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Auditor’s Responsibility is to design the audit to

provide reasonable assurance of detecting material  Financial statement fraud


misstatements in the financial statements 1. is deliberate misrepresentation, misstatement
or omission of financial statement data for the
-Conduct an audit of the FS in accordance with GAAS purpose of misleading the reader and creating a
false impression of an organization's financial
-Collect evidence to support mgmt's assertions strength.
(representations) 2. Public and private businesses commit financial
statement fraud to secure investor interest or
-Issue an opinion on FS (auditor's report) obtain bank approvals for financing, as
justification for bonuses or increased salaries or
-Maintain professional skepticism to meet expectations of shareholders.
3. Upper management is usually at the center of
-Obtain and provide reasonable assurance that material financial statement fraud because financial
misstatements (errors and fraud) are detected statements are created at the management
level.
The misstatements may emanate from:
1. Error Financial statement frauds fall into general categories.
2. Fraud These include
3. Noncompliance with Laws and Regulations a. improper revenue recognition,
_______________________________ b. manipulation of liabilities,
1. Error - unintentional misstatements in the financial c. manipulation of expenses,
statements d. improper disclosures on financial statements
Includes: Omission and Commission and
Omission – A transaction that is not recorded e. overstating assets
more difficult to detect
Commission - A transaction that is calculated Improper Revenue Recognition
incorrectly • The most common scheme used in financial
Error is: statement fraud involves manipulation of
• Mathematical or clerical mistakes in the revenue figures.
underlying records and accounting data • According to a survey by Deloitte of Accounting
• An incorrect accounting estimate arising from and Auditing Enforcement Releases (AAER) filed
oversight or misinterpretation of facts by the SEC from 2000 through 2008, improper
• Mistake in the application of accounting policies revenue recognition was recognized as the
scheme employed in 38 percent of the 403 cases
2. Fraud - refers to intentional act by one or more studied.
individuals among management •
- Those charged with governance, employees, Schemes to manipulate revenue figures typically
or third parties, involving the use of deception to obtain involve posting sales before they are made or
an unjust or illegal advantage. prior to payment.
 Auditor is primarily concerned with: • Examples include recording product shipments
fraudulent acts that cause a material to company-owned facilities as sales, re-invoicing
misstatement in the financial statements past due accounts to improve the age of
Types of Fraud receivables, pre-billing for future sales and
1. Fraudulent financial reporting duplicate billings
2. Misappropriation of assets or employees fraud
Manipulating Expenses
System of Quality Control • Another fraud involving financial statements is
1. Fraudulent financial reporting- involves intentional the deliberate manipulation of expenses.
misstatements or omissions of amounts or • The Deloitte survey of AAER filings by the SEC
disclosures in the financial statements to deceive shows that 12 percent involved expense
financial statement users manipulation and 8 percent manipulation of
- known as management fraud liabilities.
Management Fraud involves: • An example of manipulating expenses is to
1. Manipulation, falsification or alteration of capitalize normal operating expenses. This
records or documents scheme is an improper method to delay
2. Misrepresentation in or intentional omission of recognition of the expense and artificially raise
the effects of transactions from records or income figures.
documents • An example of this type of scheme is the
3. Recording of transactions without substance WorldCom scandal, where significant operating
4. Intentional misapplication of accounting expenses were listed as capital on the balance
policies sheet.
• Concealment and manipulation of liabilities Auditor’s Responsibility
frauds include failure to record accounts - To design the audit to obtain reasonable
payables or report regular expenses on financial assurance that the financial statements are free
statements. Keeping certain liabilities, leaving from material misstatement whether caused by
notes or loans off-the-books and writing off error or fraud.
money lent to executives are also common
methods of fraud. Planning Phase
1. Auditor should make inquiries of management
Improper Disclosures about the possibility of misstatement due to fraud or
• Disclosure frauds are commonly based on error:
misrepresenting the company and making false a. Management ‘s assessment of risk due to
representations in press releases and other fraud
company filings. b. Controls established to address the risks
• Making false statements in the commentary c. Any material error or fraud that has
sections of annual reports of other regulatory affected the entity or suspected fraud
filings are another source for improper that the entity is investigating.
disclosures. 2. Auditor should assess the risk that fraud and error
• Some disclosures might be intentionally may cause the FS to contain material misstatements
confusing or obscure and impossible to  PAS 240 requires the auditor to specifically
completely understand “assess the risk of material misstatements
due to fraud and consider that assessment
2. Misappropriation of assets or employee fraud in designing the audit procedures to be
– Involves theft of an entity’s assets performed”
committed by the entity’s employees Fraud risks factors
This includes: - Identify events or conditions that provide an
a. Embezzling receipts opportunity
b. Stealing entity’s assets such as cash, - A motive or a means to commit fraud
marketable securities, and inventory - Indicate that fraud may already have occurred
c. Lapping of accounts receivable
Note: often accompanied by false or misleading Auditor’s Professional judgments may be influenced :
records or documents in order to conceal the fact – The auditor may approach the audit with
that the assets are missing heightened level of professional skepticism
– The auditor’s ability to assess control risk at
Overstating Assets less than high level may be reduced and he
Overstatement of current assets on financial should be sensitive to the ability of the
statements and failure to record depreciation management to override controls
expenses are often employed as methods of fraud. – The audit team may be selected in ways that
Overstatement of inventory and accounts ensure that the knowledge, skill and ability
receivables are also commonly used to inflate of personnel assigned significant
company assets on fraudulent statements responsibilities are commensurate with the
auditor’s assessment of risk
• Fraud involves – The auditor may decide to consider
– Motivation to commit it management selection and application of
– A perceived opportunity to do so significant accounting policies, particularly
Distinguish Fraud from Error those related to income determination and
- Whether the underlying cause of misstatement in asset valuation.
the financial statements is intentional or
unintentional. Testing Phase
3. During the course of the audit, the auditor may
Responsibility of Management and Those charged with encounter circumstances that may indicate the
governance possibility of fraud or error
– Management to establish a control 4. After identifying material misstatement in the FS
environment and to implement internal • Resulted from a fraud or an error.
control policies and procedures designed to • Errors will result to adjustments of FS
ensure the detection and prevention of fraud. • Fraud may have other implications on an
– Individuals charged with governance of an audit
entity to ensure the integrity of an entity’s Not Material effect of Fraud
accounting and financial reporting system and Auditor should
that appropriate controls are in place. – Refer the matter to appropriate level of management
– Be satisfied that, the fraud has no other implications
for other aspects of the audit and that those
implications have been adequately considered
Material effect of the Fraud or unable to evaluate • Ensuring employees are properly trained and
The Auditor should: understand the Code of Conduct
- consider implication for other aspects of the audit • Monitoring compliance with the Code of Conduct
particularly the reliability of management and acting appropriately to discipline employees
• Engaging legal advisors in monitoring legal
representation
requirements
- discuss the matter and the approach to further • Maintaining a register of significant laws with witch
investigation with an appropriate level of that is at least the entity has to comply within its particular industry
one level above those involved and a record of complains
- Attempt to obtain evidence to determine whether
a material fraud in fact exists and if so their effects and Auditor’s Responsibility
- Suggest that the client consult with legal counsel • Planning Phase
about question of law 1 Obtain a general understanding of the legal and regulatory
framework applicable to the entity.
COMPLETION PHASE 2. Design procedures to help identify instances of
noncompliance with those laws and regulations where
5. The auditor should obtain a written representation
noncompliance should be considered when preparing FS
from the client’s management that 3. Design audit procedures to obtain sufficient appropriate
– It acknowledge the responsibility for the audit evidence about compliance with those laws and
implementation and operation of accounting regulations generally recognized by the auditor
and internal control system that are designed to • Effect on the determination of material amounts
prevent and detect fraud and error and disclosures in FS
– It believes the effects of those uncorrected
financial statements aggregated by the auditor ***If material risk is high, then detection risk is low.***
during the audit are immaterial to the FS taken Audit Risk - Risk that the auditor may unknowingly fail
as a whole to modify appropriately the opinion on FS that are
– It has disclosed to the auditor all significant materially misstated
facts relating to frauds or suspected frauds - Should be reduced to a low level before an
known to management that may have affected opinion on FS is expressed
the entity
– It has disclosed to the auditor the results of its
assessment of the risk that the FS may be
materially misstated as a result of fraud.
6. Material Errors or fraud exist
– He should request the management to revise
the FS, otherwise he will express a qualified or ***RMM = Exists independently of the financial
adverse opinion statement audit.
7. Unable to evaluate the effect of fraud on the FS
-because of limitation of scope, he should either
qualify or disclaim his opinion on the FS

3. Noncompliance with Laws and Regulations


• Noncompliance
– Refers to acts of omission or commission by
the entity being audited, either intentional or
unintentional, which are contrary to the
prevailing laws or regulations.
– Includes transactions entered into by or in the
name of , the entity or on its behalf by its
management or employees.
Example: Tax evasion, violation of environmental
protection laws, inside trading of securities Risk of Material Misstatement (RMM):
- Exists independently of financial statement
Management’s Responsibilities audit
• PAS 250 - Auditor assess by performing risk assessment
– The responsibility for the prevention and procedures and test of controls
detection of noncompliance rests with -Can be subdivided into inherent risk (IR) and
management control risk (CR)
Following policies and procedures Inherent Risk (IR)
• Monitoring legal requirements and ensuring that - The susceptibility of a relevant assertion to a
operating procedures are designed to meet these material misstatement, assuming there are no related
requirements controls
• Instituting and operating appropriate system of - Mistake in client’s accounting system
internal control
• Developing, publicizing and following a Code of
Conduct
- Auditor assesses but cannot change the Auditor CAN change detection risk by varying the
inherent risk (whether client’s system is good or not, it nature, extent, and timing of audit procedures.
can’t be changed)
- Assertions involving complex calculations, RMM and the assurance required from substantive
amounts derived from estimates, and cash have procedures have direct relationship. Greater risk
relatively higher inherent risk than assertions without requires more persuasive evidence, a larger sample size,
those characteristics and/or a shift from interim to year-end testing.
Control Risk (CR)
- Risk that a material misstatement that could Audit risk and materiality are affected by the size and
occur in a relevant assertion will not be prevented or complexity of the entity. They must be considered at
detected on a timely basis by the entity’s internal both the FS level and the account balance, individual
control transaction class, or disclosure item level.
- Auditor assesses but cannot change the
control risk (whether client’s internal control is good or
not, it can’t be changed)
- Function of the effectiveness of the design
and operation of internal control

Detection Risk (DR)


- The risk the auditor will not detect a
misstatement that exists in a relevant assertion =
auditor will miss the mistake
- Is a function of the effectiveness of audit
procedures
- Can be subdivided into tests of details risk (TD)
and substantive analytical procedures risk (AP)
- Auditor CAN change detection risk by varying
the nature, extent, and timing of audit procedures.

Example 1: acceptable level of DR decreases, the


assurance provided from substantive procedures should
increase:
1. Change the nature of substantive tests from
less effective to more effective procedure (direct test
toward independent parties outside the entity rather
than toward parties or documentation inside the entity)
2. Change the extent of substantive tests (use
larger sample size)
3. Change the timing of substantive tests
(perform substantive tests at year-end rather than at
interim)

Example 2: acceptable level of DR increases, the


assurance that must be obtained from substantive tests
decreases, allowing for somewhat less persuasive
evidence to be used, for a reduced extent of testing, or
for more testing to be performed at interim.

Substantive procedures always required!!!

RMM and DR have inverse relationship. When auditor


determines that risk of material misstatement is high,
detection risk should be set at a low level. Conversely,
when the risk of material misstatement is low, the
auditor can justify a higher detection risk.

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