements, m({a1, a2,a3}), m({a1, a2, a4}), . . . , and so on to the entire frame, m({}). The sum of all the belief masses
equals one, i.e.,  m(A)  1 , where A represents the subsets of elements contained in the frameA or the entire frame. By definition, the m-value assigned to an empty set is zero, i.e., m() = 0.
In situations where non-zero m-values are assigned only for the single elements, the DS
framework reduces to probability theory. Thus, DS theory is a broader framework forrepresenting uncertainties and risk, and it reduces to probability theory when m-values for all thesubset of elements are zero except the m-values for the single elements.
To illustrate the concept of the basic belief mass function, consider an example of fraud
being present (f) or absent (~f) in the financial statements of a company. The frame ofdiscernment is represented by  = {f,~f}. Suppose we have weak audit evidence that suggests a
possibility of fraud. Such evidence can be mapped in terms of the basic belief mass function as;m(f) = 0.1, m(~f) = 0, m({f,~f}) = 0.9, where m(f) = 0.1 represents that 10% of the mass is
assigned to fraud-being-present on a scale of 01, and m(~f) = 0 represents that there is noevidence negating fraud. The belief mass m({f,~f}) represents the level of ambiguity or ignorance

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

7

that exists given the available evidence. In this case, that would be 0.9 as we assume there is only
very limited evidence available.
The Belief Function, on the other hand, represents the total belief that an outcome or a setof outcomes are true or not true considering all the evidence. In general, the total belief in a set ofelements, A, of a frame , can be written as: Bel(A) =m(B) , where B represents all the



B A

subset of elements contained in A.
For the example given above, based on just one item of evidence, the belief that fraud ispresent is Bel(f) = m(f) = 0.1, and the belief that fraud is not present is Bel(~f) = m(~f) = 0,
whereas the belief that either fraud is present or not present is Bel({f,~f}) = m(f) + m(~f) +m({f,~f}) = 0.1 + 0 + 0.9 = 1.0.
In more complex situations where we have several items of evidence, a multi-step process isrequired to capture our knowledge given the available evidence. Once we have assessed thestrength of all items of evidence, we would use Dempster’s rule and then use the definition of thebelief function in terms of m-values as defined above to determine the total belief.
Next, we define the plausibility function. The plausibility function is defined as the
maximum possible belief assigned to an element or a set of elements based on the available
evidence. Mathematically it is represented as: Pl(A) =m(B) , which implies that the



AB

plausibility that the set A is true is the sum of all the m-values for subsets B that have non empty
intersection with the set A.
For our simple example, the plausibility that fraud is present, based on that one piece ofevidence is Pl(f) = m(f) + m({f,~f}) = 0.1 + 0.9 = 1.0, and the plausibility that fraud is not present
is given by Pl(~f) = m(~f) + m({f,~f}) = 0 + 0.9 = 0.9. By definition, the plausibility of a set A isequal to one minus the belief in not-A, i.e., Pl(A) = 1 – Bel(~A).
Next, we discuss the Dempster’s rule of combination. Dempster’s rule for combining various
independent items of evidence is similar to the Bayes rule of combination in probability theory.
In the case of two independent items of evidence (for more than two items of evidence, see
Shafer 1976), we can mathematically express the combined m-value for a non-empty subset A,
i.e., m(A), under Dempster’s rule as:m(A) =

 m (B1)m (B2) / K ,B1 B2 = A

1

2

(1)

where K is the renormalization constant defined as:

K =1

 m ( B1)m ( B2) .

B1 B2 = 

1

2

(2)

Equation 1 simply means that the combined m-value for a subset A is the sum of all the
products of the sets of m-values that have intersection A with renormalized by the factor K. The
second term in the renormalization constant K defined in (2) represents the conflict between thetwo items of evidence.
We illustrate the use of Dempster’s rule using the prior example. Consider the earlier

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evidence as the first item of evidence and, as assumed earlier, we represent the assessed m-values
as: m1(f) = 0.1, m1(~f) = 0, and m1({f,~f}) = 0.9. Consider a second item of audit evidence thatsuggests that there is no financial statement fraud which is assessed as 0.7 that fraud is notpresent. Assume also that this evidence says nothing about fraud being present. These judgments
can be expressed in terms of the following m-values: m2(f) = 0, m2(~f) = 0.7, m2({f,~f}) = 0.3.
Using Equation (2) above we get the following renormalization constant:
K = 1 – {m1(f)m2(~f) +m1(~f)m2(f)} = 1 – {0.1*0.7 + 0*0} = 1 – 0.07 = 0.93,
and the combined m-values as:
m(f) = {m1(f)m2(f) + m1(f)m2({f,~f}) + m1({f,~f})m2(f)}/K= {0.1*0 + 0.1*0.3 + 0.9*0}/0.93 = 0.03/0.93 = 0.0323,
m(~f) = {m1(~f)m2(~f) + m1(~f)m2({f,~f}) + m1({f,~f})m2(~f)}/K= {0*0.7 + 0*0.3 + 0.9*0.7}/0.93 = 0.63/0.93 = 0.6774,
m({f,~f}) = m1({f,~f})*m2({f,~f})/K = 0.9*0.3/0.93= 0.27/0.93 = 0.2903.
One can determine the updated beliefs and plausibilities in fraud and no-fraud using thedefinitions as discussed earlier:Bel(f) = m(f) = 0.0323, Bel(~f) = m(~f) = 0.6774,
Bel({f,~f}) = m(f) + m(~f) + m({f,~f}) = 0.0323 + 0.6774 + 0.2903 = 1.0,
Pl(f) = m(f) + m({f,~f}) = 0.0323 + 0.2903 = 0.3226, andPl(~f) = m(~f) + m({f,~f}) = 0.6774 + 0.2903 = 0.9677.
In actual audits including fraud assessment, the available audit evidence is of course much
more complex than this example. Two basic evidential models have been extensively developed in
the audit literature: the evidence ‘tree’ model and the ‘network’ model. We refer readers to
Srivastava (2011) and Mock et al. (2009) for a more thorough introduction to the evidential
reasoning approach used in this paper.

2.2 Olympus background
The Olympus fraud was exposed in July 2011 within an article published in a journal called
Facta (Facta 2011). In September, the Chief Operating Officer (COO), Mr. Michael Woodford,
sent a questionnaire letter about the issue to the Chief Executive Officer (CEO) and some otherboard directors and staff, but received no satisfactory response. After he was appointed CEO in
October, Mr. Woodford asked PricewaterhouseCoopers in the U.K. to investigate the issue andsent a questionnaire letter again to the former CEO and the board of directors. However, on
October 14, Mr. Woodford was dismissed as CEO by the board of directors. He asked the Serious
Fraud Office (SFO) in the U.K. to investigate the issue. On October 20, some institutional
shareholders requested that the company conduct a thorough investigation. In response to therequest, the company set up a third-party committee on November 1. Then, the company issued
a press release on November 11 in which it admitted that it had committed this fraud.
The fraud was a surprise to the Japanese business society and auditing profession given thatthe fraud had been perpetrated by a company with a high reputation over a period of more thanten years and given that the company’s financial statements had been audited by one of theJapanese Big 4 audit firms during that period. As noted and as is unfortunately the case in many
frauds, the fraud was not discovered by the financial statement audit.
Olympus has two main lines of business: cameras and medical instruments, primarily
endoscopes. In the 1980s, the camera business experienced a substantial downturn in demand
and Olympus’ operating income declined substantially from 6.8 billion yen in 1985 to 3.1 billion

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan9

yen in 1986. As one strategy to compensate for this decline, management decided to pursue a
strategy of increasing non-operating income through short-term investments. From 1985 to 1999
short-term investments increased five-fold and constituted more than 20% of total assets by thelate 90s, when the fraud began.
In 1990, the bubble economy in Japan which was based largely on inflated property values
burst and the stock market started to decline. Rather than supplementing the bottom line,
Olympus suffered unrecorded losses from the short-term investments (“securities” plus “shortterm specified financial instruments”) which amounted to 126 billion yen (at the end of the fiscal
year 1998) with approximately 95 billion yen accumulated by then.4 However, the company did
not need to report the accrued losses in their financial statements because accounting standards at
the time permitted financial instruments to continue to be valued at their historical cost until they
were sold or matured.
However, in 1997 discussion began regarding new accounting standards that would require
market value measurement of such financial instruments and the standards setters decided thatthe new standards would be in effect for the fiscal year 2001. Thus, in the late 1990s, Olympus
faced a pressing incentive to somehow cover the accrued losses in short-term investments whichwere approximately 95 billion yen by 1998 or more than ten times the 1998 net income. Rather
than book these losses, Olympus decided to implement some related-party and transactionaccounting tactics that materially misstated their financial statements.
The fraud was committed using two schemes. The first scheme called “Tobashi” resulted intransferring the losses in investments to other entities outside the company. To accomplish this,Olympus established investment funds (dummy companies) which then purchased the shortterm investments at their historical cost which was significantly higher than their market value atthat time. Olympus made deposits in some foreign banks and the banks provided the dummycompanies with funds to purchase financial instruments from Olympus by using the deposits as
collaterals. The “Tobashi” scheme was essentially completed by the year 2000.
The purpose of the second scheme was to dispose of the losses in the dummy companies
which were transferred to them. In acquiring some companies, Olympus first had the investment
funds purchase stock of the target companies, and then purchased those stocks from theinvestment funds at much higher prices than the original costs or the market value of the target
companies. In addition, Olympus paid unreasonably high advisory fees to a financial advisor that
had colluded with the company. The ‘profits’ of the investment funds and most of the advisory
fees were then used to offset the transferred losses. As the result of these fraudulent transactions,the losses in the short-term investments had changed their form to goodwill incurred in theacquisitions and Olympus had planned on amortizing the goodwill in the future, thus postponing
the recognition of the losses.
As is evident, the fraud schemes were complex and were carried out in a skillful manner,which involved establishing off balance sheet accounts and collusion with outsiders. In our
analysis below, we focus on the 1999 audit and on the “Tobashi” scheme as an illustration of how
our approach would have likely identified the initial fraud.

4

The case description is based on the investigation report issued by the third-party committee formed by the company(Third-party Committee 2011) unless otherwise indicated.

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3. Application of the Evidential Reasoning Framework to Olympus
We start our analysis with some evidence that would have been available given the Japanese
auditing standards as of 1999 to obtain a baseline fraud risk assessment. Then we augment thisassessment by applying the three steps sketched in Figures 1 through 4 and Table 1.
Our risk assessments focus on two measures of fraud risk: the belief-in-fraud andplausibility-of-fraud (Fukukawa and Mock 2010). The key difference in these two measures isthat belief is based on actual audit evidence that directly implies the possibility of fraud whereas
plausibility adds a measure of the level of unresolved uncertainty or ambiguity facing the audit
team at any point in the audit. As uncertainty usually cannot be totally eliminated in a complex
audit setting, plausibility usually is greater than belief. As audit evidence is accumulated,ambiguity is lowered and the measure of plausibility approaches the assessment of belief.

3.1 Assessment of Olympus fraud risk
As indicated, although the Olympus fraud had been going on for a long period, there is noevidence that the auditor had assessed fraud risk to exceed the threshold that would have resulted
in changing the normal audit approach to what could be called a forensic approach where
extensive fraud detection procedures would have been applied. Although it is unclear what thisthreshold would have been or what it normally would be in Japanese audit practice, it clearly
would have been a ‘low’ level of risk.
For purposes of discussion, for the auditor’s prior at the start of the 1999 audit, we assume
belief-in-fraud was 0.001. This essentially means that, particularly with continuing clients, theauditor would not expect the frequency of material intentional financial statement misstatement
to exceed one in a thousand. We also assume that the prior plausibility-of-fraud was 0.05. Thus,
it follows that the prior belief-in-no-fraud was 0.95 and the ambiguity level was 0.049. As theaudit firm had a long period of involvement with the client, it is certainly reasonable that
extensive 1998 audit evidence, summarized as E1.1 in Table 1, would have been available
indicating that the financial reports were not intentionally misstated. The exact level of thesepriors is not critical as sensitivity analysis shows that the main results of our illustration are notsensitive to these baseline values as long as they are ‘low’ assessments of fraud risk.
The following three steps illustrates how using a rigorous, quantitative risk assessment
method in conjunction with the more explicit and focused audit of fraud based on current
standards could have resulted in the auditors of the 1999 Olympus financial statements
discovering the fraud.

3.2 Updating the prior assessment as the three audit steps are completed
Step 1: Fraud risk assessment at the overall level
Audit practice involves a complex set of client acceptance and audit planning steps.
Obviously, a research paper cannot replicate all of the details of an actual audit. What we do toprovide a plausible description of the Olympus 1999 audit is to discuss the three general steps in
our approach; indicate some of the audit evidence that was likely available if current audit
standards (BAC 2013, JICPA Statement 240, ISA 240, SAS 99) were in place and calculate how
the baseline FR assessments might have been updated. Thus we are attempting to decide ‘what-

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan11

if’ our approach and current standards had been applied.5
The initial assessments in Step 1 involve collecting evidence E1.2 and then integrating itwith evidence E1.1 (see Table1). As indicated above, E1.1 can be interpreted as a Bayesian prior6
based on the posterior assessment at the end of the 1998 audit. We have assumed this prior was(0.001, 0.95), that is during 1998 sufficient audit evidence had been obtained to believe at a 0.95
level that there was no significant fraud.
During the early stages of the 1999 audit, the audit team would collect some overall audit
evidence such as considering general economic conditions. Current audit standards (BAC 2013,
JICPA Statement 240, ISA 240, SAS 99) indicate a number of audit steps that should be used.
For simplicity, we assume that these activities would not have produced any evidence either offraud or of no-fraud and have assumed E1.2 was assessed at (0.0, 0.0). The prior evidence (E1.1)
and the initial FR tests (E1.2) would be combined using Dempster’s rule. If E1.2 results in no
new FR evidence, the updated assessment would equal the prior.
To next update the FR assessments, we focus on a more important feature of our approach,that is considering the fraud triangle factors (incentives, opportunities, and attitude) (BAC 2013,
JICPA Statement 240, ISA 240, SAS 99) and evaluating relevant audit evidence that existed in
1999. The main difference from what the actual auditors likely did is that we utilize a formal
approach to quantify risk and we apply more current audit standards’ requirements in conducting
the fraud risk assessment.
In Figure 2 and Table 1, we document the assumed additional fraud triangle evidence thatwould be collected during ‘Step 1’ of our approach. First we consider evidence related to possible
incentives to misstate.

5

The updating has been reviewed by a practicing auditor for reasonableness, and sensitivity analysis has been
conducted to see the effects of changing these assessments.
6
It is more correct to refer to this as a Theory of Belief Functions Prior as we allow for an explicit amount of ambiguityin the prior. Both of these ‘priors’ play the same role in each formalization in that, as new evidence becomes available,
they are updated into ‘posteriors.’Fraud using
Account
Scheme B2

Evidence related to specific Account
Scheme B2

I.
IncentiveA.
Attitude

EA2 Items of evidence pertaining toattitude of management to commit fraudat specific Account B

O.
Opportunity

R2

R3

AND

Step 2Fraud inAccount B

R1

EI2 Items of evidence pertaining toincentives of management to commit
fraud at specific Account B

EO2 Items of evidence pertaining toopportunities of management to commit
fraud at specific Account B

I.
Incentive

EI1.1 Poor performance(0.1, 0)R1

EA1.1 Restrained information disclosure(0.05, 0)O.
Opportunity

R2

E1.2 General economic conditions(0.0, 0.0)

R3A.
AttitudeAND

EA1.2 Possible lack of objectivity(0.05, 0)

F. Fraud at
the Overall
Level(0.018, 0.934)

E1.1 Baseline assessment of fraud risk
(0.001, 0.95)

Step 1FIGURE 2: STEP 1 RESULTS FOR OLYMPUSOR

Evidence related to specific Account
Scheme B1

Fraud using
Account
Scheme B1

The Japanese Accounting Review, 4 (2014), 1-25

Step 3

12

EO1.1 Ineffective monitoring by BOD(0.1, 0)EO1.2 Organizational structure/culture(0.05, 0)

EO1.3 Authority concentration(0.05, 0)

EO1.4 Lack of job rotation(0.05, 0)Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

13

As stated above, after experiencing the substantial decline of operating income in the late 80s,
the company began pursuing profit from non-operating activities (i.e., short-term investment).
This strategy continued in spite of the bubble economy burst in 1990. Significant decline in
Olympus’ primary line of business and its dependence on short-term investment as a source ofincome in the midst of a prolonged recession clearly could have been an incentive formanagement to commit a fraud. Such incentives are red flags for fraud (BAC 2013, JICPAStatement 240, ISA 240, SAS 99) and should increase the auditor’s assessment of FR. To
approximate this, we assign a belief-in-fraud of 0.10 to this evidence and label it as EI1.1 inFigure 2.
Next, we consider the second fraud triangle factor, opportunities, to commit fraud. We
incorporate four items of evidence into our illustration.
Although not emphasized in audit practice or the standards at that time, current practice andstandards emphasize corporate governance as an important safeguard to financial statement
misstatement. If this aspect had been considered and investigated, the audit team would havediscovered that, at the overall level, the monitoring by the board of directors was not effective inthat the council of general executives, not the board of directors, had made most of the important
decisions including basic policies and guidelines for its business and general corporate strategy. In
addition, the corporate auditors (the audit and supervisory board members) did not attend themeetings of the council. These facts indicate that the overall effectiveness of corporate
governance was doubtful. Thus, a belief-in-fraud of 0.10 is assigned to this evidence and it islabeled as EO1.1 in Figure 2.
A second aspect related to opportunity relates to governance effectiveness in that thecompany had adopted a divisional organizational structure. In essence, the divisions operated
independently and sectionalism prevailed through the company. This fact provides additional
evidence of possible ineffectiveness of monitoring and increases the opportunity for financial
manipulation. We assign a belief-in-fraud of 0.05 to this evidence and label it as EO1.2.
Olympus had an organization that could be characterized by the concentration of vastauthority in a few hands. For example, the top management had an authority of appointment andremuneration of board directors, and it was difficult for board directors to raise an objection to
the top management. The authority concentration provides the top management with relatively
greater opportunity to commit a fraud. Thus, a belief-in-fraud of 0.05 is assigned to this evidence
and it is labeled as EO1.3.
Furthermore, job rotation did not work effectively especially in the finance and accounting
departments. Only a few people were familiar with accounting and finance issues and theauthority was concentrated in their hands. It was difficult for people outside the departments tograsp what had been done in the departments. Given that this should also increase the auditor’sbelief that fraud might exist, we assign a belief-in-fraud of 0.05 to this evidence and label it as
EO1.4.
Finally, we assess the attitude factor. The company was generally conservative about
disclosing information to outsiders. In principle, the company did not disclose information otherthan that required by regulation or law. Such reluctance to disclose information is considered asreflecting the company’s general attitude toward information disclosure and can be considered toincrease the possibility of a cover-up. This evidence is assigned a belief-in-fraud of 0.05 andlabeled as EA1.1.
In addition, the CEO, Mr. Kishimoto, was the head of the accounting department when the

14

The Japanese Accounting Review, 4 (2014), 1-25

former CEO, Mr. Shimoyama, started to focus on short-term investments in the late 80s. In
addition, Mr. Kishimoto was appointed CEO by Mr. Shimoyama in 1993. This indicates possiblelack of objectivity in that it would be difficult for Mr. Kishimoto to criticize what the former
CEO and he himself had done in the past. We assign a belief-in-fraud of 0.05 to this evidence
and label it as EA1.2.
Note that in none of these cases do we assume that the evidence would result in the auditor
increasing their belief that fraud likely would not exist. In practice, study of the client's corporate
governance would likely produce such mixed evidence. Our approach does facilitate assessment ofboth types of evidence. The main effect of such ‘positive’ evidence of good corporate governancewould be to decrease the plausibility of fraud and increase the belief that fraud does not exist.
Figure 2 shows the relationships among the items of audit evidence regarding the fraud
triangle factors at the overall level that auditors would have obtained to update the preceding FR
assessment. Based on the evidential network framework, the preceding assessment of fraud risk (abelief-in-fraud of 0.001 and a belief-in-no-fraud of 0.95) is updated to a belief-in-fraud of 0.018
and a belief-in-no-fraud of 0.934. The belief-in-fraud of 0.018 can be considered to be still below
the threshold that would trigger a forensic-type of audit approach (assumed to be 0.05). However,the plausibility-of-fraud of 0.066 is high enough for auditors to obtain further evidence. In otherwords, the belief-in-no-fraud of 0.93 is considered to be still below the threshold (assumed to be0.95) that would suggest that a forensic-type of audit approach is not appropriate.
For this situation, our approach recommends next considering any fraud risk evidence
relating directly to each material account balance and transaction stream where intentional
misstatement is at all likely. This evidence combined with Step 1 assessments will allow theauditor to focus on particular accounts that require additional (Step 3) audit effort.
Step 2: Fraud risk assessment at the account level
In Step 2, the fraud triangle factors are assessed at the account level (see Figure 3). This stepneeds to be applied to all significant accounts. Here we illustrate an application of Step 2 to theshort-term investments, a material account (24% of total assets at the end of the fiscal year 1998)
which had increased substantially in the early 90’s and which is at a very high level for this type ofclient.

Fraud using
Account
Scheme B2

Fraud using
Account
Scheme B1

Evidence related to specific Account
Scheme B1

15

Evidence related to specific Account
Scheme B1

EI2.3 Amount of short-term investments(0.05, 0)O.
Opportunity

R2

R3

I.
Incentive
R1

EI2.2 Change in accounting standards(0.2, 0)A.
AttitudeAND

A. Fraud in
Short-term
Investments(0.035, 0.918)

Step 2EI2.1 Change in external environment(0.1, 0)EO2.1 Lack of financial expertise(0.05, 0)I.
Incentive

EI1.1 Poor performance(0.1, 0)R1

EA1.1 Restrained information disclosure(0.05, 0)

EA1.2 Possible lack of objectivity(0.05, 0)

R3

AND

A.
Attitude
R2
O.
Opportunity

E1.2 General economic conditions(0.0, 0.0)

F. Fraud at
the Overall
Level(0.035, 0.918)

E1.1 Baseline assessment of fraud risk
(0.001, 0.95)

Step 1FIGURE 3: STEPS 1 AND 2 RESULTS FOR OLYMPUS

OR

Step 3

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

EO1.1 Ineffective monitoring by BOD(0.1, 0)EO2.1 Organizational structure/culture(0.05, 0)

EO1.3 Authority concentration(0.05, 0)

EO1.4 Lack of job rotation(0.05, 0)

16

The Japanese Accounting Review, 4 (2014), 1-25

First, we consider three items of evidence regarding incentives. As stated, the bubble
economy burst in 1990 and a substantial amount of losses had accrued in the short-term
investments in the early 90’s,7 of which the auditors must have been aware if they vouched theexistence and valuation of these investments. Even if the company did not need to report thelosses in 1999 according to the accounting standards in force at that time, the existence of suchlarge unreported losses can be a strong incentive to dispose of them improperly. Thus, we assign abelief-in-fraud of 0.10 to this evidence and label it as EI2.1.
Also, new fair value accounting standards had been promulgated (ASBJ 1999) that would
require fair value measurement of the investments. These were known to become effective in2001 and would have likely required the recognition of substantial losses. Such a change in
GAAP can be an incentive for the company to commit a fraud because, if not addressed, thecompany would need to report the losses in the financial statements and suffer possible
significant deterioration in earnings. Given that this seems to be a relatively stronger incentive
than others discussed, we assign a belief-in-fraud of 0.20 to this evidence and label it as EI2.2.
In addition, the short-term investments amounted to more than 20% of total assets in thepast three years. Such a composition of assets was not common to manufacturing companies andcould have been seen as a red flag for fraud risk. Thus, this evidence is assigned a belief-in-fraudof 0.05 and labeled as EI2.3.
Next, in relation to opportunity, no members of the council of general executives, of theboard of directors, or of the audit and supervisory board had significant accounting expertise,
except for those who were involved with the fraud. Most specifically, none of those who were
responsible for monitoring had a sufficient understanding of the accounting issues surrounding
the short-term investments. This implies a possible lack of monitoring and an opportunity for
management to misstate current assets. We assign a belief-in-fraud of 0.05 to this evidence andlabel it as EO2.1.
Figure 3 shows the fraud risk assessments updated based on the additional evidence obtainedat the account level using the evidential network framework. By aggregating the additional
evidence obtained at the account level, the belief-in-fraud increases from 0.018 to 0.035, theplausibility-of-fraud increases from 0.066 to 0.082, and the belief-in-no-fraud decreases from
0.934 to 0.918. A belief-in-fraud of 0.035 is probably high enough for auditors to contemplate
the necessity of additional fraud risk focused investigation even if it does not exceed the thresholdlevel. And given that the plausibility of fraud of 0.082 exceeds the threshold, we believe that theauditor should proceed to the next step.
Step 3: Assessment of account, transaction and evidence schemes
When fraud risk assessments at the account level, either plausibility-of-fraud, or certainly
belief-in-fraud, exceed or are near their thresholds (assumed to be 0.10 and 0.05), the auditor
should proceed to Step 3 for further investigation. Step 3 involves obtaining evidence andevaluating schemes used to perpetrate fraud or used to disguise, mask and conceal fraud such as
creating fictitious documents. The audit team should continue to search for additional evidence
until the plausibility-of-fraud become acceptably low (i.e., the belief-in-no-fraud is above thethreshold) or they find convincing evidence of fraud.
7

The third-party committee report states that the exact amount is not clear, but as of 1995 the losses amounted to 20 –30 billion yen.

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

17

As indicated, this step involves considering account, transaction accounting and evidence
schemes that may be used to promulgate and conceal fraud. Knowledge that may be relevant
includes that obtained from the audit firm’s past experiences, from professional literature andacademic research, from professional and regulatory quality inspection activities and fromadministrative actions and litigation against auditors.
Investigating fraud in the short-term investments
Various fraud schemes are conceivable for the short-term investments. For an illustrative
purpose, we assume that there are two possible schemes: a “loss transfer” transaction scheme
called “Tobashi” and an improper categorization scheme.8 9 While auditors need to evaluate all
feasible account and transaction schemes, we focus on these two schemes. In considering theseschemes, three categories of evidence should be investigated (Gao et al. 2013, BAC 2013, JICPAStatement 240, ISA 240, SAS 99): Transaction Accounting Schemes (non-GAAP methods ofaccounting), Evidence Schemes and Account Schemes. Each of these is discussed next.
Transaction accounting schemes
Transaction accounting schemes involve implementing inappropriate accounting
transactions or entries. These may be entering fraudulent reoccurring transactions or entering
unusual transactions such as end-of-period adjustments and management overrides. We begin
with this category because in the actual Olympus audit in September 1999, the auditors evidently
obtained information from a whistle-blower that the company had posted some questionable losstransfer transactions (“Tobashi”).10 Given this evidence, the auditors made inquiries to the head of
the accounting department and some other accounting staff about the transactions. As a result,the accounting staff admitted they had posted the questionable transactions. The auditors
required them to reverse the transactions, and they did so. As a result the company reported a lossof 17 billion yen related to these reversals.11
Given that there was evidence that the client has used inappropriate transaction accounting
methods on this highly material account, we assume this is a moderate level of evidence that
intentional misstatement may occur in this area. Thus, we assign a belief-in-fraud of 0.30 related
to the short-term investments to this evidence and label it as EAS1.1. By incorporating thisevidence into the evidential network, the belief-in-fraud increases from 0.035 to 0.068 (seeFigure 4). Thus with just the formal assessment of this one item of evidence, our illustrationshows the potential of our approach to identify material financial statement fraud.

8

The auditors must have had some knowledge about the “Tobashi” scheme because it was revealed that some securities
companies had compensated their major clients for losses caused by stock market declines by using the scheme and it
was recognized as a social problem in the early 90s. For the second scheme, a company could avoid recognizing losses
in short-term investments which should be valued at their market value by improperly categorizing them as long-term
investments which at that time could be valued using historical cost.
9
Because the prior fraud frequency information is unavailable, our evidential network assumes “OR” relationships
among audit evidence, rather than “conditional OR” relationships as adopted in Gao et al. (2013).
10
The actual information source is not known (Third-party Committee 2011).
11
When the transactions were detected, the auditor had the company cancel all of “short-term specified financial
instruments.” The 17 billion yen includes the loss in relation to the cancellation as well as the loss incurred by thereversal of the transactions.

The Japanese Accounting Review, 4 (2014), 1-25

AS2. Fraud
using Improper
Categorization(0.024, 0.908)

Step 3EAS1.1 Detection of loss transfer
transactions (0.3, 0.0)

AS1. Fraud using
Loss Transfer
Transactions(0.010, 0.965)

18

EI2.3 Amount of short-term investments(0.05, 0)O.
Opportunity

R2

R3

I.
Incentive
R1

EI2.2 Change in accounting standards(0.2, 0)A.
AttitudeAND

OR
A. Fraud in
Short-term
Investments(0.045, 0.908)

Step 2EI2.1 Change in external environment(0.1, 0)EO2.1 Lack of financial expertise(0.05, 0)I.
Incentive

EI1.1 Poor performance(0.1, 0)R1

EA1.1 Restrained information disclosure(0.05, 0)

EA1.2 Possible lack of objectivity(0.05, 0)

R3

AND

A.
Attitude
R2
O.
Opportunity

E1.2 General economic conditions(0.0, 0.0)

F. Fraud at
the Overall
Level(0.045, 0.908)

E1.1 Baseline assessment of fraud risk
(0.001, 0.95)

Step 1FIGURE 4: STEPS 1, 2, AND 3 RESULTS FOR OLYMPUS

EAS1.2 No similar loss transfer
transaction in the past (0.0, 0.7)

EO1.1 Ineffective monitoring by BOD(0.1, 0)EO2.1 Organizational structure/culture(0.05, 0)

EO1.3 Authority concentration(0.05, 0)

EO1.4 Lack of job rotation(0.05, 0)Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

19

Completing Step 3 would involve additional audit activities that we briefly discuss below.
Any additional evidence of fraud or of risk of fraud would only increase the auditor’s belief-infraud. For example, given the high level of updated belief-in-fraud risk, the auditors should havebecome more skeptical and have increased suspicion that there might have been similartransactions. Becoming more skeptical would suggest reconsideration and perhaps discounting ofother audit evidence related to this account (see below). Also, it would be prudent to clarify thewhole picture of the fraudulent transactions. This would involve investigation of additionaltransaction accounting schemes and also account schemes and evidence schemes.
Account schemes and evidence schemes
Two categories of fraud schemes have been identified and discussed by Gao et al. (2013).
Account-based fraud schemes are used by management to manipulate account balances andevidence-based fraud schemes are used by management to deceive auditors and conceal fraud by
creating fictitious evidence or manipulating evidence (Gao and Srivastava 2011). Although bothcategories should be considered in an audit where belief-in-fraud approaches or exceeds thethreshold, we focus in this illustration on evidence schemes.
Given the discovery of inappropriate accounting transactions in EAS1.1, the auditors should
consider evidence schemes that clients use to cover up misstatement. For the material short-term
investments accounts, all of the underlying assertions would need to be audited including
existence, completeness and valuation.
To test valuation, the auditors appropriately attempted to verify the market values of “shortterm specified financial instruments” at the time they were ‘sold’ and to verify the prices at which
they were actually ‘sold.’ Our approach requires consideration of evidence schemes that could be
used in such situations to misstate. The typical ones for this type of disposition of assets
transaction involve forgery of related documents and/or collusion with outsiders.
Both forgery of evidence and collusion are extremely difficult to find and thus advanced
forensic type procedures are needed. To identify forgery, it is necessary to obtain strong evidence
from outside sources that are not susceptible to management manipulation. Also, to identify
collusion, auditors should conduct audit tests that are not expected by the client and examine theresults of audit tests with particular care (for example, in obtaining confirmation evidence,
whether auditors have obtained sufficient responses to all questions that were asked). In addition,
it may have been useful to consult with fraud experts within the audit firm.
In the actual audit, the auditors were given forged market-value information from Olympus
and thus concluded that the market values were close to the prices at which the ‘sales’ of financial
instruments were booked (The third-party committee report 2011). It is quite difficult to identify
forged documents, but if the auditors had attempted to obtain corroborating valuation evidence
and had investigated related evidence schemes and had discovered the forgeries, this would haveprovided very strong evidence to increase their belief-in-fraud.
In this illustration, we update the above belief assessments assuming first that the fraudsters
were successful and the auditors accepted the valuation assertion as being appropriate. For thispossibility, we assign a belief-in-no-fraud of 0.70 to this forged evidence which suggests that theclient’s valuation assertion is valid. The revised, posterior beliefs given this evidence would be(0.045, 0.908), that is a 91% belief that the valuations are appropriate. Thus this demonstrates
the possible effectiveness of forgery in deceiving the auditor.

20

The Japanese Accounting Review, 4 (2014), 1-25

FIGURE 5: RELATIONSHIP BETWEEN EVIDENCE DISCOUNT AND BELIEF-IN-FRAUD AND
PLAUSIBILITY-OF-FRAUD
0.12
0.11
0.1
0.09
Belief-in-fraud
Plausibility-of-fraud

0.08

Threshold Level1
Threshold Level2

0.07
0.06
0.05
0.04
0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00

Evidence re-assessment with heightened skepticism
However, even if the updated belief-in-fraud of 0.045 did not exceed the threshold, theplausibility of 0.092 may still be too high to issue an unqualified opinion and thus might warrant
further investigation. Also, the new auditing standards regarding responses to fraud risk that wererecently issued in Japan (BAC 2013) require auditors to heighten their skepticism when they
make a judgment on whether there is a doubt of financial statement misstatement due to fraud. Ifthese new standards had been applied, the Olympus auditor should have become more skepticalafter obtaining evidence of fraudulent transactions.
For example, an auditor with heightened skepticism could discount evidence obtained frominside the client such as evidence concerning valuation of short-term investments. If the auditor
had discounted the belief-in-no-fraud assigned the valuation evidence provided by Olympus from
0.7 as assumed above to, say, 0.4, the resulting fraud risk would be (0.055, 0.899). In this case,this belief-in-fraud assessment exceeds the threshold for belief-in-fraud which we assume to be
0.05.
The relationship between the discounting of the beliefs regarding the valuation evidence andthe resulting belief-in-fraud and plausibility-of-fraud is plotted in Figure 5. This shows that if
the valuation evidence is discounted from 0.70 to about 0.55 then the belief that fraud may exist
exceeds the 0.05 threshold. Also, if the evidence is discounted even more to about 0.425 then theplausibility-of-fraud exceeds the 0.10 threshold. Although such precise assessments of evidential
strength are certainly difficult to make, using our formal belief-based risk assessments clearlyshows the potential value of our approach in alerting the audit team to possible material

Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

21

misstatement.
Our approach allows formal assessment of a variety of possible evidence situations. What-if
forensic tests had shown the documents to be forged? For example, the auditors could haveexamined the market value of the short-term investments at the time they were sold by obtaining
information from outside the company; that is evidence not as susceptible to management
manipulation. If the auditors had gained evidence of forged documents and assessed the evidenceas, say, (0.7, 0.0), the resulting beliefs on fraud risk would be (0.186, 0.775) with both the belief
in and plausibility of financial statement fraud significantly exceeding the thresholds.
Alternatively, the auditors with heighted skepticism may reassess the evidence obtained in
Step 2 as well. Suppose that the auditor reassessed the evidence regarding the change inaccounting standards (EI2.2, where the initial belief-in-fraud is 0.2) as 0.4 and the evidence
regarding the amount of short-term investments (EI2.3, the initial belief-in-fraud is 0.05) as 0.3.
In this case, the fraud risk would be (0.083, 0.871). Again, given the high level of fraud risk, theauditors would have been prudent in investigating the outside entities that purchased thefinancial instruments to ascertain for what purpose they purchased them at higher prices thantheir market value and investigating where the funds for the purchases came from. As stated
before, the entities that purchased the financial instruments were actually dummy companies(investment funds) established by Olympus. Also, the fund to purchase them was provided by theforeign banks using the deposits by Olympus as collateral.
In the actual audit, the auditors sent a confirmation to the banks which included a question
about whether the deposit was used as collateral, but the responses did not respond to this part ofthe confirmation. If the auditors had been interested in revealing the whole picture of thedetected fraudulent transactions including the fund sources to purchase the financial instruments,
they would have been able to relate the confirmation test results to the fraudulent transactions
and would likely have conducted further investigation into the deposits. If the auditors had foundthe entities that purchased the financial instruments were established by Olympus and the fundto purchase them were essentially provided by Olympus, the evidence (EAS1.3) would be verystrong to indicate the existence of fraud and assessed as, say, (0.95, 0.0). For this scenario, therevised, posterior beliefs given this evidence would be (0.656, 0.327). The revised fraud risk
assessments for this scenario are shown in Figure 6.

22

The Japanese Accounting Review, 4 (2014), 1-25

AS2. Fraud
using Improper
Categorization(0.008, 0.327)

AS1. Fraud using
Loss Transfer
Transactions(0.635, 0.342)

EAS1.2 No similar loss transfer
transaction in the past (0.0, 0.4)

R1

EI2.2 Change in accounting standards(0.4, 0)EI2.3 Amount of short-term investments(0.3, 0)O.
Opportunity

R2

R3

I.
Incentive

EI2.1 Change in external environment(0.1, 0)A.
AttitudeAND

Step 2

A. Fraud in
Short-term
Investments(0.656, 0.327)

OR

EAS1.3 Existence of “Tobashi” scheme(0.95, 0.0)

EO2.1 Lack of financial expertise(0.05, 0)I.
Incentive

EI1.1 Poor performance(0.1, 0)R1

EA1.1 Restrained information disclosure(0.05, 0)

R3

AND

A.
Attitude
R2
O.
Opportunity

E1.2 General economic conditions(0.0, 0.0)

EA1.2 Possible lack of objectivity(0.05, 0)
F. Fraud at
the Overall
Level(0.656, 0.327)

E1.1 Baseline assessment of fraud risk
(0.001, 0.95)
Step 1FIGURE 6: FRAUD RISK REASSESSED BY A MORE SKEPTICAL AUDITOR

Step 3EAS1.1 Detection of loss transfer
transactions (0.3, 0.0)

EO1.1 Ineffective monitoring by BOD(0.1, 0)EO2.1 Organizational structure/culture(0.05, 0)

EO1.3 Authority concentration(0.05, 0)

EO1.4 Lack of job rotation(0.05, 0)Fukukawa, Mock, and Srivastava: Assessing the Risk of Fraud at Olympus and
Identifying an Effective Audit Plan

23

We realize that it is difficult and somewhat unusual for auditors to conduct such additional
procedures. However, current standards combined with the belief-in-fraud of 0.045 and theplausibility-of-fraud of 0.098 obtained from our evidential network (Step 3 as shown in Figure 4)
would dictate that the auditors conduct additional investigation such as those illustrated above.
And if the auditors had conducted such additional procedures, they likely would have detected
the fraud. At least, the fraud risk assessments obtained from our evidential network implies thatan unqualified opinion should not have been issued without additional evidence to make thefraud risk assessments lower.

4. Summary and Conclusions
In this study, we present an approach to auditor’s fraud risk assessment in which risk
assessments are revised or updated as an auditor obtains additional evidence in each of threesteps: (1) fraud risk assessment at the overall financial statement level, (2) fraud risk assessment at
the account level, and (3) assessment of account, transaction and evidence schemes. The
approach is rigorous in that it is based on the Theory of Belief Functions and flexible so that it isapplicable to the specifics of any audit situation.
To illustrate the approach and its possible benefits, we focus on the Olympus fraud casewhich had an enormous impact on business and the audit profession in Japan. The approach isillustrated by assessing ‘what-if’ current professional guidance and standards and a rigorous
approach to assessing risks and to integrating new audit evidence into the risk assessments had
been applied to the 1999 Olympus audit. The “what-if” analysis results demonstrate that theillustrated fraud risk assessment approach would have almost certainly helped detect the Olympus
financial statement fraud. As shown, if the Olympus auditor had exercised heightened
professional skepticism as dictated by the explicit calculations of belief-in-fraud and plausibilityof-fraud obtained from our evidential network, they likely would have detected the fraud.
In response to the Olympus case, the Japanese standard setter (i.e., BAC) issued new
auditing standards regarding responses to fraud risk assessments. The standards emphasize theimportance of professional skepticism and require an auditor to heighten their skepticism when
they identify the fraud triangle factors. Although the standards list examples of such fraud
triangle factors, no guidance is provided about how obtained pieces of evidence are assessed and,more importantly, how their assessments of the evidence are aggregated to revise or update thefraud risk assessments. Given varying strength of audit evidence and auditors’ inability toaggregate audit evidence (e.g., Fukukawa and Mock 2012), our approach provides a useful tool
for auditors to do this more rigorously and more accurately. Also, this framework andillustrations such as the Olympus case provide useful materials for training auditors within anaudit firm and educating students in the classroom.

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The Japanese Accounting Review, 4 (2014), 1-25

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Identifying an Effective Audit Plan

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