AT - Fraud, Error, Noncompliance
AT - Fraud, Error, Noncompliance
AUDITING THEORY
AT.1806-The Auditor’s Responsibilities
Relating to Fraud, Error and Non-compliance MAY 2015
LECTURE NOTES
Auditor's Responsibilities Relating to Fraud and environment and implement internal control policies and
Error procedures to prevent and detect fraud. On the other
hand, TCWG, through its oversight function, shall ensure
Introduction the integrity of accounting and financial reporting systems
The auditor is responsible for obtaining reasonable and that appropriate controls are in place.
assurance that the FSs taken as a whole are free from On the other hand, the auditor’s responsibility is to obtain
material misstatement, whether caused by fraud or error. reasonable assurance about whether the FSs taken as a
Hence, the auditor’s responsibility for the detection of whole are free from material misstatement, whether
fraud and error is essentially the same. caused by fraud or error. The auditor is not responsible
Fraud refers to an intentional act by one or more for discovering fraud, and is not and cannot be held
individuals among management, TCWG, employees, or responsible for the prevention of fraud. Unless the auditor
third parties, involving the use of deception to obtain an has reason to believe the contrary, the auditor may accept
records and documents as genuine. An audit rarely
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unjust or illegal advantage. While, error pertains to
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unintentional misstatements or omissions in FSs, including involves the authentication of documents.
the omission of an amount or disclosure. Differentiating
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The auditor shall perform the procedures below following
fraud from error requires professional judgment. The risk
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of not fraud is higher than error because fraud may be maintaining an attitude of professional skepticism;
concealed, especially if through collusion.
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exercising professional judgment;
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Although fraud is a broad legal concept, the auditor is holding engagement team discussion (‘brainstorming’);
performing RAP and related activities;
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Manipulation or falsification of financial records This discussion shall place particular emphasis on how and
where the entity’s FSs may be susceptible to material
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Intentional misapplication of accounting policies occur. The team shall set aside beliefs that management
b. Misappropriation of assets (theft) - Involves the theft and TCWG are honest and have integrity.
of an entity’s assets and is often perpetrated by Performing RAP and Related Activities
employees in relatively small and immaterial amounts.
Management and Others within the Entity
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Goods or services paid for by the entity but not determine whether it has knowledge of any actual,
received suspected or alleged fraud affecting the entity, and to
Use of entity assets for personal use obtain its views about the risks of fraud.
As to perpetrator: Those Charged with Governance (TCWG)
a. Management fraud – refers to fraud involving one or
The auditor shall obtain an understanding of how TCWG
more members of management or TCWG.
exercise oversight of management’s processes for
b. Employee fraud – refers to fraud involving only
identifying and responding to the risks of fraud in the
employees of the entity.
entity and the internal control that management has
The risk of the auditor not detecting management fraud is established to mitigate these risks. TCWG of an entity
greater than for employee fraud, because management have oversight responsibility for systems for monitoring
may override otherwise effective internal controls. risk, financial control and compliance with the law.
Responsibility of Management and Those Charged The auditor shall make inquiries of TCWG to determine
with Governance (TCWG) vs. that of the Auditor whether they have knowledge of any actual, suspected or
alleged fraud affecting the entity. These inquiries are made
The primary responsibility for the prevention and detection
in part to corroborate the responses to the inquiries of
of fraud rests with both TCWG of the entity and
management.
management. Management shall establish a control
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Unusual or Unexpected Relationships Identified Irrespective of the auditor’s assessment of the risks of
management override of controls, the auditor shall design
The auditor shall evaluate whether unusual or unexpected
and perform audit procedures to:
relationships that have been identified in performing
a. Test the journal entries and other adjustments made in
analytical procedures, including those related to revenue
the preparation of the FSs.
accounts, may indicate ROMM due to fraud.
b. Review accounting estimates for biases.
c. For significant transactions that are outside the normal
Other Information
course of business for the entity, or appear to be
The auditor shall consider whether other information unusual, the auditor shall evaluate business rationale
obtained by the auditor indicates ROMM due to fraud. (or the lack thereof) of the transactions.
Evaluation of Fraud Risk Factors Evaluating Audit Evidence and Results of Audit
Fraud risks factors refer to events or conditions that Based on the audit procedures performed and the audit
indicate an incentive or pressure to commit fraud or evidence obtained, to evaluate whether the assessments of
provide an opportunity to commit fraud. The three the ROMM at the assertion level remain appropriate. This
conditions (the fraud triangle or characteristics) generally evaluation is primarily a qualitative matter based on the
present when fraud occurs are: auditor’s judgment.
a) Attitudes or rationalizations – Those involved in the
Analytical Procedures Performed in the Overall Review of
fraud are able to rationalize committing a fraudulent
the Financial Statements
act. This relates to either a person committing the
fraud, or to the entity’s control environment. The auditor shall evaluate whether analytical procedures
b) Incentives or pressures – Management and employees that are performed when forming an overall conclusion as
have an incentive (e.g., benefit or enrichment) or are to whether the FSs as a whole are consistent with the
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under pressure (e.g., threat of losing their job), which auditor’s understanding of the entity and its environment
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provides a reason to commit fraud. indicate a previously unrecognized ROMM due to fraud.
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c) Opportunities – Circumstances making execution of
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fraud possible. These circumstances exist when a
person is generally trusted, internal control is
Consideration of Identified Misstatements
The auditor’s actions depend on whether the fraud that has
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perceived to be easily overridden, or the individual
been discovered or suspected is material or immaterial:
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knows about deficiencies in internal control.
If immaterial:
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The auditor shall, based on a presumption that there are o Investigate further, i.e., discuss with appropriate
risks of fraud in revenue recognition, evaluate which types level of management (one level above the person
of revenue, revenue transactions or assertions give rise to involved)
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such risks. Otherwise, auditor shall document when this o Obtain evidence of fraud and its effects
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presumption is not applicable. For example, when revenue o Suggest client consult legal counsel
recognition is a single type of simple revenue transaction,
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e.g., leasehold revenue from a single unit rental property. Communication of Misstatements due to Fraud
Understanding the Entity’s Related Controls In the exceptional circumstances where the auditor has
doubts about the integrity or honesty of management or
The auditor shall treat assessed ROMM due to fraud as
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does not result in a material misstatement. Similarly, d) Results of the audit procedures;
TCWG may wish to be informed of such circumstances. e) Communications about fraud made to management,
TCWG, regulators and others; and
Communications to Regulatory and Enforcement f) Reasons for that conclusion ROMM due to fraud related
Authorities to revenue recognition is not applicable.
The auditor’s professional duty to maintain the Auditor’s Responsibility to Consider Laws and
confidentiality of client information may preclude reporting Regulations
fraud to a party outside the client entity. However, the
regulatory requirements, statute, the law or courts of law Introduction
overrides this duty. For example, under a BSP
requirement, the auditor of a financial institution has a The auditor needs to consider the applicable laws and
statutory duty to report the occurrence of fraud to the regulations to the entity in FSs audit because compliance
BSP. Also, under an SEC requirement, the auditor has a and non-compliance with those laws and regulations affect
duty to report material audit findings, such as those the FSs in many ways. In addition, those laws and
involving fraud or error. regulations to which an entity is subject constitute the
legal and regulatory framework in which the entity
Communication of Misstatements due to Error operates.
The auditor should communicate to management (and to Nature and Definition of Non-compliance
TCWG, where necessary) any identified material Non-compliance–Acts of omission or commission by the
misstatements resulting from error. In addition, the entity (intentional or unintentional), which are contrary to
auditor should communicate also to TCWG those the prevailing laws or regulations. Such acts include
uncorrected misstatements aggregated by the auditor transactions entered into by, or in the name of, the entity,
during the audit that were deemed by management as
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or on its behalf, by TCWG, management or employees.
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immaterial to the FSs. However, non-compliance does not include personal
misconduct (unrelated to the business activities of the
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Management Written Representations
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The auditor shall obtain written representations from
management that:
entity) by TCWG, management or employees of the entity.
Types of Laws and Regulations
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a. It acknowledges its responsibility for internal control to
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In relation to audit of FSs, there are two types:
prevent and detect fraud; a. Direct effect–Amounts and disclosures, as a result of
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b. It has disclosed to the auditor: compliance, are reported on the FSs such as tax and
the results of its assessment of the risk that the pension laws and regulations
FSs may be materially misstated due to fraud; b. Indirect effect–Relates primarily to operations of the
its knowledge or suspicion of fraud involving: entity but does not have a direct effect on an entity’s
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management; employees who have significant FSs. However non-compliance may result in fines,
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roles in internal control; or others where the fraud litigation or other consequences for the entity that may
could have a material effect on the FSs; and
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environmental regulations.
analysts, regulators or others.
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Examples of these exceptional circumstances include: Responsibility of Management for Compliance with Laws
The entity does not take the appropriate action and Regulations
regarding fraud that the auditor considers necessary,
even when the fraud is not material to the FSs; Management, with the oversight of TCWG, is responsible
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The auditor’s consideration of the ROMM due to fraud for ensuring that the entity’s operations are conducted in
and the results of audit tests indicate a significant risk accordance with laws and regulations.
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Whether an act constitutes non-compliance is b) Further information to evaluate the possible effect on
ultimately determined by a court of law. the FSs.
Ordinarily, the further removed non-compliance is from the Audit Procedures
events and transactions reflected in the FSs, the less likely
If the auditor suspects there may be non-compliance, the
the auditor is to become aware of it or to recognize the
auditor shall discuss the matter with management and,
non-compliance.
where appropriate, TCWG. If management or, as
The Auditor’s Consideration of Compliance with Laws appropriate, TCWG do not provide sufficient information
and Regulations that supports that the entity is in compliance with laws and
regulations and, in the auditor’s judgment, the effect of
Obtaining an Understanding of the Legal and Regulatory
the suspected non-compliance may be material to the FSs,
Framework
the auditor shall consider the need to obtain legal advice.
As part of obtaining an understanding of the entity and its
Evaluating the Implications of Non-Compliance
environment, the auditor shall obtain a general
understanding of: The auditor shall evaluate the implications of non-
a) The legal and regulatory framework applicable to the compliance in relation to other aspects of the audit,
entity and the industry or sector in which the entity including the auditor’s risk assessment and the reliability
operates; and of written representations, and take appropriate action.
b) How the entity is complying with that framework.
In exceptional cases, the auditor may consider whether,
Direct Effect Laws and Regulations unless prohibited by law or regulation, withdrawal from the
engagement is necessary when management or TCWG do
The auditor shall obtain sufficient appropriate audit
not take the necessary remedial action, even when the
evidence regarding compliance with the provisions of those
non-compliance is not material but the auditor may
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laws and regulations with direct effect on the material
consider seeking legal advice. If withdrawal is prohibited,
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amounts and disclosures in the FSs.
the auditor may consider alternative actions, including
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Indirect Effect Laws and Regulations describing the non-compliance in an Other Matter(s)
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The auditor shall perform the following to identify non-
paragraph in the auditor’s report.
Reporting of Identified or Suspected Non-
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compliance that may have a material effect on the FSs:
Compliance
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a. Inquiring of management and, where appropriate,
TCWG, as to whether the entity is in compliance with
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counsel concerning litigation, claims and assessments; and evidence obtained imposed by Evaluate effect on
performing substantive tests of details of classes of circumstances audit report
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appropriate, TCWG to provide written representations that with laws and regulations, determine whether the auditor
all known instances of non-compliance or suspected non- has a responsibility to report the identified or suspected
compliance with laws and regulations whose effects should non-compliance to parties outside the entity.
be considered when preparing FSs have been disclosed.
The auditor’s professional duty to maintain the
No Identified or Suspected Non-compliance confidentiality of client information may preclude reporting
identified or suspected non-compliance with laws and
In the absence of identified or suspected non-compliance, regulations to a party outside the entity.
the auditor is not required to perform audit procedures
regarding the entity’s compliance with laws and Documentation
regulations, other than those set out above.
The auditor shall document identified or suspected non-
Audit Procedures When Non-Compliance Is compliance with laws and regulations and the results of
Identified or Suspected discussion with management and, where applicable, TCWG
and other parties outside the entity. For example: copies
The auditor shall obtain: of records or documents or minutes of discussions held
a) An understanding of the nature of the act and the with management, TCWG or parties outside the entity.
circumstances in which it has occurred; and
- done -
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MULTIPLE CHOICE
Fraud and Error c. Theft of assets covered up by manipulation of
Fraud vs. Error accounting records
1. What is the primary determinate in the difference d. Agreement between two or more persons to
between fraud and errors? commit a criminal act
a. The materiality of the misstatement.
7. The most difficult type of misstatement to detect is
b. The intent to deceive.
fraud based on
c. The level of management involved.
a. The overrecording of transactions.
d. The type of transaction effected.
b. The nonrecording of transactions.
2. The following are examples of error, except c. Recorded transactions in subsidiaries or incorrect
a. A mistake in gathering or processing data from postings of recorded transactions.
which financial statements are prepared. d. Related-party receivables.
b. An incorrect accounting estimate arising from
Responsibilities for fraud
oversight or misinterpretation of facts
8. Which statement(s) is(are) incorrect regarding the
c. A mistake in the application of accounting
auditor’s responsibility to consider fraud and error in
principles relating to measurement, recognition,
an audit of financial statements?
classification, presentation, or disclosure
a. The auditor is not and cannot be held responsible
d. Misrepresentation in the financial statements of
for the prevention of fraud and error being the
events, transaction or other significant information
primary responsibility of both the management
3. The risk of not detecting a material misstatement and those charged with governance.
resulting from fraud is higher than the risk of not b. When planning and performing audit procedures
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detecting a material misstatement resulting from error and evaluating and reporting the results thereof,
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because the auditor should consider the risk of
a. The effect of fraudulent act is likely omitted in the misstatements in the financial statements resulting
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accounting records eH w from fraud.
b. Fraud is ordinarily accompanied by acts specifically c. In planning the audit, the auditor should discuss
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designed to conceal its existence and auditors do with other members of the audit team the
not make legal determinations of whether fraud susceptibility of the entity to material statements
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has actually occurred in the financial statements resulting from fraud or
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c. Fraud is always a result of connivance between or error and exercise professional skepticism (the
among employees best method to detect fraud).
d. The auditor is responsible to detect errors but not d. The auditor should design audit programs that will
fraud provide reasonable assurance that material errors
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the examination.
4. The two types of intentional misstatements that are
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relevant to the auditor’s consideration of fraud include, Engagement Team Discussion (‘Brainstorming’)
misstatements resulting from fraudulent financial 9. Brainstorming about the susceptibility of the entity’s
reporting and misstatements resulting from financial statements to material misstatement due to
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a. Deception such as manipulation, falsification engagement team members to share their insights
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(including forgery), or alteration of accounting about how and where the FSs may be susceptible
records or supporting documents from which the to material misstatement due to fraud and how
financial statements are prepared entity’s assets could be misappropriated
b. Misrepresentation in, or intentional omission from, b. Enables the auditor to consider an appropriate
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the financial statements of events, transaction or response to such susceptibility and to determine
other significant information which members of the engagement team will
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the following creates an opportunity for fraud to be a. The existence of a financial subsidiary.
committed in an organization? b. A consistent record of above average return on
a. Management demands financial success or is investment for all subsidiaries.
aggressive in its application of accounting rules. c. Complex sales transactions and transfers of funds
b. Poor internal control. between affiliated companies.
c. Commitments tied to debt covenants. d. Use of separate bank accounts for payrolls by each
d. Finding loopholes in the accounting rules to subsidiary.
achieve earnings targets.
Communicating Misstatements Resulting from Fraud
Identifying and Assessing the ROMM due to fraud 18. Communication of a misstatement resulting from
12. Which of the following is an example of a common type fraud, or a suspected fraud, or error to the appropriate
of financial reporting fraud? level of management on a timely basis is important
a. Capitalizing major overhauls to operating because it enables management to take action as
equipment. necessary. Ordinarily, the appropriate level of
b. Deferring service revenue until it is delivered to management is
customers. a. At least equal to level of persons who appear to be
c. Recording sales for inventory sold with the right to involved with misstatements or suspected fraud
return, hence, fraud on revenue recognition is b. At least one level above persons who appear to be
always presumed to exist in absence or conditions involved with the misstatement or suspected fraud
to the contrary. c. The audit committee of the board of directors
d. Excluding a contingent liability that has been d. The head of internal audit department
settled.
19. Protection Transparency, Inc. is being audited by
Responding to Assessed ROMM due to fraud Messer and Bromely, LLP. During the assessment of
13. Which of the following is most likely to be an overall fraud, Messer and Bromely discover that the controller
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response to fraud risks identified in an audit? has been creating fictional sales and posting them to
a. Supervise members of the audit team less closely the general ledger. Who should the auditors make
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and rely more upon judgment. eH w aware of this issue?
b. Use less predictable audit procedures. a. Protection Transparency's legal counsel.
c. Only use certified public accountants on the b. The law enforcement agency.
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engagement. c. The chairman of audit committee.
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d. Place increased emphasis on the audit of objective d. The predecessor auditor.
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must perform which of the following procedures? a. It acknowledges its responsibility for the
implementation and operations of accounting and
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Examine all journal Review accounting internal control systems that are designed to
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entries above materiality estimates for biases prevent and detect fraud and error
a. Yes Yes b. It has disclosed to the auditor its knowledge of
b. No No fraud or suspected fraud affecting the entity
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Evaluating the Audit Evidence and Results of Audit c. It has disclosed to the auditor its knowledge of any
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Circumstances that Indicate the Possibility of Fraud allegations of fraud, or suspected fraud affecting
15. The following are examples of circumstances that may the entity’s financial statements communicated by
indicate the possibility that the financial statements employees, former employees, analysts,
may contain a material misstatement resulting from regulations or others
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b. Noncompliance includes transactions entered into Indications of Non-Compliance with Laws and Regulations
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by, or in the name of, the entity, or on its behalf, 26. According to PSA 250 (Consideration of Laws and
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by TCWG, management or employees. Regulations in an Audit of Financial Statements), the
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c. Noncompliance includes personal misconduct of
the entity’s management or employees though
following are indications that noncompliance may have
occurred, except
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they are unrelated to the entity’s business a. Investigation by government departments or
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activities payment of fines or penalties
d. In the absence of evidence to the contrary, the b. Adverse media comment
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responsibility for evaluating noncompliance by the the auditor's attention that may indicate that
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entity to laws and regulations? noncompliance with laws or regulations has occurred
a. It is the responsibility of management, with the least likely include
oversight of those charged with governance, to a. Payments for unspecified services or loans to
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ensure that the entity’s operations are conducted consultants, related parties, employees or
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d. The auditor’s responsibility for detecting indirect- b. Obtain evidence about the potential effect of the
effect illegal acts is similar to the responsibility to illegal act on the financial statements.
detect fraud. c. Contact the local law enforcement officials
regarding potential criminal wrongdoing.
Reporting of Identified or Suspected Non-Compliance
d. Consider the impact of the illegal act on the
30. Which of the following is the auditor least likely to do
relationship with the company’s management.
when aware of an illegal act?
a. Discuss the matter with the client’s legal counsel.
- now do the DIY drill -
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Fraudulent financial Yes Yes No Yes procedures?
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reporting a. Audit procedures and fraud assessment do not
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Misappropriation of Yes No Yes No relate.
assets
Direct-effect illegal acts Yes No
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b. The assessment may require a re-audit of previous
periods.
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c. By the assignment of qualified audit staff to risky
3. Which of the following most accurately defines
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areas of the engagement.
professional skepticism as it is used in auditing
d. Management will be called upon to assist in
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standards?
coordinating audit procedures.
a. It either assumes management is honest or slightly
dishonest, but neither all the time. 9. The following are examples of circumstances that may
b. It neither assumes that management is dishonest indicate the possibility that the financial statements
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nor assumes unquestioned honesty. may contain a material misstatement resulting from
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d. It assumes that management is dishonest in only or a greater number of responses than anticipated.
rare instances. b. Large numbers of debit entries and other
adjustments made to accounts receivable records.
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magnitude.
a. how management could perpetrate and conceal
d. Unusual discrepancies between the entity's records
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d. Ensure that the client’s internal auditors act in an audit evidence or in the resolution of potential
ethical manner disagreements with management.
c. Usual delays by the entity in providing requested
12. An auditor who discovers that a client's employees
information
paid small bribes to municipal officials most likely
d. An unwillingness to address identified weaknesses
would withdraw from the engagement if
in internal control on a timely basis.
a. The payments violated the client's policies
regarding the prevention of illegal acts. 17. The following are examples of circumstances that may
b. The client receives financial assistance from a indicate the possibility that the financial statements
federal government agency. may contain a material misstatement resulting from
c. Documentation that is necessary to prove that the fraud, except
bribes were paid does not exist. a. Unwillingness by management to permit the
d. Management fails to take the appropriate remedial auditor to meet privately with those charged with
action and reliance on management’s governance.
representation becomes doubtful. b. Accounting policies that appear to be consistent
with industry norms.
13. If an illegal act is discovered during the audit of a
c. Frequent changes in accounting estimates that do
publicly held company, the auditor should
not appear to result from changed circumstances.
a. Notify the regulatory authorities.
d. Tolerance of violations of the entity’s Code of
b. Determine who was responsible for the act.
Conduct
c. Modify the extent of auditing procedures.
d. Report the act to high-level personnel within the 18. Brainstorming about the manner in which fraud may
client's organization. be committed should include all of the following except
a. Consider factors that might affect management
14. Which of the following is least likely to be included in
motivation to misstate the financial statements
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an auditor's inquiry of management while obtaining
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b. Consider weaknesses in internal control that would
information to identify the risks of material
allow a fraud to take place or management
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misstatement due to fraud?
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a. Are financial reporting operations controlled by and
c. Consider the materiality of the individual account
limited to one location?
balances for substantive testing
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b. Does it have knowledge of fraud or suspect fraud?
d. Consider factors that may enable an individual
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c. Does it have programs to mitigate fraud risks?
capable of committing a fraud to rationalize
d. Has it reported to the audit committee the nature
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perpetrating it
of the company's internal control?
19. In evaluating the effect of fraud upon the audit
15. Which of the following could indicate that the risk of
procedures the auditor should consider
fraud and other irregularities perpetrated by senior
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