Auditors Responsibility Introduction

Design the Audit to provide reasonable assurance of

detecting material misstatements in the financial
statements.
Misstatements may come from:
ERROR
FRAUD; and
NON COMPLIANCE with LAWS and REGULATIONS
 Error
It refers to unintentional misstatements
in the financial statements, including the omission
of an amount or a disclosure, such as:
Mathematical or clerical mistakes in the underlying
records and accounting data.

An incorrect accounting estimate arising from

oversight or misinterpretation of facts.

Mistake in the application of accounting policies.

Fraud

Intentional act by one or more individuals among

management, those charged with governance,
employees, or third parties involving the use of
deception to obtain unjust/illegal advantage.
Auditor is PRIMARILY CONCERNED with the
fraudulent acts that cause material misstatements
in the financial statements.
 TYPES OF FRAUD

Fraudulent Financial Reporting

It involves intentional misstatements or omissions

of amounts or disclosures in the financial statement
users.

It is also known as management fraud.

This may involve:

Manipulation, falsification or alteration

of records or documents.

Misinterpretation in or intentional omission

of the effects of transactions from records
or documents.

Recording of transactions without substance.

Intentional misapplication of accounting policies.

Misappropriation of assets/employee fraud

Theft of an entitys assets committed by the entitys

employees.
Accompanied by false or misleading records
Examples:
EMBEZZLING RECEIPTS
STEALING CASH, INVENTORY, and MARKETABLE
SECURITIES
LAPPING OF ACCOUNTS RECEIVABLE
 The primary factor that distinguishes fraud
from error is whether the underlying cause
of misstatement in the financial statement
is intentional or unintentional.

The auditors responsibility for detection of fraud

and error is essentially the same.
Responsibility of Management and those
charged with Governance
For PREVENTION and DETECTION of fraud and error.
PSA 240 requires:
Management establish a control environment and,
implement internal control policies and procedures
to ensure the detection and prevention of fraud.
Individuals charged with governance ensure the
integrity of an entitys accounting and financial
reporting systems and that appropriate controls are
in place.
Auditors Responsibility

Auditor is not and cannot be held responsible

for the prevention of fraud and error.

The auditors responsibility is to design the

audit to obtain reasonable assurance that the
financial statements are free from material
misstatements.
Planning Phase

1. The auditor should make inquiries of management

about the possibility of misstatements due to the
fraud and error. This may include:
Managements assessment of risks due to fraud
Controls established to address the risks; and
Any material error or fraud that has affected the
entity or suspected fraud that the entity is
investigating
Planning Phase

2. The auditor should assess the risk that the fraud

or error may cause the financial statements to
contain material misstatements.
Fraud risks factors does not indicate the existence
of fraud but have been present in circumstances
where frauds have occurred.
Planning Phase

Judgements about the Increased risk of material

misstatements due to fraud may influence the
auditors professional judgements in the ff. ways:
Approach the audit with a heightened level of
professional skepticism
The ability to assess control risk at less than high
level may be reduced and the auditor should be
sensitive to the ability of management to override
controls.
Planning Phase

The audit team may be selected in ways that ensure

that the knowledge, skill, and ability of personnel
assigned significant responsibilities are
commensurate with the auditors assessment of
risks.
Decide to consider management selection and
application of significant accounting policies,
particularly those related to income determination
and asset valuation.
Testing Phase

3. During the course of the audit, the auditor

may encounter circumstances that may indicate
the possibility of fraud or error.

4. The auditor should consider whether such a

misstatement resulted from a fraud or an error.
Immaterial fraud
Material fraud
Unable to evaluate
Completion Phase
5. The auditor should obtain a written
representation from the clients management
that:
It acknowledges its responsibility for the
implementation and operations of accounting and
internal control systems to help detect and
prevent fraud and error
Effects of those uncorrected financial statement
misstatements aggregated by the auditor during
the audit are immaterial, both individually and in
aggregate. A summary of such items should be
included or attached thereunto.
Completion Phase

Disclosed to the auditor all significant facts

relating to any frauds or suspected frauds known
to management that may have affected the entity.
Disclosed to the auditor the results of its
assessment of the risks that the financial
statement may be materially misstated due to
fraud.
 Consider the Effect on the Auditors Report

6. When the auditor believes that material error

or fraud exists, he should request the management
to revise the financial statements. Otherwise,
The auditor will express a qualified or adverse
opinion.
 7. If the auditor is unable to evaluate the effect of
fraud on the financial statements, the auditor should
either qualify or disclaim his opinion on the
financial statements.
 subsequent discovery of material
misstatements in the financial statements
resulting from fraud or error does not, in and
of itself, indicate that the auditor has failed to
adhere to the basic principles and essential
procedures of an audit.
the risk of not detecting a material misstatements
resulting from fraud is higher than
the risk of not detecting misstatements
resulting from an error.
the risk of the auditor not detecting a material
misstatement resulting from management fraud
is greater than for employee fraud.
Noncompliance with Laws and Regulations

Noncompliance Acts of omission or commission

by the entity being audited, either intentional or
unintentional, which are contrary to the prevailing
laws or regulations.
Examples:
Tax Evasion
Violation of environmental protection laws
Inside trading of securities
 Management Responsibility

To ensure that the entitys operations are conducted

in accordance with laws and regulations.

The responsibility for the prevention and detection

of non- compliance rests with management.
 Monitoring legal requirements and ensuring
that operating procedures are designed to meet
this requirements.

Instituting and operating appropriate systems

of internal control.

Developing, publicizing and following a Code of

Conduct.
 Monitoring compliance with the code of conduct
and acting appropriately to discipline employees
who failed to comply with it.

Engaging legal advisors to assist in monitoring

legal requirements.

Maintaining a register of significant laws with

which the entity has to comply within its particular
Industry and a record of complaints.
Auditors Responsibility

The auditor should recognize that

noncompliance by the entity with laws and
regulations may materially affect the financial
statements.
Planning Phase

1. The auditor should obtain a general

understanding of the legal and regulatory
framework applicable to the entity and the
industry and how the entity is complying with that
framework. Through the:
Use of existing knowledge of the entitys industry
and business.
Inquire of management concerning the entitys
policies and procedures regarding compliance with
laws and regulations.
Planning Phase

Inquire of management as to the laws or

regulations that may be expected to have a
fundamental effect on the operations of the entity.
Discuss with the management the policies or
procedures adopted for identifying, evaluating,
and accounting for litigation claims and
assessments.
Discuss the legal and regulatory framework with
the auditors of subsidiaries in other countries.
Planning Phase

2. The auditor should design procedures to help

identify instances of noncompliance with those
laws and regulations where noncompliance should
be considered when preparing financial
statements , such as:
Inquiring of management as to whether the entity
is in compliance with such laws and regulations.
Inspecting correspondence with the relevant
licensing or regulatory authorities.
Planning Phase

3. Design audit procedures to obtain sufficient

appropriate audit evidence about compliance
with those laws and regulations generally
recognized by the auditor to have an effect on the
determination of material amounts and
disclosures in financial statements.
Testing Phase

4. Evaluate the possible effect on the financial

statements.

5. Document the findings, discuss them with

management and consider implication on other
aspects of the audit.
Completion Phase

6. The auditor should obtain written representations

that management has disclosed to the auditor all
known actual or possible noncompliance with
laws and regulations that could materially affect
the financial statements.
Consider the Effect on the Auditors Report

7. When the auditor believes that there is

non compliance with laws and regulations that
materially affects the financial statements, he
should request the management to revise the
financial statements. Otherwise, the auditor will
express a qualified or adverse opinion.
8. If a scope limitation has precluded the auditor
from obtaining sufficient appropriate evidence to
evaluate the effect of non compliance with laws
and regulations, the auditor should express a
qualified opinion or a disclaimer of opinion.
The risk is higher with regard to material
misstatements resulting from non-compliance with
laws and regulations.

Auditors are primarily concern with the

non-compliance that will have a direct and material
effect in the financial statements.

Non-compliance may involve conduct designed

to conceal it, such as collusion, forgery, deliberate
failure to record transactions, senior management
Override of controls or intentional misinterpretations.
Examples of Risk Factors Relating to
Misstatements Resulting from Fraud
The auditor exercises professional judgement when
considering fraud risk factors individually or in
combination and whether there are specific
controls that mitigate the risk.
3 Group categories:
Managements characteristics and influence over
the control environment.
Industry Conditions
Operation Characteristics and Financial Stability
1. Managements Characteristics and Influence
over the control environment.

These factors pertain to managements abilities,

pressures, styles, and attitude relating to internal
control and the financial reporting process.

There is motivation for management to engage

in fraudulent financial reporting.
 There is a failure by the management to display
and communicate an appropriate attitude regarding
internal control and the financial reporting process.

Non-financial management participates excessively

in, or is preoccupied with, the selection of accounting
principles or the determination of significant estimates.

There is a high turnover of management, counsel

or board members.
 There is a strained relationship between
Management and the current, or predecessor

There is a history of securities law violations, or

claims against the entity or its management alleging
fraud or violations of securities laws.

The corporate governance structure is weak

or ineffective.
Fraud Risk Factors Relating to Industry
Conditions
The ff. involve the economic and regulatory environment
in which the entity operates.
New accounting statutory or regulatory requirements
that could impair the financial stability or profitability
of the entity.
A high degree of competition or market saturation,
accompanied by declining margins.
A declining industry with increasing business failures
and significant declines in customer demand.
Rapid changes in the industry, such as high
vulnerability to changes in technology or rapid product
obsolescence.
3. Operating Characteristics and Financial
Stability

These factors pertain to the nature and complexity

of the entity and its transactions, the entitys financial
condition and its profitability.

There is motivation for management to engage

in fraudulent financial reporting.
 Inability to generate cash flows from operations
while reporting earnings and earnings growth.

Significant pressure to obtain additional capacity

necessary to stay competitive, considering the
financial position of the entity.

Assets, liabilities, revenues or expenses based on

significant estimates that involves unusually
subjective judgements or that are subject to potential
significant change.
 Significant related party transactions which are not
in the ordinary course of the business.

Significant related party transactions which are not

audited or are audited by another firm.

Significant, unusual or highly complex transactions

that pose difficult questions concerning substance
over form.
 Significant bank accounts or subsidiary or branch
operations in tax-haven jurisdictions for which there
appears to be no clear business justification.

An overlay complex organizational structure

involving numerous or unusual legal entities,
managerial lines of authority or contractual
arrangements without apparent business purpose.

Difficulty in determining the organization or person

controlling the entity.
 Unusually rapid growth or profitability, especially
compared with that of other companies in the same
Industry.
Especially high vulnerability to changes in interest
rates.
Unusually high dependence on debt, a marginal
ability to meet debt repayment requirements, or debt
covenants that are difficult to maintain.
 A threat of imminent bankruptcy, foreclosure or
hostile takeover.

Adverse consequences on significant pending

transactions if poor financial results are reported.
A poor or deteriorating financial position when
management has personally guaranteed significant
debts of the entity.
Fraud Risk Factors Relating to Misstatements
Resulting from Misappropriation of Assets
Grouped into 2 categories:
Susceptibility of Assets to Misappropriation
Controls
The extent of the auditors consideration in
category 2 is influenced by those in category 1
Fraud Risk Factors Relating to Susceptibility of
Assets to Misappropriation
The Nature of an entitys assets and the degree to
which they are subject to theft.
Large amount of cash on hand or processed
Inventory characteristics, such as small size
combined with high value and high demand
Easily convertible assets such as bearer bonds,
diamonds, or computer chips
Fixed asset characteristics, such as small size
combined with marketability and lack of ownership
identification.
2. Fraud Factors Relating to Controls

Lack of appropriate management oversight.

Lack of procedures to screen job applicants

for positions where employees have access to assets
susceptible to misappropriation.

Inadequate record keeping for assets

susceptible to misappropriation.

Lack of appropriate segregation of duties.

 Lack of appropriate system of authorization and
approval of transactions.

Poor physical safeguards over cash, investments,

inventory or fixed assets.

Lack of timely and appropriate documentation for

transactions.

Lack of mandatory vacation for employees

performing key control functions.
1. If the auditor believes that the fraud or error has
a material effect on the financial statements but
the client is not willing to correct the
misstatement, the auditor would most likely
issue a/an:
a) Qualified or disclaimer opinion
b) Qualified or adverse opinion
c) Unmodified report
d) Unmodified opinion
2. If the auditor is precluded by the entity from
obtaining evidence to evaluate whether fraud or
error that may be material to the financial
statements has occurred, the auditor should
issue a report that contains:
a) Unmodified opinion
b) Adverse opinion
c) Either qualified opinion or a disclaimer opinion
d) Either qualified or adverse opinion
3. These are acts of omission or commission by
the entity being audited either intentional or
unintentional, which are contrary to the
prevailing law.
a) Fraud
b) Noncompliance
c) Misappropriation
d) Defalcation
4. Generally the decision to notify parties outside
the clients organization regarding
noncompliance with law and regulations is the
responsibility of the:
a) Management
b) Internal auditors
c) Independent auditor
d) Clients legal counsel
5. Fraudulent financial reporting is often called as
a) Misappropriation of assets
b) Employee fraud
c) Management fraud
d) defalcfacation
6. Which one of the following terms relates to the
embezzling of receipts
a) Misrepresentation
b) Misappropriation
c) Misapplication
d) Manipulation