Lecture 2

Objectives and Scope of Financial

Statement Audit

Learning outcomes
Explain the objective of conducting an audit
Explain the auditor’s responsibility for detecting
fraud
Explain the categories of management assertions
Identify and State management assertions about
items and components in the financial statements
Describe and apply the audit objectives that relate
to managements assertions
 Objective of Conducting an Audit of
Financial Statements
In conducting an audit of financial statements, the overall
objectives of the auditor are:

(a)To obtain reasonable assurance about whether the financial

statements as a whole are free from material misstatement, whether
due to fraud or error, thereby enabling the auditor to express an
opinion on whether the financial statements are prepared, in all
material respects, in accordance with an applicable financial reporting
framework; and

(b) To report on the financial statements, and communicate as required

by the ISAs, in accordance with the auditor’s findings.
 Directors’ Responsibilities
Section 169 of Companies Act stated that the directors of
every company shall present at its annual general
meeting a financial statements for the financial years.

The financial statement of a company shall be duly

audited before they are presented in the annual general
meeting
 Responsibilities of an auditor
• The auditor’s opinion on the financial
statements is based on the concept of
obtaining reasonable assurance; hence, in an
audit, the auditor does not guarantee that
material misstatements, whether from fraud
or error, will be detected.
• However, it is important to note that auditor is
still responsible to detect material fraud and
error.

4
Fraud and the auditor ( ISA240)

Management responsibilities on fraud

The primary responsibility for the prevention and
detection of fraud rests with both those charged with
governance of the entity and management.
It is important that management, with the oversight
of those charged with governance, place a strong
emphasis on fraud prevention, which may reduce
opportunities for fraud to take place, and fraud
deterrence, which could persuade individuals not to
commit fraud because of the likelihood of detection
and punishment
 Auditor’s Responsibilities

The auditor is engaged to give an opinion as to whether the

financial statements give a true and fair view. This means
that the auditor is aiming to detect material misstatements
in the financial statements. Auditors do not have a duty to
detect fraud.

When obtaining reasonable assurance, the auditor is responsible

for maintaining professional skepticism throughout the audit.

The requirements are designed to assist the auditor

in identifying and assessing the risks of material misstatement
due to fraud and in designing procedures to detect
such misstatement
Auditor’s Responsibilities

Professional skepticism- An attitude that include questioning

mind and critical assessment . The auditor should not assume
that management is dishonest nor should be assumed
unquestioned management honesty

Unless the auditor has reason to believe the contrary,

the auditor may accept records and documents as genuine.
If conditions identified during the audit cause the auditor to
believe that a document may not be authentic or that terms
in a document have been modified but not disclosed to the
auditor, the auditor shall investigate further.
 Some definitions review
• Misstatement
• Misstatement in F/S can arise from fraud or error, that include
omissions of an amount of disclosure
• Misstatement may consist of the following:
• A difference of amount, classification or presentation of reported
financial statement item and the amount , classification, or
presentation that would have been reported under approved
accounting standards
• The omission of a financial statement element, account or item
• A financial statement disclosure that is not presented in
accordance with approved accounting standards
• The omission of information required to be disclosed in accordance
with approved accounting standards
Some definitions review
• Fraud
• Intentional act involving the use of deception to obtain an unjust
or illegal advantage
Fraud could be classified into 2 type:
• Misstatements arising from fraudulent financial reporting
• Misstatements arising from misappropriation of assets
• Error
• Unintentional misstatements or omissions of amounts or
disclosure
• Mistakes in gathering or processing data from which financial
statements are prepared
• Unreasonable accounting estimates arising from oversight or
misinterpretation of facts
• Mistake in application of accounting standards
 Frauds relevant to auditors

Fraudulent Financial
Reporting

Management Fraud Material Misstatement

Arising From
Fraud
Misappropriation/
Theft of Assets
Employee Fraud
Fraudulent Financial Reporting
Fraudulent financial reporting may be accomplished by the
following:

•Manipulation, falsification (including forgery), or alteration of

accounting records or supporting documentation from which the
financial statements are prepared.

•Misrepresentation in, or intentional omission from, the financial

statements of events, transactions or other significant
information.

•Intentional misapplication of accounting principles relating to

amounts, classification, manner of presentation, or disclosure.
Misappropriation of asset
Misappropriation of assets involves the theft of an entity’s assets
and is often perpetrated by employees in relatively small and
immaterial amounts.

it can also involve management who are usually more able to

disguise or conceal misappropriations in ways that are difficult to
detect.

Misappropriation of assets can be accomplished in a variety of

ways including:
• Embezzling receipts
• Stealing physical assets or intellectual property
•Causing the entity to pay for goods or cash not received
Management Fraud
• Management has ability to perpetrate fraud because
it is in the position to directly or indirectly manipulate
the accounting records and prepare fraudulent
financial report

• Fraudulent activity involved management override of

internal controls, collusion among the management ,
employees, or third party

• Because of the characteristic of fraud, an auditor may

unknowingly rely on audit evidence that appears to
be valid, but in fact is false and fraudulent.
Fraud Risk Identification Process

• Communication among audit team

• Inquiries of management and others
• Identify Fraud Risk factors
• Analytical procedures
• Other information
 Communication among audit team

ISA 315 requires a discussion among the engagement

team members and a determination by the engagement
partner of which matters are to be communicated to those
team members not involved in the discussion
The objective of the communication are to
Provides an opportunity for more experienced engagement team
members to share their insights about how and where the financial
statements may be susceptible to material misstatement due to
fraud
Enables the auditor to consider an appropriate response to such
susceptibility and to determine which members of the engagement
team will conduct certain audit procedures.
Permits the auditor to determine how the results of audit
procedures will be shared among the engagement team and how to
deal with any allegations of fraud that may come to the auditor’s
attention.
 Inquiry of management and other
• The primary responsibility for the prevention and detection of fraud
rests with both those charged with governance of the entity and
management.
• Auditor should inquire about the management knowledge of fraud
within the entity. This include that:

Management’s assessment of the risk that the financial statements may

be materially misstated due to fraud.
Management’s process for identifying and responding to the risks of
fraud in the entity, including any specific risks of fraud that management
has identified or that have been brought to its attention, or classes of
transactions, account balances, or disclosures for which a risk of fraud is
likely to exist
Management’s communication, if any, to those charged with
governance regarding its processes for identifying and responding to the
risks of fraud in the entity; and
Management’s communication, if any, to employees regarding its view
on business practices and ethical behavior.
 Inquiry of management and other
• For those entities that have an internal audit function, the
auditor shall make inquiries of internal audit to determine
whether it has knowledge of any actual, suspected or
alleged fraud affecting the entity, and to obtain its views
about the risks of fraud.

• The auditor shall obtain an understanding of how those

charged with governance exercise oversight of
management’s processes for identifying and responding to
the risks of fraud in the entity and the internal control that
management has established to mitigate these risks,
whether they have knowledge of any actual, suspected or
alleged fraud affecting the entity.
Fraud Risk Factor
ISA 240 The auditor’s responsibilities to consider
fraud in an audit of financial statement
• The auditor shall evaluate whether the information obtained
from the other risk assessment procedures and related
activities performed indicates that one or more fraud risk
factors are present.
• While fraud risk factors may not necessarily indicate the
existence of fraud, they have often been present in
circumstances where frauds have occurred and therefore may
indicate risks of material misstatement due to fraud
Fraud risk factors are events or conditions that indicate an
incentive, pressure or opportunity to commit fraud
An Incentive /pressure to perpetrate fraud
An Opportunity to carry out the fraud
An attitude/ rationalization to justify the fraudulent action
 Fraud Risk Factors( Fraudulent Financial Reporting)
Incentives/Pressures ( Not Exhaustive List)

Financial stability or profitability is threatened by economic, industry, or entity operating

conditions, such as : high degree of competition or market saturation, accompanied by
declining margins, high vulnerability to rapid changes, such as changes in technology,
product obsolescence, or interest rates.

Excessive pressure exists for management to meet the requirements or expectations of

third parties due to: need to obtain additional debt or equity financing to stay competitive –
including financing of major research and development or capital expenditures.

Information available indicates that the personal financial situation of management or

those charged with governance is threatened by the entity’s financial performance arising
from: Significant portions of their compensation (for example, bonuses, stock options, and
earn-out arrangements) being contingent upon achieving aggressive targets for stock price,
operating results, financial position, or cash flow

There is excessive pressure on management or operating personnel to meet financial

targets established by those charged with governance, including sales or profitability
incentive goals.(Para A 25, ISA240)
Fraud Risk Factors( Fraudulent Financial Reporting)
Opportunities ( Not Exhaustive List)
The nature of the industry or the entity’s operations provides opportunities to engage in
fraudulent financial reporting that can arise from the following:
Significant related-party transactions not in the ordinary course of business or with related
entities not audited or audited by another firm.
 A strong financial presence or ability to dominate a certain industry sector that allows the
entity to dictate terms or conditions to suppliers or customers that may result in
inappropriate or non-arm’s-length transactions.

The monitoring of management is not effective as a result of the following:

Domination of management by a single person or small group (in a non owner managed
business) without compensating controls.
Oversight by those charged with governance over the financial reporting process and
internal control is not effective.

There is a complex or unstable organizational structure:

High turnover of senior management, legal counsel, or those charged with governance.

Internal control components are deficient as a result of the following:

• Inadequate monitoring of controls, including automated controls and controls over
interim financial reporting
 Fraud Risk Factors( Fraudulent Financial Reporting)
Attitudes/ Rationalisations( Not Exhaustive List)

Communication, implementation, support, or enforcement of the entity’s

values or ethical standards by management, or the communication of
inappropriate values or ethical standards, that are not effective.

Nonfinancial management’s excessive participation in or preoccupation with

the selection of accounting policies or the determination of significant
estimates.

Known history of violations of securities laws or other laws and regulations,

or claims against the entity, its senior management, or those charged with
governance alleging fraud or violations of laws and regulations.

 Excessive interest by management in maintaining or increasing the entity’s

stock price or earnings trend.
Fraud Risk Factors( Misappropriation of Asset)

Incentives/Pressures ( Not Exhaustive List)

Personal financial obligations may create pressure on management

or employees with access to cash or other assets susceptible to theft
to misappropriate those assets.

Adverse relationships between the entity and employees with access

to cash or other assets susceptible to theft may motivate those
employees to misappropriate those assets.
Fraud Risk Factors( Misappropriation of Asset)

Opportunities ( Not Exhaustive List)

Certain characteristics or circumstances may increase the susceptibility of assets to

misappropriation. For example, opportunities to misappropriate assets increase when
there are the following:
•Large amounts of cash on hand or processed.
•Inventory items that are small in size, of high value, or in high demand

Inadequate internal control over assets may increase the susceptibility of

misappropriation of those assets.
•Inadequate segregation of duties or independent checks.
•Inadequate oversight of senior management expenditures, such as travel and other
re-imbursements.
Fraud Risk Factors( Misappropriation of Assets)

Attitudes/ Rationalisations( Not Exhaustive List)

Disregard for the need for monitoring or reducing risks related to
misappropriations of assets.
Disregard for internal control over misappropriation of assets by overriding
existing controls or by failing to take appropriate remedial action on known
deficiencies in internal control.
Behavior indicating displeasure or dissatisfaction with the entity or its
treatment of the employee.
Changes in behavior or lifestyle that may indicate assets have been
misappropriated
Analytical Procedure & Other information

The auditor shall evaluate whether unusual or unexpected relationships

that have been identified in performing analytical procedures, including
those related to revenue accounts, may indicate risks of material
misstatement due to fraud.
Other information obtained about the entity and its environment may be
helpful in identifying the risks of material misstatement due to fraud. The
discussion among team members may provide information that is helpful in
identifying such risks. In addition, information obtained from the auditor’s
client acceptance and retention processes, and experience gained on other
engagements performed for the entity, for example, engagements to review
interim financial information, may be relevant in the identification of the
risks of material misstatement due to fraud.
2 Level of Assessment

• In accordance with ISA 315, the auditor shall

identify and assess the risks of material
misstatement due to fraud at the financial
statement level, and at the assertion level for
classes of transactions, account balances and
disclosures
 Auditors response to those fraud risk
factors
Overall Responses
Increase professional skepticism
Assign and supervise personnel taking account of the knowledge,
skill and ability of the individuals to be given significant engagement
responsibilities and the auditor’s assessment of the risks of material
misstatement due to fraud for the engagement
Evaluate whether the selection and application of accounting
policies by the entity, particularly those related to subjective
measurements and complex transactions, may be indicative of
fraudulent financial reporting resulting from management’s effort
to manage earnings
Incorporate an element of unpredictability in the selection of the
nature, timing and extent of audit procedures.
 Responses at Assertion level
The auditor’s responses to address the assessed risks of material misstatement
due to fraud at the assertion level may include changing the nature, timing and
extent of audit procedures in the following ways:
 The nature of audit procedures to be performed may need to be changed to
obtain audit evidence that is more reliable and relevant
 The timing of substantive procedures may need to be modifiedThe auditor may
conclude that performing substantive testing at or near the period end better
addresses an assessed risk of material misstatement due to fraud.
 The extent of the procedures applied reflects the assessment of the risks of
material misstatement due to fraud. For example, increasing sample sizes or
performing analytical procedures at a more detailed level may be appropriate
 Respond to the risk of
management override of controls
Management is in a unique position to perpetrate fraud because of
management’s ability to manipulate accounting records and prepare
fraudulent financial statements by overriding controls that otherwise appear
to be operating effectively. The following step should be carried out
1)Test the appropriateness of journal entries recorded in the general ledger
and other adjustments made in the preparation of the financial statements
2)Review accounting estimates for biases and evaluate whether the
circumstances producing the bias, if any, represent a risk of material
misstatement due to fraud. In performing this review, auditor should
Evaluate whether the judgments and decisions made by management in
making the accounting estimates included in the financial statements,
even if they are individually reasonable, indicate a possible bias on the
part of the entity’s management that may represent a risk of material
misstatement due to fraud
Respond to the risk of
management override of controls
Perform a retrospective review of management judgments and assumptions
related to significant accounting estimates reflected in the financial
statements of the prior year.
3) Understanding the business rationales of significant transaction:
For significant transactions that are outside the normal course of business for
the entity, or that otherwise appear to be unusual given the auditor’s
understanding of the entity and its environment and other information
obtained during the audit, the auditor shall evaluate whether the business
rationale (or the lack thereof) of the transactions suggests that they may have
been entered into to engage in fraudulent financial reporting or to conceal
misappropriation of assets.
 Communication to Management, Those Charged
with Governance and Other about fraud
If the auditor has identified a fraud or has obtained information that indicates
that a fraud may exist, the auditor shall communicate these matters on a
timely basis to the appropriate level of management in order to inform those
with primary responsibility for the prevention and detection of fraud of
matters relevant to their responsibilities.

If the auditor has identified or suspects fraud involving management,

employees who have significant roles in internal control and others, the
auditor shall communicate these matters to those charged with governance on
a timely basis and discuss with them the nature, timing and extent of audit
procedures necessary to complete the audit

If the auditor has identified or suspects a fraud, the auditor shall determine
whether there is a responsibility to report the occurrence or suspicion to a
party outside the entity. Although the auditor’s professional duty to maintain
the confidentiality of client information may preclude such reporting, the
auditor’s legal responsibilities may override the duty of confidentiality such as
required by law and regulatory, to successor auditor, in responses to subpoena
 Evaluation of audit evidence
If the auditor identifies a misstatement, the auditor shall evaluate whether
such a misstatement is indicative of fraud. If there is such an indication, the
auditor shall evaluate the implications of the misstatement in relation to
other aspects of the audit, discuss and approach to further investigation
with appropriate level of management, if possible, suggest client consult
the legal counsel.
If the auditor identifies a misstatement, whether material or not, and the
auditor has reason to believe that it is or may be the result of management
fraud, the auditor shall reevaluate the assessment of the risks of material
misstatement due to fraud and its resulting impact on the nature, timing
and extent of audit procedures to respond to the assessed risks.
The auditor shall also consider whether circumstances or conditions
indicate possible collusion involving employees, management or third
parties when reconsidering the reliability of evidence previously obtained
Evaluation of audit evidence

If, as a result of a misstatement resulting from fraud or suspected fraud,

the auditor encounters exceptional circumstances that bring into question
the auditor’s ability to continue performing the audit, the auditor shall:
a) Determine the professional and legal responsibilities applicable in the
circumstances, including whether there is a requirement for the auditor to
report to the person or persons who made the audit appointment or, in
some cases, to regulatory authorities;
b) Consider whether it is appropriate to withdraw from the engagement,
c) if auditors withdraws, auditor should
Discuss with the appropriate level of management and those charged with
governance the auditor’s withdrawal from the engagement and the reasons
for the withdrawal
Determine whether there is a professional or legal requirement to report
to the person or persons who made the audit appointment or, in some
cases, to regulatory authorities, the auditor’s withdrawal from the
engagement and the reasons for the withdrawal.
Documenting & Communicating about
fraud to management and others

Documenting fraud risk factor

• Document in working papers to show evidence that
the risk of material misstatement due to fraud or
error have been assessed, including
• How the risk factors are identified
• Auditors’ response to those risk factors
Financial Statements Cycles

Audits are performed by dividing the financial

statements into smaller segments or components.
Typically, transaction cycle are shown as follow:
1)Revenue Cycle
2)Purchase Cycle
3)Human Resource Management/Payroll Cycle
4)Inventory Cycle
5)Financing Cycle
Management Assertions
• Management is responsible for the true and fair presentation of
financial statements. Assertions are expressed or implied
representations by management that are reflected in the financial
statements components

Management Assertions-3 categories

1. Assertions about classes of transactions and
events for the period under audit

2. Assertions about account balances at period end

3. Assertions about presentation and disclosure

Transaction Flow Example
Ledgers,
Transactions Journals Trial Balance,
and Financial
Sales Statements
Sales
journal
General ledger
and subsidiary
records
Cash Cash receipts
receipts journal
General ledger
trial balance
Acquisition
Acquisitions Financial
of goods
journal statements
and services
Transaction Flow Example
Ledgers,
Transactions Journals Trial Balance,
Cash and Financial
Cash Statements
disbursements
disbursements
journal General ledger
and subsidiary
records
Payroll
Payroll
services and
journal
disbursements General ledger
trial balance
Allocation
General Financial
and
journal statements
adjustments
 Relationships Among Transaction Cycles

General
cash

Capital acquisition
and repayment cycle

Sales and Acquisition Payroll and

collection and payment personnel
cycle cycle cycle

Inventory and
warehousing
cycle
 Balance and Transactions Affecting Balances
Example
Accounts Receivable (in thousands)
Beginning balance $ 17,521

Sales $144,328 $137,087 Cash receipts

Sales returns
$ 1,242 and allowances

Charge-off of
$ 3,323 uncollectible
accounts

Ending balance $ 20,197

 Management Assertions for
Each Category of Assertions
Assertions About Classes Assertions About Assertions About
of Transactions and Events Account Balances Presentation and Disclosure
Occurrence Existence Occurrence and rights
and obligations
Completeness Completeness Completeness
Accuracy Valuation and Accuracy and
allocation valuation
Classification Classification and
understandability
Cutoff
Rights and
obligations
Management Assertion about class of transactions and events/
Transaction related audit objectives

All transactions and events that

Occurrence have been recorded have occurred

All transactions and events that should

Completeness be recorded have been recorded

Amount and other data relating to

Accuracy transactions and events have been
recorded appropriately

Transactions and events have been

Classification recorded in proper accounts.

Transactions and events have been

Cut -off recorded in the correct accounting period.
 ABC Sdn Bhd
(Applied to Sales Transactions)

Management Assertions General Transaction- Specific Sales Transaction-

About Classes of related Audit related Audit Objectives
Transactions and Events Objectives
Occurrence Occurrence Recorded sales are for
shipments made to
Non fictitious customers
Completeness Completeness Existing sales
transactions are recorded
Accuracy Accuracy Recorded sales are for
the amount of goods
shipped and are correctly
billed and recorded
 ABC Sdn Bhd.
(Applied to Sales Transactions)

Management Assertions General Transaction- Specific Sales Transaction-

About Classes of related Audit related Audit Objectives
Transactions and Events Objectives

Accuracy Accuracy Sales transactions are

properly included in the
master file and are
correctly summarized
Classification Classification Sales transactions are
properly classified
Cutoff Cut off Sales transactions are
recorded on the correct
accounting period.
 Assertions About Account Balances
/ General Balance-Related Audit Objectives

Asset, liabilities and equity interest

Existence exist
All assets, liabilities and equity interest
Completeness that should have been recorded
have been recorded
Assets, liabilities and equity interest are
included in the financial statement
Valuation and at appropriate amount and any resulting
allocation valuation or allocation adjustment are
appropriately recorded

The entity holds and control

Right and the rights to assets,
Obligation and liabilities are the obligation of entity
 ABC Sdn Bhd.
(Applied to Inventory)

Management Assertions General Balance- Specific Balance-related Audit

About Account Balances related Audit Objectives Applied to Inventory
Objectives

Existence Existence All recorded inventory exists

at the balance sheet date
Completeness Completeness All existing inventory has
been counted and included
in the inventory summary

Valuation and Accuracy Inventory quantities on the

allocation client’s perpetual records
agree with items physically
on hand
Prices used to value
inventories are materially
correct
Extensions of price times
quantity are correct and
details are correctly added
 ABC Sdn Bhd.
(Applied to Inventory)

Management Assertions General Balance- Specific Balance-related Audit

About Account Balances related Audit Objectives Applied to Inventory
Objectives
Valuation and Detail tie-in Total of inventory items
allocation agrees with general ledger
Realizable Inventories have been written
value down where net realizable
value is impaired
Rights and obligations Rights and The company has title to all
obligations inventory items listed
Inventories are not pledged
as collateral
Assertions About Presentation and Disclosure
Disclose events, transactions, and other
Occurrence and
matters have been occurred and
right and obligation pertain to the entity

All disclosed event

that should have been included in the
Completeness financial Statement
have been included

Classification and Financial information is appropriately

understandability presented , described and disclosures
are clearly expressed

Accuracy and Financial and other information are

Valuation Disclosed fairly and appropriate amount
How Audit Objectives Are Met

The auditor must obtain sufficient appropriate

audit evidence to support all management
assertions in the financial statements.