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    Auditing Theory 2018 Chapter 3

    Uploaded by

    Joseph Salido

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    © All Rights Reserved
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    el Chapter 3 AUDITOR’S RESPONSIBILITY “The fair presentation of the financial statements in accordance with the applicable financial reposting standatds is the responsibility of the client’s management. The auditor’s responsibility is to design the audit to provide reasonable assurance of detecting material misstatements in the financial statements. These misstatements may emanate from 1, Error, 2. Fraud, and 3. Noncompliance with Laws and Regulations @ ERROR The term “error” refers to unintentional misstatements in the financial statements, including the omission of an amount or a disclosure, such as: # Mathematical or cleticel mistakes in the underlying records and accounting data = An incorrect accounting estimate arising from ese ot misinterpretation of facts * Mistake in the application of accounting policies @ FRAUD Fraud refers to intentional act by one or mote individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain aa unjust or illegal advantage. Although fraud is a broad legal concept, the auditor is primarily concerned with fraudulent acts that cause a material misstatement in the financial statements IFB: Digital Accounting Books PH a) he bye to eA rr ry Types of Fraud Thete are two types of fraud that are relevant to financial statement audit, Misstatements resulting from fraudulen; financial reporting and misstatements resulting from misappropriation of assets i. Fraudulent financial reporting involves intentional misstatements or omissions of amounts ot disclosures in the financial statements to deceive financial siatement users. This type of fraud is also known as management fraud because it usually involves members of management ox those charged with governance. This may involve * Manipulation, falsification or alteration of records or documents * Mistepresentation in os intentional omission of the effects of transactions from records or documents * Recording of transactions without substance * Intentional misapplication of accounting policies 2. Misappropriation of assets ot employee fraud involves theft of an entity’s assets committed by the entity's employees. This may include = Embezzling receipts " Stealing entity’s assets such as cash, marketable secutities, and inventory = Lapping of accounts receivable ‘This type of fraud is often accompanied by false of misleading records or documents in ordet to conceal the fact chat the assets are missing 'B: Digital Accounting Books PH All rights belongs to respective authors Fraud involves motivation to commit it and a perceived SPPortunity to do so. For example, an employee might be motivated to steal company’s assets because this employee lives beyond his means. Also, a member of management may be forced to manipulate the financial statements in order to meet an overly optimistic projection. A perceived opportunity to commit fraud may exist when there is no proper segregation of duties ainong employees or when management believes that internal contzol can be casily circurnvented. ‘The primary factor that distinguishes fraud from error is whether the underlying cause of misstatement in the financial statements is intentional or unintentional. Although the auditor may be able to identify opportunities for fraud to be perpetrated, it is often difficult, if not impossible, for the auditor to determine intent, particalarly in matters involving management judgment, such as accounting estimates and the appropriate application of accounting principles. Consequently, the auditor's responsibility for the detection of fraud and error is essentially the same. Responsibility of Management and Those Charged with Governance The responsibility for the prevention and detection of fraud and error rests with both management and those charged with the governance of the entity. In this regard, PSA 240 requires = Management to establish a control environment and to implement internal control policies and procedures designed to ensure, among others, the detection and prevention of fraud and error. * Individuals charged with governance of an entity to ensure the integrity of an eatity’s accounting and financial reporting systems and that appropriate controls are in place. 'B: Digital Accounting Books All nghts belongs to respective at Auditor's Responsibility Although the annual audit of financial statements sa, act as deterrent to fraud and error, the auditor is not ang cannot be held responsible for the prevention of and ertor, The auditor's responsibility is to design the audit to obtain reasonable assurance that the Financia) statements are free from material misstatements, whether caused by error or fraud. Maud + PLANNING PHASE 1. When planning an audit, the auditor should make inquities of management about the possibility of misstatements due to fraud and error. Such inquiries may include * Management's assessment of risks due 10 fraud * Controls established to address the risks * Any macerial error or fraud that has affected the entity or suspected fraud that the entity is investigating ‘The auditor's inquiries of management may provide useful information concerning the risk of material misstatements in the financial statements resulting from employee fraud. However, such inguizies are ualikely to provice useful information regarding the tisk of material misstatements in the financial statements resulting from management fraud. Accordingly, the auditor should also inquire of those individual in charge of governance to seek theit views on the adequacy of accounting and intetnal. control systems in place, the risk of fraud and ctror, and the integrity of management. 'B: Digital Accounting Book: All rights belongs to respective aut! The auditor should assess the risk that fraud of error may cause the financial statements to contain material misstatements, In this regard, PSA 240 requires the auditor to specifically “assess the risk: of material misstatements due to fraud and consider that assessment in designing the adit procedures to be performed,” ‘The fact that fraud is usually concealed can make it very difficult to detect. Nevertheless, using the auditor's knowledge of the business, the auditor may identify events or conditions that provide an opportunity, 2 motive or a means to commit fraud, or indicate that fraud. may already have occurred. Such events ot conditions are referred to as “fraud risk factors”. Fraud risk factors do not necessarily indicate the existence of fraud, however, they often have been present in circumstances where frauds have occurred, Examples of fraud risk factors taken from PSA 240 are set out at the end of this chapter. Judgments about the increased risk of material misstatements due to fraud may influence the auditor’s professional judgments in the following ways: "The auditor may approcch the audit with a heightened level of professional skepticism. * The auditor's ability to assess control risk atless than high level may be reduced and the auditor should be sensitive to the ability of the management to override controls. B: Digital Accounting Books PH © The audit team may be selected in way, that ensure that the knowledge, skill, ang) abihty of perionnel assigned significa, responsibilities are commensurate with the auditor's aveeesnent of risk * The auditor may decide to consider rasagernent selection and application of wignificant accounting — polici particularly those related to income determination and asset valuation TESTING PHASE 4. During the course of the audit, the auditor may (encounter circumstances that may indicate the possibility of fraud or ertor, For example, there are discrepancies found in the accounting records, conflicting or missing documents ot lack of cooperation from management. In these circumstances, the auditor should perform procedures necessary to determine whether material misstatements cxist, After identifying material misstatement in the financial statements, the auditor should consider whether such a misstatement resulted from a fraud of an error: This is important because erzors will only result to an adjustment of financial statements but fraud may have other implications on an audit. Tf the auditor believes that the ‘misstatement 's, or may be the cesult of fraud, but the effect on the financial statements is not material, the auditor should Refer the matter to the appropriate level of Management at least one level above those involved, and B: Digital Accounting Books PH Be satisfied that, given the position of the likely perpetrator, the fraud has no other implications for other aspects of the audit or that those implications have been adequately considered. However, if the auditor detects a material fraud ot has been unable to evaluate whether the effect on financial statement is material or immaterial, the auditor should * Consider implication for other aspects of the audit particularly the reliability of management representations Discuss the matter and the approach to further investigation with an appropriate level of that is at least one level above those involved, * Attempt to obtain evidence to determine whether a material fraud in fact exists and, if so, their effect, and "Suggest that the client consult with legal counsel about questions of law. COMPLETION PHASE 5. The auditor should obtain a written representation from the client's management that * it acknowledges its responsibility for the implementation and operations of aécounting and internal control systems that are designed to prevent and detect fraud and error; 'B: Digital Accounting Books PH All rights belongs to respective at = itbelieves the effects of those uncorrected financial statement misstatements aggregated by the auditor dating the audit are immaterial, both individually and in the aggregate, to the financial statements taken as a whole. A summary of such items should be inchided in or attached to the written representation; = it has disclosed to the auditor all significant facts relating to any frauds or suspected frauds known to management thet may have affected the entity; and * ithas disclosed to the auditor the results of its assessment of the risk that the Ginancial statements may be materially misstated as 2 result of fraud. CONSIDER THE EFFECT ON THE AUDITOR'S 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 ot adverse opinion. If the auditor is unable to evaluate the effect of fraud on the financial statements because of a limitation on the scope of the auditor's ‘examination, the auditor should either qualify or disclaim his opinion on the financial statements. PI Because of the inherent limitations of an audit there is an unavoidable risk that material misstatements in the Enancial statements resulting from fraud and error may not be detected. Therefore, the subsequent discovery of ‘material misstatementin 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 misstatement resulting from fraud is higher than the risk of not detecting misstatements resulting from error. This is due to the fact that fraud may involve sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, ot intentional snisrepresentation being made to the auditor. Hence, audit procedutes that are effective for detecting material errors may be ineffective for detecting material fraud, especially those concealed through collusion. Furthermore, the risk of the auditor not detecting a material misstatement resulting from management fraud is greater than for employee fraud, because those charged with governance and management are often in a position that assumes their integrity and enables them to override the formally established control procedures. Certain levels of management may be in a position to override contol procedures designed to prevent similar frauds by other employees, for example, by directing subordinates to record transactions incorrectly of to conceal them. Given its position of authority within an entity, management has the ability to either direct employees to do something or solicit cheir help to assist management in carrying out a fraud, with or without the employees’ knowledge. 'B: Digital Accounting Books All rights belongs to respective at NONCOMPLIANCE WITH LAWS AND REGULATIONS Noncompliance refers to acts of omission or commission by the entity being audited, either intentional or unintentional, which are contrary to the prevailing laws ot regulations. Such acts include transactions entered into by, ox in the name of, the entity of on its behalf by its management or employees, Common examples include: *® Tax evasion * Violation of eaviroamental protection laws = Inside trading of securities rz Management's Responsibility I is management’s responsibility to ensure that the entity's operations are conducted in accordance with laws and regulations. The responsibility for the prevention and detection of noncompliance rests with management. (PSA 250) “The following policies and procedures, among others, may assist management in discharging its responsibilities for the prevention and detection of noncompliance: © Monitoring legal requirements and ensuring that operating procedures are designed to meet these requirements. = Instituting and operating appropriate systems of internal control. * Developing, publicizing and following a Code of Conduct. Ensuting employees are properly trained and ind the Code of Conduct. . etl 5: Digital Accounting Books PH All rights belongs to respective at Monitoring compliance with the Code of Conduct and acting appropriately to discipline employers whe fail tr comply with it Engaging legal advisors to assist in monitoring, legal requirements, Maintaining a register of significant lays with which the entity has to comply within its particular industry and a record of complaints. In larger entities, these policies and procedures may be supplemented by assigning appropriate responsibilities to an internal audit function an audit committee. Auditor's Responsibility An audit cannot be expected to detect noncompliance with all laws and regulations. Nevertheless, the auditor should recognize that noncompliance by the entity sith laws and regulations may materially affect the financial statements. PLANNING PHASE 1. In order to plan the audit, the auditor should applicable to the entity and the industry and how the entity is complying with that framework, To obtain the general understanding of laws and regulations, the auditor would ordinarily: = Use the existing knowledge of the entity's industry and business. f management concerning the and procedures regarding laws and regulations. + Inquire of m entity’ policies compliance with = Inquire of management as TO the laws or ons that may be expected to have fandamental effect on the operations of the entity: + Discuss with management the policies or procedures adopsed for identifying, evaluating and accounting for litigation claims and assessments. + Discuss the legal and regulatory framework with auditors of subsidiaries in other countries (for example, if the subsidiary is required to adhere to the securities regulations of the parent company). ‘After obtaining the general understanding, the auditor should design procedures to help identify instances of noncompliance with those laws and regulations where noncompliance should be considered when preparing Ginancial statements, such as: = Inquiting of management as to whether the entity is in compliance with such laws and regulations, Inspecting correspondence with the relevant licensing or regulatory authorities The auditor should also 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, When the auditor becomes aware of information concerning a possible instance of noncompliance, the auditor should obtain an understanding of the nature of the act and the clreumstances in which it has occurred, and sufficient other information to evaluate the Possible effect on the financial statements. When evaluating the possible effect on the financial statements, the auditor considers: "The potential financial consequences, such as fines, penalties, damages, threat of exproptiation of assets, enforced discontinuation of operations and litigation. ® Whether the potential financial consequences tequire disclosure. * Whether the potential financial consequences are so serious 2s to call into question the fair presentation given by the financial statements. When the auditor believes there may be noncompliaince, the auditor should document the findings, discuss them with management, and consider the implication ‘on other aspects of the audit B: Digital Accounting Books PH + COMPLETION PHASE. 6. ‘The auditor should obtain writer representations that management has discleined to the auditor all known actual or possible noncompliance with laws and regulations thar could materially affect the financial staternens ap CONSIDER THE EFFECT ON THE AUDITOR'S REPORT 7. When the auditor believes that there is noncompliance with Inws and regulations thar materially affects the financial statements, he should request the management to revise the financial statements, Otherwise, a qualified or adverse opinion will be issued. 8. Ifa scope limitation has precluded the auditor from obtaining sufficient appropriate evidence to evaluate the effect of noncompliance with laws and regulations, the auditor should express a qualified opinion ot a disclaimer of opinion. An audit is subject to the unavoidable risk that some material misstatements in the financial statements will not be detected, even though the audit is properly planned and performed in accordance with PSAs. This tisk is higher with regard to material misstatements resulting from noncompliance with laws and regulations because: = There are many laws and regulations relating principally to the operating aspects of the entity that typically do not have a material effect on the financial statements and are not captured by the accounting and internal control systems. Auditors ate primarily concern with the noncompliance that, will have a direct and material effect in the financial statements, Hence, auditors do not normally design audit procedures to detect noncompliance that will 'B: U.gital Accounting Books PH All rights belongs to respective at not directly affect the fair presentation of the Gnancial statements unless the results of other Ptocedures that were applied cause the auditor to Suspect that a material indirect effect noncompliance may have occurred. Noncompliance may involve conduct designed to conceal it, such as collusion, forgery, deliberate failure to record transactions, senior management override of controls ot intentional misrepresentations being made to the auditor. Examples of Risk Factors Relating to Misetatements Resulting from Fraud “The fraud tisk factots identified below ate examples of such factors ppically faced by auditors in a broad range of situations. However, the fraud risk factors listed below are only examples; not all of these factors are likely to be present in all audits, nor is the list necessarily complete, Furthermore, the auditor exercises professional judgment when considering fraud risk factors individually or in combination and whether there are specific controls that mitigate the risk. Fraud Risk Factors Relating to Misstatements Resulting ftom Fraudulent Financial Reporting Fraud risk factors that relate to misstatements resulting from fraudulent financial reporting may be grouped in the following three categories: 1. Management's Characteristics and Influence over the Control Environment. 2. Industry Conditions 3. Operating Characteristics and Financial Stability. ‘2. Digital Accounting Books PH All rights belongs to respective at ce categories, examples of fraud tisk factors ch of these thr 2 Fa st from fraudulent financial reporting relating to misstatements arising are set out below. 1. Fraud Risk Factors Relating to Management's Characteristics and Influence over the Control Environment These fraud tisk factots pertain to management’ abilities, pressures, style, and attitade relating to internal control and the financial reporting process. * There is motivation for management to engage in fraudulent financial reporting. Specific indicators might include the following: — A significant portion of management’s compensation is represented by bonuses, stock options or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position or cash flow. — There is excessive interest by management in maintaining or increasing the entity’s stock price ot earnings trend through the usé of unusually aggressive accounting practices, — Management commits to analysts, cteditors and other third parties to achieving what appear to be unduly aggressive or clearly unrealistic forecasts. ~ Management has an interest in pursuing inappropriate means (o minimize reported earnings for tax-motivated reasons. * There is a failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. Specific indicators might inchade the following: — Management does not effectively communicate and support the entity’s values ox ethics, or management communicates inappropriate values o ethics, — Management is dominated by a single petson ot a stall group without compensating controls such as effective oversight by those charged with governance. — Management does not monitor significant controls adequately. - Management fails to correct known material weaknesses in internal control on a timely basis. — Management sets unduly aggressive financial targets and expectations for operating personnel. — Management displays a significant disregard for regulatory authorities. — Management continues to employ ineffective accounting, information technology or internal auditing staff. + Non-financial management participates excessively in, or is preoccupied with, the selection of accounting principles or the determination of significasit estimates. * There is a high turnover of management, counsel or board members. B: Digital Accounting Books PH All rights belongs to respective authors Please consid il ‘There is a strained telavonship between management 4 the current or predecessor auditor, Specific indica, might include the following: — Frequent disputes with the curtent or a predecessey auditor on accounting, auditing or reporting marrey, ~ Unreasonable demands on the auditor, includiny unreasonable time constraints regarding the completion of the audit or the issuance of the auditor's report. — Formal or informal restrictions on the auditor that inappropriately limit the auditor's access to pecple of information, or limit the auditor’s ability to communicate effectively with those charged with governance, — Domineering management behavior in dealing with the auditor, especially involving attempts to influence the scope of the auditor’s work. ‘Thete is a history of securities law violations, o claims against the entity or its management alleging fraud or violations of securities laws. The corporate governance structure is weak or ineffective, which may be evidenced by, for example: = A lack of members who are independeat of management. — Little attention being paid to financial reporting matters and to the accounting and internal contol systems by those charged with governance. 'B: Digital Accounting Books PH All rights belongs to respective authors Please consider buvina the ariainat- Fraud Risk Factors Relating to Industry Conditions These fraud risk factors 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 rapidly changing technology or rapid product obsolescence. Frand Risk Factors Relating to Operating Characteristics and Financial Stability These fraud risk factors pertain to the nature and complexity of the entity and its transactions, the entity’s financial condition, and its profitability. Inability to generate cash flows from operations while reporting carnings and earnings growth. Significant pressure to obtain additional capital necessary to stay competitive, considering the financial position of the entity (including « need for funds to finance major research and development or capital expenditures). ‘Assets, liabilities, revenues or expenses based on significant estimates that involve unusually subjective judgments or uncertainties, of that are subject 10 potential i thange in the near term in a manner that ma example, the ultimate collectibility of receivables, the timing of revenue recognition, the realizability of financia) instruments based on highly-subjective valuation of collateral or difficult-to-assess repayment sources, or 4 significant deferral of costs). Significant zelated party transactions which ate not in the ordinary course of business. Significant related party transactions which are not audited ot are audited by another firm. Significant, uausuel ot highly complex transactions (especially those close to. year-end) 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 overly complex organizational structure involving ‘Aumerous or unusual legal entities, managerial lines of authority or contractual arrangements without apparent business purpose. Diffculyy in determining the organization or person (ot persons) 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. Vausualy high dependence on debt,a matginal ability to mect debt repayment requirements, or debt covenants that ate difficult to maintain. CIP coe lad ieMalel2)

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