Chapter 3 | Auditors Responsibility

Management responsibility Prepare

Auditors responsibility Design audit to provide reasonable assurance of detecting material
misstatements

1. Error
2. Fraud
3. Noncompliance with Laws and Regulations

Error Unintentional misstatements including omission of an amount or disclosure

- Mathematical or clerical mistakes (ex. Adds check, formulas in excel)

- Incorrect accounting estimate (ex. Warranty provisions)
- Mistake in application of accounting policies (ex. Accrual basis of preparation of FS)

Fraud intentional act, involve use of deception to obtain unjust/illegal advantage

Fraudulent act that cause a material misstatement in the financial statements

Types of Fraud:

1. Fraudulent financial reporting - also known as Management Fraud

Manipulation, falsification, alteration of documents
Misrepresentation/ intentional omission
Recording without substance
Intentional misapplication of accounting policies

2. Misappropriation of assets also known as Employee Fraud

Embezzling receipts
Stealing entitys assets
Lapping of accounts receivable
Fraud triangle:

Attitude / Rationalization
Opportunity
Incentive / Pressure

Responsibility of detecting fraud and error is the same

Responsibility of Management and those charged with governance

1. Management
Establish control environment
Implement internal control
Ensure detection and prevention of fraud and error

2. Individuals charged with governance

Ensure integrity
Ensure that appropriate controls are in place

Auditors Responsibility

Auditor is not responsible for the prevention of fraud

Planning phase

1. Make inquiries of management about (inquiry, analytical review, observation)

- Managements assessment of risk due to fraud
- Controls established to address the risk
- Any material error or fraud that has affected the entity

2. Assess the risk that fraud or error may cause the financial statements (Fraud triangle)
- Fraud risk factors: doesnt mean fraud is present, but:

- May approach audit with heightened level of professional skepticism

- Should be sensitive to management override of controls
- Audit team to be selected with the same level of knowledge with the
personnel assigned
- May decide to consider management selection and application of
accounting policies to income determination and asset valuation
Testing phase

3. Perform procedures necessary to determine whether material misstatements exist.

Likelihood can it occur (Fraud Triangle)

Magnitude - potential misstatement to the financial statements if conditions occur

Example: A jewelry manufacturer has numerous small inventory items with a high monetary
value. The characteristics of the items make them more susceptible to misappropriation.
Consequently, we may determine that there is a higher likelihood of misstatement of
inventory. In addition, the potential magnitude of the misstatement is higher due to the
monetary value of the items. Therefore, we may identify a risk of material misstatement due
to fraud.

4. Consider whether misstatement resulted from fraud or error

If resulted from fraud but immaterial

Refer to appropriate level of management
Ensure fraud has no other implications

If material fraud was detected

Consider implication on reliability of management representations
Discuss with appropriate level of management
Obtain evidence
Suggest to consult with legal counsel

Completion phase

5. Obtain written representation letter

Acknowledge the implementation and operations
Effects of uncorrected misstatements
Disclosed significant facts on fraud or suspected fraud
Disclosed assessment of the risk

Effects on the auditors report

6. Request the management to request the management to revise. Otherwise,

Issue qualified or adverse opinion

7. If unable to evaluate the effect or theres a limitation in auditors examination,

Issue qualified or disclaimer
Noncompliance with laws and regulations

Noncompliance acts of omission or commission by the entity being audited

Tax Evasion
Violation of environmental protection laws
Inside trading of securities

Managements Responsibility

- To ensure that the entitys operations are conducted in accordance with laws and regulations.
- Prevention and detection
- Policies and procedures:
Monitoring legal requirements
Instituting and operating systems of internal control
Developing code of conduct
Ensuring employees are properly trained
Monitoring compliance with code of conduct
Engaging legal advisors
Maintaining register of significant laws

Auditors Responsibility

- Audit cannot be expected to detect noncompliance

- Should recognize material effect in the FS by noncompliance

1. Planning phase
Auditor should have a general understanding of the legal and regulatory
framework
- Direct effect
- Indirect effect

Procedures to help identify instances of noncompliance

- Inquire as to whether the entity is in compliance with such laws
- Inspect relevant licensing

Design audit procedures to obtain sufficient appropriate evidence about

compliance
- If we do not identify or suspect non-compliance, we do not perform any
further procedures regarding the entitys compliance with other laws
and regulations.
 2. Testing phase
Evaluate effect on the financial statements (all throughout check minutes,
read articles)
We consider the materiality of the non-compliance on both a quantitative and
qualitative basis, including adequacy of disclosures in the financial statements
Example: We may identify a payment made to facilitate a contract for an
amount that is significantly below our tolerable error. However, the
consequence of such a payment may result in litigation against the entity and
the potential for significant fines and restrictions on future trading of the entity.
Although the initial payment may be small, the resulting consequences may be
material to the financial statements requiring a provision and/or disclosure of
the circumstances.

3. Completion phase
Obtain written representation that the management disclose all known possible
non compliance

Consider the effects of auditors report

- Request the management revise the financial statements, otherwise issue qualified or adverse
opinion

- If there will be limitation in evaluating evidence, auditor should issue disclaimer of opinion

Presumptive risks of material misstatement due to fraud

1. Revenue recognition
2. Related party relationships transactions
3. Risk of management override of controls
4. Significant unusual transactions