AUDITING

Session 7
 ISA 240
The Auditor’s responsibilities relating to fraud in
an audit of financial statements
• Misstatements in financial statements can arise from
either fraud or error.
• Intentional actions are fraud, unintentional are errors.
There are two types of misstatements:
1. Resulting from fraudulent financial reporting,
2. Resulting from misappropriation of assets.
 RESPONSIBILITY FOR PREVENTION
• Primary responsibility of prevention / detection of
fraud rests with (1) those charged with governance,
and (2) management of the company.
• Management should inculcate a culture of honesty
and ethical behavior.
• Those charged with governance are required to
oversee (oversight) the financial reporting process to
(1) identify inappropriate influence, and (2) potential
of overriding controls
 FRAUD CHARACTERISTICS
1. Incentive or undue pressure, to achieve unrealistic
earnings target or financial outcome – particularly
when consequence of failing to meet goals is high
2. When people believe internal controls can be
overridden – when individual is on position of trust
3. When individuals are able to rationalize committing
fraudulent acts
4. Earnings management usually start with small
actions or adjustments.
 FRAUD & ERROR
• It is the responsibility of management and those charged
with governance (BOD) to prevent and detect fraud
• The internal auditor can help to prevent fraud - by
assessing the adequacy and effectiveness of IC systems.
• The very existence of an IA department may act as a
deterrence to fraud.
• The objective of the auditor is to identify and assess the
risks of material misstatement, whether due to fraud or
error, through understanding the entity and its
environment, including the entity's internal control…
 DETECTING FRAUD
• In planning the audit, auditors must be alert to the
possibility of fraud and assess the risk that fraud
might occur (Professional Skepticism)
• 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
• Auditor shall have a presumption of fraud in Revenue.
FRAUD ASSESSMENT PROCEDURES
• Discussion among the Engagement Team (brain
storming, previous experience)
a) How and where the entity’s FS may be susceptible
to material misstatement due to fraud,
b) how management could perpetrate and conceal
fraudulent financial reporting, and
c) how assets of the entity could be misappropriated
 FRAUD ASSESSMENT … (2)
• Circumstances that might be indicative of aggressive
earnings management
• The known factors affecting the entity that may create an
incentive or pressure on management
• Management’s oversight of employees with access to
cash or other assets
• Any unusual or unexplained changes in behaviour or
lifestyle of management or employees
• Any allegations of fraud that have come to the auditor’s
attention.
 DISCUSSIONS WITH MANAGEMENT
• Subsidiary locations, business segments, types of
transactions, account balances or financial statement
categories where the possibility of error may be high,
or where fraud risk factors may exist.
• How those charged with the governance exercise
oversight of management’s processes.
• Work of the entity’s internal audit function (report)
• How management communicates to employees its
view on ethical behaviour (code of conduct)
 RISK OF FRAUDULENT REPORTING
• Significant portion of management compensation contingent upon
achieving aggressive targets etc.
• Interest by management in managing the entity's share price
• Domination by single person/ small group without compensating
controls
• Setting of unduly financial target and expectations for operating
personnel
• Display of significant disregard for regulatory authorities
• Employing ineffective accounting, IT or IA staff, and participation of
non-financial management in selection of accounting policies etc.
• High turnover of management staff or board members
• Strained relationship with existing/ predecessor auditor
RISK OF FRAUDULENT REPORTING (2)
• Increasing competition and declining margins/ customer
demands
• Declining industry with increasing business failures
• Rapid changes in industry like rapidly changing technology
• Reporting earning/ growth while inability to generate cash flows
• Balances and/ or transactions based on significant estimates
• Significant related party transactions
• Significant, unusual, or complex transaction particularly at or
near the year-end
• Significant bank account or business locations without clear
business justification
RISK OF FRAUDULENT REPORTING (3)
• Over complex organizational structure involving various/
unusual legal entities, lines of authority
• Unusual rapid growth/ profitability as compare to
competitors
• Dependence on debt, marginal ability to pay debt
• Threat of imminent bankruptcy, foreclosure, or hostile
takeover
• Adverse consequences on significant pending
transactions if poor results are reported
• A poor or deteriorating financial position when
management has personally guaranteed significant debts
of the entity
 SUSCEPTIBILITY OF ASSETS TO
MISAPPROPRIATION
• Large amounts of cash on hand or processed
• Easily convertible assets such as bearer bonds, or diamonds
• Lack of management oversight
• Lacking to screen job applicants for positions where employees
• Inadequate record keeping
• Lack of appropriate segregation of duties
• Lack of system of authorization and approval of transactions
• Poor physical safeguards over assets
• Lack of mandatory vacations / job rotations for employees
performing key control functions
 OTHER CIRCUMSTANCES
• Unrealistic time deadlines for audit completion
imposed by management
• Reluctance by management to engage in frank
communication with third parties
• Imposing limitation on audit scope
• Identification of important matters not previously
disclosed by management
• Significant difficult-to-audit figures in the accounts
 OTHER CIRCUMSTANCES (2)
• Aggressive application of accounting principles
• Conflicting or unsatisfactory evidence provided by
management or employees
• Unusual documentary evidence such as handwritten
alteration to document
• Information provided unwillingly or unreasonable delayed
• Seriously incomplete or inadequate accounting records
• Unusual transactions, by virtue of their nature, volume or
complexity
FRAUD – OTHER PERSPECTIVE
• https://youtu.be/7Ac7LzckbW0