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.