AUDITING THEORY

AT.106.1-Consideration of Fraud, Error and Non-compliance

LECTURE NOTES
Auditor's Responsibilities Relating to Fraud and On the other hand, the auditor’s responsibility is to obtain
Error reasonable assurance about whether the FSs taken as a
whole are free from material misstatement, whether
Introduction caused by fraud or error. The auditor is not responsible
The auditor is responsible for obtaining reasonable for discovering fraud, and is not and cannot be held
assurance that the FSs taken as a whole are free from responsible for the prevention of fraud. Unless the auditor
material misstatement, whether caused by fraud or error. has reason to believe the contrary, the auditor may accept
Hence, the auditor’s responsibility for the detection of records and documents as genuine. An audit rarely
fraud and error is essentially the same. involves the authentication of documents.

Fraud refers to an intentional act by one or more The auditor shall perform the procedures below following
individuals among management, TCWG, employees, or the risk-based audit process:
third parties, involving the use of deception to obtain an • maintaining an attitude of professional skepticism;
unjust or illegal advantage. While, error pertains to • exercising professional judgment;
unintentional misstatements or omissions in FSs, including • holding engagement team discussion (‘brainstorming’);
the omission of an amount or disclosure. Differentiating • performing RAP and related activities;
fraud from error requires professional judgment. The risk • identifying and assessing the ROMM due to fraud;
of not fraud is higher than error because fraud may be • responding to assessed ROMM due to fraud;
concealed, especially if through collusion. • evaluating the audit evidence and the results of audit;
• communicating misstatements resulting from fraud;
Although fraud is a broad legal concept, the auditor is • obtaining management representations;
concerned with fraud that causes a material misstatement • considering withdrawing from engagement; and
in the FSs. In addition, the auditor does not make legal • documenting the results of work.
determinations of whether fraud has actually occurred.
Discussion Among the Engagement Team
Types of Fraud
This discussion shall place particular emphasis on how and
In relation to audit of financial statements: where the entity’s FSs may be susceptible to material
a. Fraudulent financial reporting – Involves intentional misstatement due to fraud, including how fraud might
misstatements, including omissions of amounts or occur. The team shall set aside beliefs that management
disclosures in FSs, to deceive FS users, normally and TCWG are honest and have integrity.
involves management. Examples are the following:
• Manipulation or falsification of financial records Performing RAP and Related Activities
• Misrepresentation or intentional omission of Management and Others within the Entity
information in the FSs
• Intentional misapplication of accounting policies The auditor shall make inquiries of management, and
b. Misappropriation of assets (theft) - Involves the theft others within the entity as appropriate, to determine
of an entity’s assets and is often perpetrated by whether they have knowledge of any actual, suspected or
employees in relatively small and immaterial amounts. alleged fraud affecting the entity.
However, it can also involve management and TCWG.
The auditor shall make inquiries of internal audit to
Examples of this type of fraud are the following:
determine whether it has knowledge of any actual,
• Embezzling receipts
suspected or alleged fraud affecting the entity, and to
• Lapping of accounts receivable
obtain its views about the risks of fraud.
• Entity funds sent to a personal bank account
• Inventory items sold personally by entity Those Charged with Governance (TCWG)
employees
The auditor shall obtain an understanding of how TCWG
• Goods or services paid for by the entity but not
exercise oversight of management’s processes for
received
identifying and responding to the risks of fraud in the
• Use of entity assets for personal use
entity and the internal control that management has
As to perpetrator: established to mitigate these risks. TCWG of an entity
a. Management fraud – refers to fraud involving one or have oversight responsibility for systems for monitoring
more members of management or TCWG. risk, financial control and compliance with the law.
b. Employee fraud – refers to fraud involving only
The auditor shall make inquiries of TCWG to determine
employees of the entity.
whether they have knowledge of any actual, suspected or
The risk of the auditor not detecting management fraud is alleged fraud affecting the entity. These inquiries are made
greater than for employee fraud, because management in part to corroborate the responses to the inquiries of
may override otherwise effective internal controls. management.
Unusual or Unexpected Relationships Identified
Responsibility of Management and Those Charged
with Governance (TCWG) vs. that of the Auditor The auditor shall evaluate whether unusual or unexpected
relationships that have been identified in performing
The primary responsibility for the prevention and detection
analytical procedures, including those related to revenue
of fraud rests with both TCWG of the entity and
accounts, may indicate ROMM due to fraud.
management. Management shall establish a control
environment and implement internal control policies and
Other Information
procedures to prevent and detect fraud. On the other
hand, TCWG, through its oversight function, shall ensure The auditor shall consider whether other information
the integrity of accounting and financial reporting systems obtained by the auditor indicates ROMM due to fraud.
and that appropriate controls are in place.

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Evaluation of Fraud Risk Factors
Based on the audit procedures performed and the audit
Fraud risks factors refer to events or conditions that evidence obtained, to evaluate whether the assessments of
indicate an incentive or pressure to commit fraud or the ROMM at the assertion level remain appropriate. This
provide an opportunity to commit fraud. The three evaluation is primarily a qualitative matter based on the
conditions (the fraud triangle or characteristics) generally auditor’s judgment.
present when fraud occurs are:
Analytical Procedures Performed in the Overall Review of
a) Attitudes or rationalizations – Those involved in the
the Financial Statements
fraud are able to rationalize committing a fraudulent
act. This relates to either a person committing the The auditor shall evaluate whether analytical procedures
fraud, or to the entity’s control environment. that are performed when forming an overall conclusion as
b) Incentives or pressures – Management and employees to whether the FSs as a whole are consistent with the
have an incentive (e.g., benefit or enrichment) or are auditor’s understanding of the entity and its environment
under pressure (e.g., threat of losing their job), which indicate a previously unrecognized ROMM due to fraud.
provides a reason to commit fraud.
c) Opportunities – Circumstances making execution of Consideration of Identified Misstatements
fraud possible. These circumstances exist when a
person is generally trusted, internal control is The auditor’s actions depend on whether the fraud that has
perceived to be easily overridden, or the individual been discovered or suspected is material or immaterial:
knows about deficiencies in internal control. • If immaterial:
o Refer to appropriate level of management (one
Identifying and Assessing the ROMM Due to Fraud level above the person involved)
o Gain satisfaction no FSs effect
The auditor shall identify and assess the ROMM due to • If material or unable to evaluate whether material or
fraud at the FSs level, and at the assertion level for classes immaterial:
of transactions, account balances and disclosures. o Consider implications for audit, e.g., reliability of
management representations
Risks of Fraud in Revenue Recognition
o Investigate further, i.e., discuss with appropriate
The auditor shall, based on a presumption that there are level of management (one level above the person
risks of fraud in revenue recognition, evaluate which types involved)
of revenue, revenue transactions or assertions give rise to o Obtain evidence of fraud and its effects
such risks. Otherwise, auditor shall document when this o Suggest client consult legal counsel
presumption is not applicable. For example, when revenue
recognition is a single type of simple revenue transaction, Communication of Misstatements due to Fraud
e.g., leasehold revenue from a single unit rental property.
In the exceptional circumstances where the auditor has
Understanding the Entity’s Related Controls doubts about the integrity or honesty of management or
TCWG, the auditor may consider it appropriate to obtain
The auditor shall treat assessed ROMM due to fraud as
legal advice to assist in determining the appropriate course
significant risks and accordingly, obtain an understanding
of action.
of the entity’s related controls, including control activities.
Responding to Assessed ROMM Due to Fraud Communication To Management

Overall Responses The communication enables management to act on a

timely basis. The communication is made even if the
The auditor shall determine overall responses to address matter might be considered inconsequential (for example,
the assessed ROMM due to fraud at the FSs level. a minor defalcation by an employee at a low level in the
Audit Procedures Responsive to Assessed Risks of Material entity’s organization). The determination whom to
Misstatement Due to Fraud at the Assertion Level communicate is a matter of professional judgment which
normally is at least one level above the person involved.
The auditor shall design and perform FAP whose nature,
timing and extent are responsive to the assessed ROMM Communication With Those Charged With Governance
due to fraud at the assertion level.
The auditor’s communication with TCWG may be made
Audit Procedures Responsive to Risks Related to orally or in writing. Due to the nature and sensitivity of
Management Override of Controls fraud involving senior management, or fraud that results in
Management is in a unique position to perpetrate fraud a material misstatement in the FSs, the auditor reports
because of management’s ability to manipulate accounting such matters on a timely basis and may consider it
records and prepare fraudulent FSs by overriding controls necessary to also report such matters in writing.
that otherwise appears to be operating effectively. Due to
the unpredictable way in which such override could occur, In some cases, the auditor may consider it appropriate to
it is a ROMM due to fraud and thus a significant risk. communicate with TCWG when the auditor becomes aware
of fraud involving employees other than management that
Irrespective of the auditor’s assessment of the risks of does not result in a material misstatement. Similarly,
management override of controls, the auditor shall design TCWG may wish to be informed of such circumstances.
and perform audit procedures to:
a. Test the journal entries and other adjustments made in Communications to Regulatory and Enforcement
the preparation of the FSs. Authorities
b. Review accounting estimates for biases. The auditor’s professional duty to maintain the
c. For significant transactions that are outside the normal confidentiality of client information may preclude reporting
course of business for the entity, or appear to be fraud to a party outside the client entity. However, the
unusual, the auditor shall evaluate business rationale regulatory requirements, statute, the law or courts of law
(or the lack thereof) of the transactions. overrides this duty. For example, under a BSP
requirement, the auditor of a financial institution has a
Evaluating Audit Evidence and Results of Audit statutory duty to report the occurrence of fraud to the

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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
or on its behalf, by TCWG, management or employees.
immaterial to the FSs.
However, non-compliance does not include personal
Management Written Representations misconduct (unrelated to the business activities of the
entity) by TCWG, management or employees of the entity.
The auditor shall obtain written representations from
management that: Types of Laws and Regulations
a. It acknowledges its responsibility for internal control to
In relation to audit of FSs, there are two types:
prevent and detect fraud;
a. Direct effect–Amounts and disclosures, as a result of
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
management; employees who have significant
FSs. However non-compliance may result in fines,
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
have a material effect on the FSs. Examples may
• its knowledge of any allegations of fraud, or
include compliance with the terms of an operating
suspected fraud, affecting the entity’s FSs
license, regulatory solvency requirements, or
communicated by employees, former employees,
environmental regulations.
analysts, regulators or others.
Responsibility for Compliance with Laws and
Auditor Unable to Continue the Engagement
Regulations
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
• 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.
of material and pervasive fraud; or
• The auditor has significant concern about the Responsibility of the Auditor
competence or integrity of management or TCWG. The auditor is responsible for obtaining reasonable
If, as a result of circumstances, the auditor shall: assurance that the FSs, taken as a whole, are free from
a) Consider whether it is appropriate to withdraw from material misstatement, whether caused by fraud or error.
the engagement; and The auditor shall identify ROMM of the FSs due to non-
b) If the auditor withdraws: compliance with laws and regulations. However, the
• Discuss with the appropriate level of management auditor is not responsible for preventing non-compliance
and TCWG, including the reasons thereof; and and cannot be expected to detect non-compliance with all
• Determine whether there is a professional or legal laws and regulations. In the absence of evidence to the
requirement to report to the person or persons or, contrary, the auditor is entitled to assume the entity is in
in some cases, to regulatory authorities. compliance with applicable laws and regulations affecting
Documentation the client

The auditor’s documentation shall include the: In the context of laws and regulations, the potential effects
a) Significant decisions reached during ‘brainstorming’ of inherent limitations on the auditor’s ability to detect
regarding the susceptibility of the entity’s FSs to material misstatements are greater because:
material misstatement due to fraud; • Many laws and regulations, relating principally to the
b) Identified and assessed ROMM due to fraud at the FSs operating aspects of an entity, do not affect the FSs.
level and at the assertion level. • Non-compliance may be concealed, management
c) Responses to the assessed ROMM: the overall override of controls or intentional misrepresentations
responses and the nature, timing and extent of FAP; to the auditor.
d) Results of the audit procedures; • Whether an act constitutes non-compliance is
e) Communications about fraud made to management, ultimately determined by a court of law.
TCWG, regulators and others; and Ordinarily, the further removed non-compliance is from the
f) Reasons for that conclusion ROMM due to fraud related events and transactions reflected in the FSs, the less likely
to revenue recognition is not applicable. the auditor is to become aware of it or to recognize the
non-compliance.
Auditor’s Responsibility to Consider Laws and
Regulations The Auditor’s Consideration of Compliance with Laws
and Regulations
Introduction
Obtaining an Understanding of the Legal and Regulatory
The auditor needs to consider the applicable laws and Framework
regulations to the entity in FSs audit because compliance

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As part of obtaining an understanding of the entity and its appropriate, TCWG do not provide sufficient information
environment, the auditor shall obtain a general that supports that the entity is in compliance with laws and
understanding of: regulations and, in the auditor’s judgment, the effect of
a) The legal and regulatory framework applicable to the the suspected non-compliance may be material to the FSs,
entity and the industry or sector in which the entity the auditor shall consider the need to obtain legal advice.
operates; and
Evaluating the Implications of Non-Compliance
b) How the entity is complying with that framework.
The auditor shall evaluate the implications of non-
Direct Effect Laws and Regulations
compliance in relation to other aspects of the audit,
The auditor shall obtain sufficient appropriate audit including the auditor’s risk assessment and the reliability
evidence regarding compliance with the provisions of those of written representations, and take appropriate action.
laws and regulations with direct effect on the material
In exceptional cases, the auditor may consider whether,
amounts and disclosures in the FSs.
unless prohibited by law or regulation, withdrawal from the
Indirect Effect Laws and Regulations engagement is necessary when management or TCWG do
not take the necessary remedial action, even when the
The auditor shall perform the following to identify non-
non-compliance is not material but the auditor may
compliance that may have a material effect on the FSs:
consider seeking legal advice. If withdrawal is prohibited,
a. Inquiring of management and, where appropriate,
the auditor may consider alternative actions, including
TCWG, as to whether the entity is in compliance with
describing the non-compliance in an Other Matter(s)
such laws and regulations; and
paragraph in the auditor’s report.
b. Inspecting correspondence, if any, with the relevant
licensing or regulatory authorities. Reporting of Identified or Suspected Non-
Compliance
Non-Compliance Brought to the Auditor’s Attention by
Other Audit Procedures Reporting to Those Charged with Governance
During the audit, the auditor shall remain alert to the The auditor shall communicate to TCWG matters involving
possibility that other audit procedures applied may bring non-compliance with laws and regulations, unless those
instances of non-compliance or suspected non-compliance are clearly inconsequential and they are involved in
with laws and regulations to the auditor’s attention. management and already aware of it.
If the auditor suspects that management or TCWG is
Audit procedures applied to form an opinion on the FSs
involved in non-compliance, communicate the matter to
may bring instances of non-compliance or suspected non-
the next higher level of authority at the entity, if it exists.
compliance with laws and regulations to the auditor’s
Otherwise consider obtaining legal advice.
attention. For example, such audit procedures may
include: reading minutes; inquiring of the entity’s Reporting in the Auditor’s Report
management and in-house legal counsel or external legal
counsel concerning litigation, claims and assessments; and Results Opinion
performing substantive tests of details of classes of No sufficient appropriate audit
transactions, account balances or disclosures. evidence obtained as precluded by Qualified or
management or TCWG Disclaimer
Written Representations
No sufficient appropriate audit
The auditor shall request management and, where evidence obtained imposed by Evaluate effect on
appropriate, TCWG to provide written representations that circumstances audit report
all known instances of non-compliance or suspected non- Contains material misstatement Qualified or Adverse
compliance with laws and regulations whose effects should
be considered when preparing FSs have been disclosed. Reporting to Regulatory and Enforcement Authorities

No Identified or Suspected Non-compliance If the auditor has identified or suspects non-compliance

with laws and regulations, determine whether the auditor
In the absence of identified or suspected non-compliance, has a responsibility to report the identified or suspected
the auditor is not required to perform audit procedures non-compliance to parties outside the entity.
regarding the entity’s compliance with laws and
The auditor’s professional duty to maintain the
regulations, other than those set out above.
confidentiality of client information may preclude reporting
Audit Procedures When Non-Compliance Is identified or suspected non-compliance with laws and
Identified or Suspected regulations to a party outside the entity.

The auditor shall obtain: Documentation

a) An understanding of the nature of the act and the The auditor shall document identified or suspected non-
circumstances in which it has occurred; and compliance with laws and regulations and the results of
b) Further information to evaluate the possible effect on discussion with management and, where applicable, TCWG
the FSs. and other parties outside the entity. For example: copies
Audit Procedures of records or documents or minutes of discussions held
with management, TCWG or parties outside the entity.
If the auditor suspects there may be non-compliance, the
auditor shall discuss the matter with management and, - done -
where appropriate, TCWG. If management or, as

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 MULTIPLE CHOICE QUESTIONS
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
detecting a material misstatement resulting from error and evaluating and reporting the results thereof,
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
accounting records from fraud.
b. Fraud is ordinarily accompanied by acts specifically c. In planning the audit, the auditor should discuss
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
has actually occurred in the financial statements resulting from fraud or
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
and fraud will be detected in the ordinary course of
Types of fraud
the examination.
4. The two types of intentional misstatements that are
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
misappropriation of assets. Fraudulent financial fraud include the following advantages?
reporting least likely involve a. Provides an opportunity for more experienced
a. Deception such as manipulation, falsification engagement team members to share their insights
(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
the financial statements of events, transaction or response to such susceptibility and to determine
other significant information which members of the engagement team will
c. Intentional misapplication of accounting principles conduct certain audit procedures.
relating to measurement, recognition, c. Permits the auditor to determine how the results of
classification, presentation, or disclosure audit procedures will be shared among the
d. Embezzling receipts, stealing physical assets or engagement team and how to deal with any
intellectual property , causing an entity to pay for allegations of fraud that may come to the auditor’s
goods and services not received, or using an attention.
entity’s assets for personal use. d. All of the above.
5. In comparing management fraud with employee fraud, Risk Assessment Procedures and Related Activities
the auditor’s risk of failing to discover the fraud is 10. Sources of information gathered to assess fraud risks
a. Greater for employee fraud because of the higher usually do not include:
crime rate among blue collar workers a. Analytical procedures.
b. Greater for management fraud because of b. Inquiries of management and others within the
management’s ability to override existing internal entity.
controls, which is always assumed in audit. c. Communication among audit team members.
c. Greater for employee fraud because of the larger d. Review of corporate charter and bylaws.
number of employees in the organization
11. Categories of fraud risk factors (whose presence often
d. Greater for management fraud because managers
has been observed in circumstances where frauds have
are inherently smarter than employees
occurred) in relation to misstatements arising from
6. Which of the following constitutes the fraud of larceny? misappropriation of assets and fraudulent financial
a. Misappropriation of assets that have been reporting are: opportunities; attitudes or
entrusted to one’s care rationalizations; and pressures or incentives. Which of
b. Theft of assets

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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
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
and rely more upon judgment. 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.
engagement. c. The chairman of audit committee.
d. Place increased emphasis on the audit of objective d. The predecessor auditor.
transactions rather than subjective transactions.
Management Representations
14. As part of designing and performing procedures to 20. The auditor least likely obtains written representations
address management override of controls, auditors from management that:
must perform which of the following procedures? a. It acknowledges its responsibility for the
implementation and operations of accounting and
Examine all journal Review accounting internal control systems that are designed to
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
c. Yes No involving employees who have significant roles in
d. No Yes internal control only.
Evaluating the Audit Evidence and Results of Audit c. It has disclosed to the auditor its knowledge of any
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
fraud, except d. It has disclosed to the auditor the results of its
a. Transactions that are recorded in a complete or assessment of the risk that the financial
timely manner or are properly recorded as to statements may be materially misstated as a result
amount, accounting period, classification, or entity of fraud
policy. Withdrawing from engagement
b. Unsupported or unauthorized balances or 21. The auditor may encounter exceptional circumstances
transactions. that bring into question the auditors ability to continue
c. Last-minute adjustments that significantly affect performing the audit, including where
financial results or unusual journal entries. a. The entity does not take the remedial action
d. Tips or complaints to the auditor about alleged regarding fraud that the auditor considers
fraud. necessary in the circumstances, even when the
16. The following are examples of circumstances that may fraud is not material to the financial statements
indicate the possibility that the financial statements b. The auditor’s consideration of the risk of material
may contain a material misstatement resulting from misstatement resulting from fraud and the results
fraud, except of audit tests indicate a significant risk of material
a. Missing documents. and pervasive fraud
b. Documents that appear to have been altered. c. The auditor has significant concern about the
c. Unavailability of other than photocopied or competence or integrity of management or those
electronically transmitted documents when charged with governance that affect the auditor's
documents in original form are expected to exist. ability to rely on management's representations.
d. Significant explained items on reconciliations. d. All of the above

17. Which of the following might be considered a "red flag"

indicating possible fraud in a large manufacturing
company with several subsidiaries?

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Documentation a. When the auditor becomes aware of information
22. PSAs require auditors to document which of the concerning a possible instance of noncompliance,
following matters related to the auditor’s consideration the auditor shall obtain an understanding of the
of material misstatements due to fraud? nature of the act and the circumstances in which it
a. Reasons supporting a conclusion that there is not a has occurred and evaluate the possible effect on
significant risk of material improper expense the financial statements.
recognition. b. If the auditor has identified or suspects
b. Procedures performed to obtain information noncompliance with laws and regulations, the
necessary to identify and assess the risks of auditor shall determine whether the auditor has a
material fraud. responsibility to report the identified or suspected
c. Results of the internal auditor’s procedures noncompliance to parties outside the entity.
performed to address the risk of management c. The auditor shall document identified or suspected
override of controls. non-compliance with laws and regulations but not
d. Discussions with management regarding the results of discussion with management, and
separation of duties. where applicable, those charged with governance
and other parties outside the entity.
Non-compliance with Laws and Regulations
d. The auditor may withdraw from the engagement
Nature, Definition and Types
when the entity does not take the remedial action
23. Which statement is incorrect regarding the auditor’s
that the auditor considers necessary in the
consideration of laws and regulations in an audit of
circumstances, even when the noncompliance is
financial statements?
not material to the financial statements or affects
a. Noncompliance refers to acts of omission or
auditor’s ability to rely on management
commission by the entity being audited which are
representations.
contrary to prevailing laws and regulations
b. Noncompliance includes transactions entered into Indications of Non-Compliance with Laws and Regulations
by, or in the name of, the entity, or on its behalf, 26. According to PSA 250 (Consideration of Laws and
by TCWG, management or employees. Regulations in an Audit of Financial Statements), the
c. Noncompliance includes personal misconduct of following are indications that noncompliance may have
the entity’s management or employees though occurred, except
they are unrelated to the entity’s business a. Investigation by government departments or
activities payment of fines or penalties
d. In the absence of evidence to the contrary, the b. Adverse media comment
auditor is entitled to assume the entity is in c. Authorized transactions or properly recorded
compliance with applicable laws and regulations transactions
affecting the client. d. Purchasing at prices significantly above or below
market price
Responsibility for Compliance with Laws and Regulations
24. Which of the following is incorrect about the auditor’s 27. Examples of the type of information that may come to
responsibility for evaluating noncompliance by the the auditor's attention that may indicate that
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
ensure that the entity’s operations are conducted consultants, related parties, employees or
in accordance with laws and regulations, including government employees.
compliance with laws and regulations that b. Purchasing at prices significantly above or below
determine the form or content of the entity’s market price.
financial statements. This includes responsibility c. Unauthorized transactions or improperly recorded
for the prevention and detection of non-compliance transactions.
with laws and regulations. d. Payments with proper exchange control
b. An audit cannot be expected to detect documentation.
noncompliance with all laws and regulations.
Audit Procedures When Non-Compliance Is Identified or
Detection of noncompliance, regardless of
Suspected
materiality, requires considerations of the
28. When an auditor becomes aware of a possible illegal
implications for the integrity of management or
act by a client, the auditor should obtain an
employees
understanding of the nature of the act to
c. Generally, the further removed non-compliance is
a. Increase the assessed level of control risk.
from the events and transactions reflected in the
b. Recommend remedial actions to the audit
financial statements, the more likely the auditor is
committee.
to become aware of it or to recognize the possible
c. Evaluate the effect on the financial statements and
non-compliance. This is because an illegal act by
may consider seeking legal advice especially when
the client often relate to operating aspects rather
involving members of senior management,
than accounting aspects.
including members of the board of directors.
d. In order to plan the audit, the auditor should
d. Determine the reliability of management’s
obtain a general understanding of the legal and
representations.
regulatory framework applicable to the entity and
the industry and how the entity is complying with 29. Which of the following statements is usually true?
that framework. a. It is easier for the auditor to uncover fraud than
errors.
The Auditor’s Consideration of Compliance with Laws and
b. It is easier for the auditor to uncover indirect-
Regulations
effect illegal acts than fraud.
25. Which of the following is incorrect about the auditor’s
c. The auditor’s responsibility for detecting direct-
responsibility for evaluating noncompliance by the
effect illegal acts is similar to the responsibility to
entity to laws and regulations?
detect fraud.

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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 your STD-

SELF-TEST DRILL (STD)

1. Which of the following are most often involved in 7. Which of the following is least likely to be required on
perpetrating fraud in financial statement reporting? an audit in accordance with PSAs?
a. The auditors and the attorneys. a. Test appropriateness of journal entries and
b. The audit committee members. adjustment.
c. The chief executive and chief financial officers. b. Review accounting estimates for biases.
d. The accounts payable clerks. c. Evaluate the business rationale for significant
unusual transactions.
2. Audits of financial statements are designed to obtain
d. Make a legal determination of whether fraud has
reasonable assurance of detecting material
occurred.
misstatements due to
a. b. c. d. 8. How will the results of the auditor's assessment of
Errors Yes Yes Yes No fraud risk factors further affect the planned audit
Fraudulent financial Yes Yes No Yes procedures?
reporting a. Audit procedures and fraud assessment do not
Misappropriation of Yes No Yes No relate.
assets b. The assessment may require a re-audit of previous
Direct-effect illegal acts Yes No Yes No periods.
c. By the assignment of qualified audit staff to risky
3. Which of the following most accurately defines
areas of the engagement.
professional skepticism as it is used in auditing
d. Management will be called upon to assist in
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
nor assumes unquestioned honesty. may contain a material misstatement resulting from
c. It assumes management is honest most of the fraud, except
time. a. Fewer responses to confirmations than anticipated
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.
4. Brainstorming about the manner in which fraud may
c. Missing inventory or physical assets of significant
be committed should include all of the following except
magnitude.
a. how management could perpetrate and conceal
d. Unusual discrepancies between the entity's records
fraudulent financial reporting
and confirmation replies.
b. any unusual or unexplained changes in behavior or
lifestyle of management or employees 10. If an auditor believes a client may have committed
c. any fraud risk factors observed to be present in the illegal acts, which of the following actions should the
engagement auditor take?
d. all of the above a. Consult with the client’s counsel and the auditor’s
counsel to determine how the suspected illegal
5. Which of the following best represents actions that
acts will be communicated to stockholders.
may indicate fraud is pervasive throughout the
b. Extend auditing procedures to determine whether
company under audit?
the suspected illegal acts have a material effect on
a. The company's management negotiates deals with
the financial statements.
vendors in such a manner as to pay lower prices.
c. Make inquiries of the client’s management and
b. The company's management drives luxury vehicles
obtain an understanding of the circumstances
and takes personal vacations to exotic places.
underlying the acts and of other evidence to
c. The company's management takes an overly
determine the effects of the acts on the financial
aggressive approach to revenue recognition.
statements.
d. The company's management estimates bad debts
d. Notify each member of the audit committee of the
using an aged accounts receivables ledger rather
board of directors about the nature of the acts and
than as a percent of sales.
request that they advise an approach to be taken
6. If the audit team discovers that fraud risk factors are by the auditor.
present on an engagement, it should then:
11. Which of the following is an auditor responsible for
a. resign from the client and inform the audit
concerning the detection of illegal activities of an audit
committee and regulatory authorities.
client?
b. modify procedures to actively search for the
a. Assess the inherent risk of material misstatements
existence of fraud.
due to illegal acts
c. reduce the amount of evidence required and resort
b. Monitor legal requirements and ensure that the
to management inquiry.
client’s operating procedures are designed to meet
d. turn the audit over to forensic accountants.
these requirements, for the period under audit
c. Ensure that the client appoints an audit committee

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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
an auditor's inquiry of management while obtaining
b. Consider weaknesses in internal control that would
information to identify the risks of material
allow a fraud to take place or management
misstatement due to fraud?
override of controls
a. Are financial reporting operations controlled by and
c. Consider the materiality of the individual account
limited to one location?
balances for substantive testing
b. Does it have knowledge of fraud or suspect fraud?
d. Consider factors that may enable an individual
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
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
a. The type of fraud that may occur.
management is higher than normal?
b. The potential significance and likelihood of
a. There are very few related party transactions.
occurrence of fraud.
b. The auditor has not audited this client before.
c. The pervasiveness of fraud detected.
c. Management turnover is unusually high.
d. All of the above.
d. The auditor discovers a GAAP departure during the
audit. 20. Relative to internal controls, what is a primary risk of
fraud in the client company?
16. The following are examples of circumstances that may
a. The risk that management overrides controls.
indicate the possibility that the financial statements
b. The risk that management changes controls each
may contain a material misstatement resulting from
year.
fraud, except
c. The risk that management carefully enforces and
a. Undue time pressures imposed by management to
monitors controls.
resolve complex or contentious issues.
d. The risk that the audit committee monitors
b. Complaints by management about the conduct of
controls.
the audit or management intimidation of
engagement team members, particularly in
connection with the auditor’s critical assessment of
☺ - end of AT.106.1- ☺

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