MODULE 4: THE AUDITOR’S RESPONSIBILITY

I. Description
This module discusses on auditor’s responsibility as well as the management and those
charged with governance. This also discusses the causes of misstatements in the financial
statements.

II. Objectives
After completing the module, the students are expected to:

 Identify the management’s responsibilities.

 Identify the auditor’s responsibilities
 Define fraud, error and noncompliance with the laws and regulations

III. Duration
Start: Week 5
End: Week 5

IV. Learning Contents

A. AUDITOR’S RESPONSIBILITY

The fair presentation of the financial statements in accordance with the applicable financial
reporting framework 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
3. Noncompliance with the laws and regulations.

The objectives of the auditor are:

(a) To identify and assess the risks of material misstatement of the financial statements
due to fraud;

(b) To obtain sufficient appropriate audit evidence about the assessed risks of material
misstatement due to fraud, through designing and implementing appropriate responses;
and

(c) To respond appropriately to identified or suspected fraud.

B. ERROR AND FRAUD

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 1

Desiree D. Cemefrania, CPA
The auditor’s responsibility is to design an audit to provide reasonable assurance of
detecting material misstatements in the financial statements. The misstatements may
emanate from:

1. Error – unintentional misstatements in the financial statements, including the omission of

an amount or a disclosure such as:

a. Mathematical or clerical mistakes in the records and accounting data

b. Incorrect accounting estimates arising from oversight or misinterpretation
of facts
c. Mistakes in the application of the accounting policies

2. Fraud – intentional act by one or more individuals among management, those charged
with governance, employees, or third parties, involving the use of deception to obtain an
unjust or illegal advantage.

Although fraud is a broad legal concept, for the purposes of the PSAs, the auditor is
concerned with fraud that causes a material misstatement in the financial statements.

Fraud risk factors – Events or conditions that indicate an incentive or pressure to

commit fraud or provide an opportunity to commit fraud.

Two Types of Intentional Misstatements:

1. Misstatements resulting from fraudulent financial reporting - involves intentional

misstatements including omissions of amounts or disclosures in financial statements to
deceive financial statement users.

It can be caused by the efforts of management to manage earnings in order to deceive

financial statement users by influencing their perceptions as to the entity’s performance
and profitability.

Fraudulent financial reporting may be accomplished by the following:

 Manipulation, falsification (including forgery), or alteration of accounting records

or supporting documentation from which the financial statements are prepared.

 Misrepresentation in, or intentional omission from, the financial statements of

events, transactions or other significant information.

 Intentional misapplication of accounting principles relating to amounts,

classification, manner of presentation, or disclosure.

 Recording of transactions without substance

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 2

Desiree D. Cemefrania, CPA
2. Misstatements resulting from misappropriation of assets - involves the theft of an
entity’s assets and is often perpetrated by employees in relatively small and immaterial
amounts. However, it can also involve management who are usually more able to
disguise or conceal misappropriations in ways that are difficult to detect.

Misappropriation of assets can be accomplished in a variety of ways including:

 Embezzling receipts
 Stealing physical assets or intellectual property
 Causing an entity to pay for goods and services not received
 Using an entity’s assets for personal use

Misappropriation of assets is often accompanied by false or misleading records or

documents in order to conceal the fact that the assets are missing or have been pledged
without proper authorization.

Misstatements in the financial statements can arise from either fraud or error. The
distinguishing factor between fraud and error is whether the underlying action that results
in the misstatement of the financial statements is intentional or unintentional.

PRIMARY RESPONSIBILITY IN DETECTING FRAUD AND ERROR

The primary responsibility for the prevention and detection of fraud rests with both those
charged with governance of the entity and management. It is important that management,
with the oversight of those charged with governance, place a strong emphasis on fraud
prevention, which may reduce opportunities for fraud to take place, and fraud deterrence,
which could persuade individuals not to commit fraud because of the likelihood of detection
and punishment.

The PSA 240 requires:

1. Management to establish a control environment and to implement internal control

policies and procedures designed to ensure the detection and prevention of fraud and
error.

2. Individuals charged with governance of an entity’s accounting and financial reporting

systems and that appropriate controls are in place.

An auditor conducting an audit in accordance with PSAs is responsible for obtaining

reasonable assurance that the financial statements taken as a whole are free from material
misstatement, whether caused by fraud or error. As described in PSA 200, “Objective and
General Principles Governing an Audit of Financial Statements,” owing to the inherent
limitations of an audit, there is an unavoidable risk that some material misstatements of the

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 3

Desiree D. Cemefrania, CPA
financial statements will not be detected, even though the audit is properly planned and
performed in accordance with the PSAs.

The auditor cannot be held responsible for the prevention and detection of fraud and
error.

The risk of not detecting a material misstatement resulting from fraud is higher than the risk
of not detecting one resulting from error. This is because fraud may involve sophisticated
and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to
record transactions, or intentional misrepresentations being made to the auditor. Such
attempts at concealment may be even more difficult to detect when accompanied by
collusion.

Collusion may cause the auditor to believe that audit evidence is persuasive when it is, in
fact, false. The auditor’s ability to detect a fraud depends on factors such as the skillfulness
of the perpetrator, the frequency and extent of manipulation, the degree of collusion
involved, the relative size of individual amounts manipulated, and the seniority of those
individuals involved. While the auditor may be able to identify potential opportunities for fraud
to be perpetrated, it is difficult for the auditor to determine whether misstatements in
judgment areas such as accounting estimates are caused by fraud or error.

Furthermore, the risk of the auditor not detecting a material misstatement resulting from
management fraud is greater than for employee fraud, because management is frequently in
a position to directly or indirectly manipulate accounting records, present fraudulent financial
information or override control procedures designed to prevent similar frauds by other
employees.

When obtaining reasonable assurance, the auditor is responsible for maintaining an attitude
of professional skepticism throughout the audit, considering the potential for management
override of controls and recognizing the fact that audit procedures that are effective for
detecting error may not be effective in detecting fraud. The requirements in this PSA are
designed to assist the auditor in identifying and assessing the risks of material misstatement
due to fraud and in designing procedures to detect such misstatement.

Planning Phase

1. When planning the audit, it is appropriate for the auditor to make inquiries of
management regarding:
 Management’s own assessment of the risk of fraud and
 The controls in place to prevent and detect it
 Any material error or fraud that has affected the entity or suspected fraud that the
entity is investigating.

2. In accordance with PSA 315, the auditor shall identify and assess the risks of material
misstatement due to fraud at the financial statement level, and at the assertion level for
classes of transactions, account balances and disclosures.

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 4

Desiree D. Cemefrania, CPA
 The fact that fraud is usually concealed can make it very difficult to detect. Nevertheless,
the auditor may identify events or conditions that indicate an incentive or pressure to
commit fraud or provide an opportunity to commit fraud (fraud risk factors).

Testing Phase

3. During the course of the audit, the auditor may encounter circumstances that may
indicate the possibility of fraud or error.

 Discrepancies in the accounting records, including:

 Transactions that are not recorded in a complete or timely manner or are
improperly recorded as to amount, accounting period, classification, or entity
policy.
 Unsupported or unauthorized balances or transactions. • Last-minute
adjustments that significantly affect financial results.
 Evidence of employees’ access to systems and records inconsistent with that
necessary to perform their authorized duties.
 Tips or complaints to the auditor about alleged fraud.

 Conflicting or missing evidence

 Problematic or unusual relationships between the auditor and management
 Unwillingness by management to permit the auditor to meet privately with those
charged with governance.
 Accounting policies that appear to be at variance with industry norms.
 Frequent changes in accounting estimates that do not appear to result from changed
circumstances.
 Tolerance of violations of the entity’s Code of Conduct.

In these circumstances, the auditor should perform procedures necessary to determine

whether material misstatements exist.

4. When material misstatements in the financial statements are identified, the auditor
should consider whether such a misstatement resulted from fraud or an error. This is
essential because errors may result to adjustments to the financial statements, but fraud
may have other implications on the audit.

If the misstatements resulted from fraud and the auditor believed it is immaterial, the
auditor should:
 Report such matter to the appropriate level of management (at least one level
above those involved); or
 Be satisfied that given the position of the likely perpetrator, the fraud has no other
implications for other aspects of the audit or those implications have been
adequately considered.

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 5

Desiree D. Cemefrania, CPA
 For material misstatements resulting from fraud or has been unable to evaluate its
materiality, the auditor should:

 Consider implication for other aspects of the audit particularly the reliability of
the management representations.
 Discuss the matter and the approach to further investigation with an
appropriate level 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
 Suggest that the client consult with legal counsel about questions of law.

Completion Phase

5. The auditor should obtain written representation from management that:

 The management acknowledges its responsibilities for the implementation and

operations of accounting and internal control systems that are designed to
prevent and detect fraud and error.
 It believes the effect of those uncorrected misstatements aggregated by the
auditor during the audit are immaterial, both individually and in aggregate, to the
financial statements taken as a whole. The summary of the items should be
included in the written representations.
 It has disclosed to the auditor all significant facts relating to any fraud or
suspected frauds known to the managements that may have affected the entity.
 It has disclosed to the auditor the results of its assessment of risk that the
financial statements may be materially misstated as a result of fraud.

Reporting Phase

6. When the auditor a material error or fraud exists, the auditor should request the
management to revise the financial statements. Otherwise the auditor shall issue a
qualified or adverse opinion.

7. If the auditor is unable to evaluate the effect of the fraud on the financial statements
because of scope limitation to the examination, the auditor should either qualify or
disclaim an opinion to the financial statements.

C. NONCOMPLIANCE WITH LAWS AND REGULATIONS

Noncompliance refers to acts of omissions or commission by the entity, either intentional or

unintentional, which are contrary to the prevailing laws or regulations. Such acts include
transactions entered into by, or in the name of, the entity, or on its behalf, by those charged
with governance, management or employees. Non-compliance does not include personal

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 6

Desiree D. Cemefrania, CPA
misconduct (unrelated to the business activities of the entity) by those charged with
governance, management or employees of the entity.

 Tax evasions
 Violations of environmental protections laws
 Inside trading of securities (Insider trading in securities may occur when a person in
possession of material nonpublic information about a company trades in the
company’s securities and makes a profit or avoids a loss)

Non-compliance with laws and regulations may result in fines, litigation or other
consequences for the entity that may have a material effect on the financial statements.

Responsibility of the Management

It is the responsibility of management, with the oversight of those charged with governance,
to ensure that the entity’s operations are conducted in accordance with the provisions of
laws and regulations, including compliance with the provisions of laws and regulations that
determine the reported amounts and disclosures in an entity’s financial statements.

 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.
 Ensuring employees are properly trained and understand the code of conduct.
 Monitoring compliance with the code of conduct and acting appropriately to discipline
employees who fail to comply with it.
 Engaging legal advisors to assist in monitoring legal requirements.
 Maintaining a register of significant laws and regulations with which the entity has to
comply within its particular industry and a record of complaints.

Responsibility of the Auditor

The requirements in PSA 250 (Considerations of Laws and Regulations in the audit of
financial statements) are designed to assist the auditor in identifying material misstatement
of the financial statements due to non-compliance with laws and regulations. However, the
auditor is not responsible for preventing noncompliance and cannot be expected to detect
non-compliance with all laws and regulations.

Planning Phase

1. As part of obtaining an understanding of the entity and its environment in accordance

with PSA 315 Redrafted ( Identifying and Assessing the Risks of Material Misstatement
through Understanding the Entity and Its Environment), the auditor shall obtain a general
understanding of:

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 7

Desiree D. Cemefrania, CPA
 (a) The legal and regulatory framework applicable to the entity and the industry or
sector in which the entity operates; and

(b) How the entity is complying with that framework

To obtain a general understanding of the legal and regulatory framework, and how the
entity complies with that framework, the auditor may,

 Use the auditor’s existing understanding of the entity’s industry, regulatory and
other external factors;
 Update the understanding of those laws and regulations that directly determine
the reported amounts and disclosures in the financial statements;
 Inquire of management as to other laws or regulations that may be expected to
have a fundamental effect on the operations of the entity;
 Inquire of management concerning the entity’s policies and procedures regarding
compliance with laws and regulations; and
 Inquire of management regarding the policies or procedures adopted for
identifying, evaluating and accounting for litigation claims.

2. Audit procedures applied to form an opinion on the financial statements may bring
instances of non-compliance or suspected non-compliance with laws and regulations to
the auditor’s attention. For example, such audit procedures may include:

 Reading minutes;
 Inquiring of the entity’s management and in-house legal counsel or external legal
counsel concerning litigation, claims and assessments; and
 Performing substantive tests of details of classes of transactions, account
balances or disclosures.

3. The auditor should obtain sufficient appropriate audit evidence about compliance with
the provisions of 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 possible instance of

noncompliance, the auditor should obtain an understanding of the nature of the act and
circumstances in which it occurred, and other information to evaluate the possible effect
on the financial statements.

Matters relevant to the auditor’s evaluation of the possible effect on the financial
statements include:

 The potential financial consequences of non-compliance with laws and

regulations on the financial statements including, for example, the imposition of

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 8

Desiree D. Cemefrania, CPA
 fines, penalties, damages, threat of expropriation of assets, enforced
discontinuation of operations, and litigation.
 Whether the potential financial consequences require disclosure.
 Whether the potential financial consequences are so serious as to call into
question the fair presentation of the financial statements, or otherwise make the
financial statements misleading.

5. The auditor shall document identified or suspected non-compliance with laws and
regulations and the results of discussion with management and, where applicable,
those charged with governance and other parties outside the entity.

Completion Phase

6. The auditor shall request management and, where appropriate, those charged with
governance to provide written representations that all known instances of noncompliance
or suspected non-compliance with laws and regulations whose effects should be
considered when preparing financial statements have been disclosed to the auditor.

Reporting Phase

7. If the auditor concludes that the non-compliance has a material effect on the financial
statements, and has not been adequately reflected in the financial statements, the
auditor shall, in accordance with PSA 705 (Revised and Redrafted), express a qualified
or adverse opinion on the financial statements. (The management did not revise the
financial statements)

8. If the auditor is precluded by management or those charged with governance from

obtaining sufficient appropriate audit evidence to evaluate whether noncompliance that
may be material to the financial statements has, or is likely to have, occurred, the auditor
shall express a qualified opinion or disclaim an opinion on the financial statements
on the basis of a limitation on the scope of the audit in accordance with PSA 705
(Revised and Redrafted). (Evidence of scope limitation)

The risk is higher with regards to noncompliance with regard to material misstatement
resulting from noncompliance with the laws and regulations for such reasons as the
following:

 There are many laws and regulations, relating principally to the operating aspects of
an entity that typically do not affect the financial statements and are not captured by
the entity’s information systems relevant to financial reporting.

 Non-compliance may involve conduct designed to conceal it, such as collusion,

forgery, deliberate failure to record transactions, management override of controls or
intentional misrepresentations being made to the auditor.

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 9

Desiree D. Cemefrania, CPA
  Whether an act constitutes non-compliance is ultimately a matter for legal
determination by a court of law.

V. References

 Auditing Theory by J. Salosagcol, Tiu and Hermosilla

 PSA 240 (Redrafted) - THE AUDITOR’S RESPONSIBILITIES RELATING TO
FRAUD IN AN AUDIT OF FINANCIAL STATEMENTS
 PSA 250 - CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF
FINANCIAL STATEMENTS

ACCTG 109 – AUDITING AND ASSURANCE PRINCIPLES 10

Desiree D. Cemefrania, CPA