Chapter 8 — Consideration of Fraud, Error, and Non-compliance CHAPTER 8& CONSIDERATION OF FRAUD, ERROR AND NON-COMPLIANCE Chapter Overview and Objectives: This chapter discusses the auditor’s consideration of fraud, error and non- compliance in audits of financial statements. At the end of this chapter, readers should be able to discuss the following: Primary causes of material misstatements Definition of fraud and its types Fraud in comparison with error Characteristics of fraud Responsibilities for the prevention and detection of fraud Responsibilities of the auditor over fraud Audit procedures and documentation relating to fraud Consideration of laws and regulations and non-compliance Responsibilities of the auditor for laws, regulations and non-compliance 0. Audit procedures and documentation relating to laws, regulation and non-compliance 11. Examples of fraud risk factors, indications of possibility of fraud and indications of non-compliance BOON aNEwNE Relevant References: PSA 240 - The Auditor's Responsil of Financial Statements ies Relating to Fraud in an Audit PSA 250 (Revised) - Consideration of Laws and Regulations in an Audit of Financial Statements PSA 260 - Communication with Those Charged with Governance Aim... Believe... Claim... Page 285Chapter 8 — Consideration of Fraud, Error, and Non-compliance peesubisieda the objective of an audit of financial statements Is for oe itertoobt inrearonable assurance about whether the financial stater ssawhcle an free from material misstatement, whether due to fraud of thereby enabling the auditor to express an opinion on whether the fj statements are prepared, in all material respects, in accordance applicable financial reporting framework. Mancia) With ay From the above objective, fraud and error are the primary causes of m misstatement that could affect the financial statements. PSA 240 even ex Provided that misstatements in the financial statements can arise from fraud or error. Thus, it is only appropriate for the auditor to consider these in an audit of financial statements. lateria) lity either items FRAUD AND ERROR Definition For audit of financial statements Purposes, the following are the definition of fraud and error. Error refers to an unintentional misstatement in financial statements, including the omission of an amount or a disclosure, such as the following: > A mistake in gathering or Processing data from which financial statements are prepared, > An incorrect accounting estimate misinterpretation of facts. > A mistake in the applicatioy Measurement, recognition, cl arising from oversight n of accounting principles relating t® assification, presentation or disclosure. employees, or third parti illegal advantage. The Although fraud is a broad k is concerned with fraud statements, legal concept, for the purposes of the PSAs, the aust that causes a Material misstatement in the fina™ the between fraud and error is whethe © misstatements of the financial sta result in th are intentional or unintentional,Chapter 8 — Consideration of Fraud, Error, and Non-compliance Types of Fraud The two types of intentional misstatements relevant to the auditors are misstatements resulting from the following: 1. Frau eporting (FFR) Fraudulent financial reporting involves intentional misstatements including omissions of amounts or disclosures in financial statements to deceive financial statement users, FFR 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. FFR may be accomplished by the following: Y 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. FFR often involves management override of controls that otherwise may appear to be operating effectively. FFR can be committed by management overriding controls using such techniques as: Y Recording fictitious journal entries, particularly close to the end of an accounting period, to manipulate operating results or achieve other objectives; Y Inappropriately adjusting assumptions and changing judgments used to estimate account balances; Y Omitting, advancing or delaying recognition in the financial statements of events and transactions that have occurred during the reporting period; Y Concealing, or not disclosing, facts that could affect the amounts recorded in the financial statements; Y Engaging in complex transactions that are structured to misrepresent the financial position or financial performance of the entity; and Y Altering records and terms related to significant and unusual transactions. 2. Misappropriation of assets (MOA) Misappropriation of assets involves the theft of an entity's assets MOA 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. Aim... Believe... Claim... Page 287Chapter 8 ~ Consideration of Fraud, Error, and Non-compliance MOA can be accomplished in a variety of ways including: v Embezzling receipts (for example, seriall Collection accounts receivable or diverting eka in respect of write ersonal bank accounts); Steating physic assets or intellectual property (for example, steali inventory for personal use or for sale, stealing scrap for resale, COlludi with a competitor by disclosing technological data in return ¢2 payment); ; Causing an entity to pay for goods and services not receiveg (fo example, payments to fictitious vendors, kickbacks paid by vendors to the entity’s purchasing agents in return for inflating prices, payments fictitious employees); and Using an entity’s assets for personal use (for example, using the entitys assets as collateral for a personal loan or a loan to a related party) S oy | N-off Summary ~ Primary Causes of Material Misstatements Intention deceive FS Fraud Error Various types (e.9. Fraudulent , 4 rounding, Types financial sec of | transposition, eros reporting (FFR) of commission and omissions) Intentional. To conceal assets that are missing/ pledged | Unintentional. Intentional. To users without proper authorization Management Gommited override of | Theft of enttys Mistake; | rougl controls assets isi ation | (moog misinterpret | Impact on audit procedures A Nature More extensive | Less extensive | Timing Closer to Period-end ino period Extent Higher sample sizes and Procedures Lower samples? *) Land procedures _— Aim... Belies Clai paseChapter 8 — Consideration of Fraud, Error, and Non-compliance Other types of fraud Other types of fraud that may be relevant to audit of financial statements include 1, Management fraud refers to fraud involving one or more members of management or those charged with governance. This type of fraud is commonly associated to FFR since FFR usually involves members of the management and those charged with governance. Employee fraud refers to fraud involving only employees of the entity. This type of fraud is commonly associated to MOA since MOA is often perpetrated by employees in relatively small and immaterial amounts IMPORTANT NOTES: Eee ¥ Employee fraud can also involve management who are usually more able to disguise or conceal misappropriations in ways that are difficult to detect. Employees could also take part in committing FFR. Fraudulent activities that could affect the entity’s financial statements may be committed by management and or employees with or without the participation of an outsider or other parties. v v Characteristics of Fraud Fraud involves (1) incentive or pressure to commit fraud, (2) a perceived ‘opportunity to do so and (3) some rationalization of the act. Examples (lifted from PSA 240): > Incentive or pressure to commit fraudulent financial reporting may exist when management is under pressure, from sources outside or inside the entity, to achieve an expected (and perhaps unrealistic) earnings target or financial outcome — particularly since the consequences to management for failing to meet financial goals can be significant. Similarly, individuals may have an incentive to misappropriate assets, for example, because the individuals are living beyond their means. > A perceived opportunity to commit fraud may exist when an individual believes internal control can be overridden, for example, because the individual is in a position of trust or has knowledge of specific weaknesses in internal control. > Individuals may be able to rationalize committing a fraudulent act. Some individuals possess an attitude, character or set of ethical values that allow them knowingly and intentionally to commit a dishonest act. However, even otherwise honest individuals can commit fraud in an environment that imposes sufficient pressure on them. This concept is more popularly known as the fraud triangle or fraudulent triangular. Aim... Believe... Claim... Page 289Chapter 8 — Consideration of Fraud, Error, and Non cornice Responsibility for the prevention and detection of frau ; The primary responsibility for the prevention and detection of fraug both those charged with governance of the entity and management > Management means such personnel who are responsible to fo, day to day functions of the business, internal controls ang for Maley financial statements. > Those charged with governance means such personne} Who supervise the performance of management and are respongi approving financial statements. n ets ag, al ble fo, Specific responsibilities of management include the following: 1. It is important that management, with the oversight of those charged wit, Bovernance, place a strong emphasis on fraud prevention, which may redie Opportunities for fraud to take place, and fraud deterrence, which coulg Persuade individuals not to commit fraud because of the likelihood of detection and punishment. This involves a commitment to creating a cute of honesty and ethical behavior which can be reinforced by an active oversight by those charged with governance. 2. It is the responsibility of management, with oversight from those charged with governance, to establish a control environment and maintain polices and procedures to assist in achieving the objective of ensuring, as far Possible, the orderly and efficient conduct of the entity's business. 3. It is the responsibility of those charged with governance of the entity to ensure, through oversight of management, that the entity establishes and maintains internal control to provide reasonable assurance with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. Responsibilities of the Auditor When considering fraud, the objectives of the auditor are: Y To identify and assess the risks of material misstatement of the finan Statements due to fraud; Y To obtain sufficient a of material misstat implementing appro, Y To respond appropri * cod Ppropriate audit evidence about the assessed" tement due to fraud, through designing ® priate responses; and lately to identified or suspected fraudChapter 8 - Consideration of Fraud, Error, and Non-compliance \n order to attain these objectives, the auditor shall consider and observe the following: 1. Overall objective of the audit An auditor conducting an audit in accordance with PSAs obtains reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. Inherent limitations of an audit in the context of fraud a. Owing to the inherent limitations of an audit, there is an unavoidable tisk that some material misstatements of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with PSAs. The risk of not detecting a material misstatement resulting from fraud is higher than the risk of not detecting a material misstatement resulting from error 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. 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 and present fraudulent financial information. d. The subsequent discovery of a material misstatement of the financial statements resulting from fraud does not, in and of itself, indicate a failure to comply with PSAs. 3. Professional skepticism Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. Professional skepticism requires an ‘ongoing questioning of whether the information and audit evidence obtained suggests that a material misstatement due to fraud may exist. When obtaining reasonable assurance, an auditor maintains an attitude of professional skepticism throughout the audit, considers the potential for management override of controls and recognizes the fact that audit procedures that are effective for detecting error may not be appropriate in the context of an identified risk of material misstatement due to fraud. Page 291Chapter 8 - Consideration of Fraud, Error, and xeon ; it i attitu 2) Sheps, The auditor should maintain an we ti, throughout the audit, recognizing the Possibility that a stan misstatement due to fraud could exist, notwithstanding the auditor, ms experience with the entity about the honesty and integrity of Managemen and those charged with governance. An example of application of professional skepticism is: were res inquiries of management or those charged with governance are inc, the auditor shall investigate the inconsistencies. POnses ty ONSisteny, 4. Discussion among the Engagement Team ; ; Members of the engagement team should discuss the Susceptibility of thy entity's financial statements to material misstatement due to fraud. Prior to or in conjunction with obtaining information to identi the audit team should discuss the potential for a material to fraud, including * Fraud Brainstorming - Exchanging of ideas among team members about how and where the financial statements mi ight be susceptible to fraud, how management could perpetrate and conceal fraudulent financial Teporting, and how assets could be misappropriated. * Fraud Discussion - Emphasizin, Proper state of mind rey due to fraud ify risks of frau, misstatement due ig the importance of maintaining the Barding the potential for material misstatement The discussion should a. Include consideration of known factors affecting incentives/pressures for fraud, opportunities, » and culture or environment that enables management to rationalize committing fraud b. Emphasize the need to maintain a Questioning mind and to exercst Professional skepticism ¢. Include key members of the audit team * If multiple locations are involved, there could be multiple discussions in different locations. + Itmay be useful to include any specialists assigned to the audit tea” in the discussion, AUDIT PROCEDURES Risk Assessment Procedures and Related Acti t ae and performing the audit to reduce audit risk to an acceptably me the auditor should Consider the risks Of material misstatements i? “ nancial statements whether due to fraud or error. The auditor shall Mn Bee Cath PasChapter 8 — Consideration of Fraud, Error, and Non-compliance Obtain an understanding of the entity and its environment As required by PSA 315, to obtain an understanding of the entity and its environment, including its internal control, the auditor performs risk assessment procedures. As part of this work, the auditor performs the following procedures to obtain information that is used to identify the risks of material misstatement due to fraud: a. Makes inquiries of management, of those charged with governance, and of others within the entity as appropriate and obtains an understanding of how those charged with governance exercise oversight of management's processes for identifying and responding to the risks of fraud and the internal control that management has established to mitigate these risks. 1 When obtaining an understanding of the entity and its environment, including its internal control, the auditor should make inquiries of management regarding: Management's assessment of the risk that the financial statements may be materially misstated due to fraud; Management's process for identifying and responding to the risks of fraud in the entity, including any specific risks of fraud that management has identified or account balances, classes of transactions or disclosures for which a risk of fraud is likely to exist; Management’s communication, if any, to those charged with governance regarding its processes for identifying and responding to the risks of fraud in the entity; and Management's communication, if any, to employees regarding its views on business practices and ethical behavior. b. Consider whether one or more fraud risk factors are present. Fraud risk factors are events or conditions that indicate an incentive or pressure to commit fraud, or provide an opportunity to commit fraud. in considering fraud risk factors, the auditor should use professional judgment in determining whether a risk factor is present and in | identifying and assessing the risk of material misstatement due to fraud. A list of fraud risk providers can be found at Appendix C of this book. < Considers any unusual or unexpected relationships that have been identified in performing analytical procedures. The auditor should consider unusual or unexpected relationships that have been identified in performing analytical procedures including its internal control, may indicate risks of material misstatement due to fraud. Aim... Believe_. Claim... Page 293Chapter 8 — Consideration of Fraud, Error, and Non-compliance forming this, the auditor shall: : mDewelop expectations about plausible relationships that reasonably expected to exist based on the auditor s Linder standing of the entity and its environment, including its internal contra, * Design analytical procedures that will include Procedures Felated 1, revenue accounts with the objective of identifying Unusual oy unexpected relationships that may indicate risks of Mater misstatement due to fraudulent financial reporting, such 85, for example, fictitious sales or significant returns from Customers that might indicate undisclosed side agreements. d. Considers other information that may be helpful in identifying the risks of material misstatement due to fraud. 2. Identify and assess the risks of material misstatement due to fraud To assess the risks of material misstatement due to fraud, the auditor uses professional judgment and: * Identifies risks of fraud by considering the information obtained through Performing risk assessment procedures and by considering the classes of transactions, account balances and disclosures in the financal statements; * Relates the identified risks of fraud to what can gO wrong at the assertion level; and * Considers the likely magnitude of the Potential misstatement including the possibility that the risk mi possi ight give rise to multiple misstatements and the likelihood of the risk occurring, Further Audit Procedures and Related Activities 1. Responses to the risks of m: The auditor responds to the ri i ie the followingwove 1° te T#KS of material misstatement due to fal# © Aresponse that has an oversChapter 8 — Consideration of Fraud, Error, and Non-compliance * Aresponse to identified risks involving the performance of certain audit procedures to address the risks of material misstatement due to fraud involving management override of controls, given the unpredictable ways in which such override could occur. In determining overall responses to address the risks of material misstatement due to fraud at the financial statement level the auditor should: * Consider the assignment and supervision of personnel; * Consider the accounting policies used by the entity; and * Incorporate an element of unpredictability in the selection of the nature, timing and extent of audit procedures. ‘Audit procedures responsive to management override of controls As discussed earlier, management is in a unique position to perpetrate fraud because of management's ability to directly or indirectly manipulate accounting records and prepare fraudulent financial statements by overriding controls that otherwise appear to be operating effectively. To respond to the risk of management override of controls, the auditor should design and perform audit procedures to: 1. Test the appropriateness of journal entries recorded in the general ledger and other adjustments made in the preparation of financial statements; 2. Review accounting estimates for biases that could result in material misstatement due to fraud; and 3. Obtain an understanding of the business rationale of significant transactions that the auditor becomes aware of that are outside of the normal course of business for the entity, or that otherwise appear to be unusual given the auditor’s understanding of the entity and its environment. Audit procedures responsive to risks of material misstatement due to fraud at the assertion level The auditor's responses to address the assessed risks of material misstatement due to fraud at the assertion level may include changing the nature, timing, and extent of audit procedures in the following ways: © The nature of audit procedures to be performed may need to be changed to obtain audit evidence that is more reliable and relevant or to obtain additional corroborative information. © The timing of substantive procedures may need to be modified. The auditor may conclude that performing substantive testing at or near the period end better addresses an assessed risk of material misstatement due to fraud. ES Aim... Believe. 7 Page 295Chapter 8 - Consideration of Fraud, Error, and Deana © Theextent of the procedures applied reflects the ae eM OF the rig of material misstatement due to fraud. For example, Increasing Samp, sizes or performing analytical procedures at a more detailed leg be appropriate. 2. Evaluation of audit evidence The auditor shall evaluate whether analytical procedures that are Perfor at or near the end of the audit when forming an overall conclusion ato whether the financial statement as a whole are consistent with the auditor, knowledge of the business indicate a previously unrecognized risk of materia) misstatement due to fraud. When the auditor identifies a misstatement, the auditor should consider whether such a misstatement may be indicative of fraud and if there is such an indication, the auditor should consider the implications of the misstatement in relation to other aspects of the audit, particularly the reliability of management representations. When the auditor confirms that, or is unable to conclude whether, the financial statements are materially misstated as a result of fraud, the auditor should consider the implications for the audit. Obtain management representations ‘The auditor should obtain written a. It acknowledges its responsibi internal control to prevent and detect fraud; b. It has disclosed to the auditor the results of its assessment of the that the financial statemen: ts may be materially misstated as a result fraud; ¢._ Ithas disclosed to the au affecting the entity invoh * Management; * Employees who have © Others where the fra statements; and us. d. It has discl itor it sac ag gy en entity’s financial state™ |, es, former employees, analysts, regula! representations from management that: lity for the design and implementation of ditor its knowledge of fraud or suspected frau4 Iving: Significant roles in internal control; of ud could have a material effect on the fina! cid ‘ir Believe. CainChapter 8 - Consideration of Fraud, Error, and Non-compliance AUDITOR IS UNABLE TO CONTINUE THE ENGAGEMENT If, as a result of a misstatement resulting from fraud or suspected fraud, the auditor encounters exceptional circumstances that bring into question the auditor's ability to continue performing the audit the auditor should: a. Consider the professional and legal responsibilities applicable in the circumstances, including whether there is a requirement for the auditor to report to the person or persons who made the audit appointment or, in some cases, to regulatory authorities; b. Consider the possibility of withdrawing from the engagement; and c. Ifthe auditor withdraws: * Discuss with the appropriate level of management and those charged with governance the auditor’s withdrawal from the ‘engagement and the reasons for the withdrawal; and * Consider whether there is a professional or legal requirement to report to the person or persons who made the audit appointment or, in some cases, to regulatory authorities, the auditor’s withdrawal from the engagement and the reasons for the withdrawal. Such exceptional circumstances can arise, for example, when: ‘© The entity does not take the appropriate action regarding fraud that the auditor considers necessary in the circumstances, even when the fraud is not material to the financial statements; © The auditor's consideration of the risks of material misstatement due to fraud and the results of audit tests indicate a significant risk of material and pervasive fraud; or © The auditor has significant concern about the competence or integrity of management or those charged with governance. COMMUNICATION Communications to management The determination of which level of management is the appropriate one is a matter of professional judgment and is affected by such factors as the likelihood of collusion and the nature and magnitude of the suspected fraud. Ordinarily, the appropriate level of management is at least one level above the persons who appear to be involved with the suspected fraud. If the auditor has identified a fraud or has obtained information that indicates that a fraud may exist, the auditor should communicate these matters as soon as practicable to the appropriate level of management. This is so even if the matter might be considered inconsequential (for example, a minor defalcation by an ). employee at a low level in the entity's organizatic Page 297Chapter 8 ~ Consideration of Fraud, Error, and snail Communications with those charged wah sovernanc uae The auditor should communicate the following ‘ Ee vi governance as soon as practicable either in writing or orally. ds When the auditor has identified fraud involving management, empl who have significant roles in internal control or others where the fraug results in a material misstatement in the financial statements Significant deficiency in the design or implementation of internal control prevent and detect fraud which may have come to the auditor's attention Moreover, if the integrity or honesty of management or those charged with governance is doubted, the auditor considers seeking legal advice to assist in the determination of the appropriate course of action. Communications to Regulatory and Enforcement Authorities The auditor's professional duty to maintain the confidentiality of client information may preclude reporting fraud to a party outside the client entity. The auditor considers obtaining legal advice to. determine the appropriate course of action in such circumstances. However, by regulatory requirements, statute, th in certain circumstances, the duty of confidentiality may be overrides fe law or courts of law. Examples (lifted from PSA 240) Under a BSP requirement, the auditor of a financial institution hs a statutory duty to report the occurrence of fraud to the BSP. TS are di * i ter" i using professional judgment. ‘ocumented is for the auditor to de! 1, The documentation of the audi os r 7 a yn environment and the aud; ManoPS understanding of the entity # et n itor i . misstatement should include: * assessment of the risks of a core Stns Teached during the discussion anes Susceptibility of the entity's #! ‘atement due to fraud; and Tisks of material misstatement due nd at the assertion level. eBarding the statements to material Missti b. The identified and assessed at the financial Statement level aChapter 8 — Consideration of Fraud, Error, and Non-compliance 2. The documentation of the auditor's responses to the assessed risks of material misstatement should include: a. The overall responses to the assessed risks of material misstatements due to fraud at the financial statement level and the nature, timing and extent of audit procedures, and the linkage of those procedures with the assessed risks of material misstatement due to fraud at the assertion level; and b. The results of the audit procedures, including those designed to address the risk of management override of controls. 3. The auditor should document communications about fraud made to management, those charged with governance, regulators and others. 4. When the auditor has concluded that the presumption that there is a risk of material misstatement due to fraud related to revenue recognition is not applicable in the circumstances of the engagement, the auditor should document the reasons for that conclusion. CONSIDERATION OF LAWS AND REGULATIONS The effect on financial statements of laws and regulations varies considerably. Some entities operate in heavily regulated industries such as banks and chemical companies. Others are subject only to the many laws and regulations that relate generally to the operating aspects of the business such as those related to ‘occupational safety and health, and equal employment opportunity. Those laws and regulations to which an entity is subject constitute the legal and regulatory framework. Some laws or regulations have a direct effect on the financial statements in that they determine the reported amounts and disclosures in an entity's financial statements. Other laws or regulations are to be complied with by management or set the provisions under which the entity is allowed to conduct its business but do not have a direct effect on an entity's financial statements. 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. NON-COMPLIANCE Non-compliance (previously referred to as illegal acts) pertains to acts of ‘omission or commission, intentional or unintentional, committed by the entity, ‘or by those charged with governance, by management or by other individuals | working for or under the direction of the entity, which are contrary to the prevailing laws or regulations. Non-compliance does not include personal | misconduct (unrelated to the business activities of the entity). ES Aim... Believe. Claim... Page 299Chapter 8 — Consideration of Fraud, Error, and Non-compliance Such acts include transactions entered into by, or in the name of, the enti “ on its behalf, by those charged with governance, management or employees Non-compliance does not include personal misconduct (unrelateg to business activities of the entity) by those charged with governance, Managemen or employees of the entity. Responsibility for the compliance with laws and regulations Itis the responsibility of management, with the oversight of those charged wis, governance, to ensure that the entity's operations are conducted in accordance with laws and regulations, including compliance with the provisions of laws ang regulations that determine the reported amounts and disclosures in an entitys financial statements. Consequently, the responsibility for the prevention and detection noncompliance rests with management and those charged with governance. The following policies and procedures, among others, may assist those charge! with governance and management in discharging its responsibilities for te 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. * Ensuring employees are properly trained and understand the Code Conduct. * Monitoring compliance with the Code of Conduct and at 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 with which the entity has ® comply within its particular industry and a record of complaints. In larger entities, these policies and procedures may be supplemented ® assigning appropriate responsibilities to: * Aninternal audit function. © Anaudit committee. * Acompliance function. Responsibilities of the Auditor The auditor is not, and cannot be held responsible enting noncor The fact that an anal audits carried out may, howe cer» dete Aim... Believe... Claim... LSChapter 8 — Consideration of Fraud, Error, and Non-compliance When considering laws and regulations, the objectives of the auditor are: Y To obtain sufficient appropriate audit evidence regarding compliance with the provisions of those laws and regulations generally recognized to have a direct effect on the determination of material amounts and disclosures in the financial statements; Y To perform specified audit procedures to help identify instances of noncompliance with other laws and regulations that may have a material effect on the financial statements; and ¥ To respond appropriately to non-compliance or suspected non- compliance with laws and regulations identified during the audit. In order to attain these objectives, the auditor shall consider and observe the following: L Overall objective of the audit An auditor conducting an audit in accordance with PSAs obtains reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. Inherent limitations of an audit in the context of fraud An audit is subject to the unavoidable risk that some material misstatements of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with PSAs. This risk is higher with regard to material misstatements resulting from noncompliance with laws and regulations due to factors such as: © 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 entity's information systems relevant to the audit. * Noncompliance may involve conduct designed to conceal it, such as collusion, forgery, deliberate failure to record transactions, senior management override of controls or intentional misrepresentations being made to the auditor. ‘© Much of the evidence obtained by the auditor is persuasive rather than conclusive in nature. © Whether an act constitutes non-compliance is ultimately a matter for legal determination by a court of law. Professional skepticism a The auditor should plan and perform the audit with an attitude of professional skepticism recognizing that the audit may reveal conditions or events that would lead to questioning whether an entity is complying with laws and regulations. Aim... Believe... Claim... Page 301Chapter 8 — Consideration of Fraud, Error, and Non-compliance GENERAL AUDIT PROCEDURES 1. Risk assessment procedures and related activities When planning and performing audit procedures and in evalua, reporting the results thereof, the auditor should recognin® * noncompliance by the entity with laws and regulations may Material the financial statements. However, an audit cannot be expecteg tod noncompliance with all laws and regulations. In order to plan the audit, the auditor should obtain a general under. of the legal and regulatory framework applicable to the entity industry and how the entity is complying with that framework, stand and ne To obtain the general understanding of laws and regulations, the would ordinarily: © Use the existing knowledge of the entity's industry and business, * Inquire of management concerning the entity's policies and Procedures regarding compliance with laws and regulations. * Inquire of management as to the laws or regulations that may ie expected to have a fundamental effect on the operations of the enti, * Discuss with management the policies or procedures adopted fa identifying, evaluating and accounting for litigation claims ad assessments. © Discuss the legal and regulatory framework with auditors of subsidiaries in other countries (for example, if the subsidiary is required to adhereto the securities regulations of the parent company). Udit, After obtaining the general understanding, the auditor should perfom procedures to help identify instances of noncompliance with those laws and regulations where noncompliance should be considered when preparit financial statements, specifically: ‘* Inquiring of management as to whether the entity is in compliance wit such laws and regulations. © Inspecting correspondence with the relevant licensing or regulsto authorities. 2. Further audit procedures i The auditor should obtain sufficient appropriate audit evidence reg compliance with those laws and regulations generally recognized © auditor to have a direct effect on the determination of material amount’ disclosures in financial statements. Aim... Believe... Claim...Chapter 8 - Consideration of Fraud, Error, and Non-compliance During the audit, the auditor should be alert to the fact that procedures applied for the purpose of forming an opinion on the financial statements may bring instances of possible noncompliance with laws and regulations to the auditor's attention. Examples of instances indicating possible non-compliance are provided at Appendix C of this book. 3. Management representations The auditor shall request management, and where appropriate, those charge with governance, to provide written representations that all known actual or possible noncompliance with laws and regulations whose effects should be considered when preparing financial statements have been disclosed to the auditor. AUDIT PROCEDURES WHEN NON-COMPLIANCE IS IDENTIFIED OR SUSPECTED When the auditor becomes aware of information concerning a possible instance of noncompliance, the auditor shall perform the following procedures 1. The auditor shall obtain: ¥ An understanding of the nature of the act and the circumstances in which it has occurred ¥ Sufficient other information to evaluate the possible effect on the financial statements. 2. If the auditor suspects there may be non-compliance, the auditor shall discuss the matter with management and, where appropriate, those charged with governance. The purpose of this is to obtain sufficient information that supports that the entity is in compliance with laws and regulations when, in the auditor's judgment, the effect of the suspected noncompliance may be material to the financial statements. ¥ if management or, as appropriate, those charged with governance do not provide sufficient information the auditor shall consider the need to obtain legal advice. ¥ If sufficient information about suspected non-compliance cannot be obtained, the auditor shall evaluate the effect of the lack of sufficient appropriate audit evidence on the auditor's 3. The auditor shall evaluate the implications of non-compliance in relation to other aspects of the audit, including the auditor's risk assessment and the reliability of written representations, and take appropriate action, Aim... Believe... Claim... — Page 303Chapter 8 ~ Consideration of Fraud, Error, and Non-compliance 4, The auditor may discuss the findings with those cl aree with g 7 where they may be able to provide additional audit evidence. For ¢, why the auditor may confirm that those charged with governance haye the an understanding of the facts and circumstances relevant to transact) 7 events that have led to the possibility of non-compliance with laws ~ regulations. REPORTING OF NONCOMPLIANCE To Those Charged with Governance Unless all of those charged with governance are involved in management of, entity, the auditor shall communicate with those charged with over, Matters involving non-compliance with laws and regulations that come to auditor's attention during the course of the audit, other than wher n the Matters are clearly inconsequential, If, in the auditor's judgment, the non-compliance referred is believed to be intentional and material, the auditor shall communicate the Matter to those charged with governance as soon as practicable. If the auditor suspects that management or those charged with governance are involved in non-compliance, the auditor shall communicate the matter to the next higher level of authority at the entity, if it exists, such as an audit committee or supervisory board. Where no higher authority exists, or if the auditor believes that the communication may not be acted upon or is unsure as to the personto whom to report, the auditor shall consider the need to obtain legal advice. Moreover, in certain cases, communication with management or those charged with governance may be restricted or prohibited by law or regulation, Example (lifted from PSA 250 Revised) Y — Tipping-off provisions that ‘might prejudice an investigation by an appropriate authority into an actual, or suspected, non-compliance. In the Auditor's Report on the Financial Statements The following are the possible effects of Non-compliance in the auditor's report 1. Ifthe auditor concludes that the non-compliance has a material effect onthe financial statements, and has not been adequately reflected in the financil statements, the auditor shall express a qualified or adverse opinion onthe financial statements, Ifthe auditor is precluded by management or those charged with govern" from obtaining sufficient appropriate audit evidence to evaluate whe" ‘ noncompliance that may be material to the financial statements has, % likely to have, occurred, the auditor Shall express a qualified opinio® disclaim an opinion on the financial statements, Aim... Believe... Claim. <<chat The auditor may conclude that withdrs necessary when the entity does not take th considers necessary in the circumstances, not material to the financial statements, ‘awal from the engagement is 'e remedial action that the auditor even when the non-compliance is to Regulatory and Enforcement Authorities if the auditor has identified or suspects Non-compliance with laws and regulations, the auditor shall determine whether the auditor has a responsibility to report the identified or suspected non-compliance to parties outside the entity. Although the auditor's professional duty to maintain the confidentiality of client information may ordinarily preclude such reporting, the auditor's legal responsibilities may override the duty of confidentiality in some circumstances. Communication to an appropriate authority outside the entity may be required or appropriate in the circumstances because of the following conditions: 1. Law, regulation or relevant ethical requirements require the auditor to report; Examples (lifted from PSA 250 Revised) Y In some jurisdictions, statutory requirements exist for the auditor of a financial institution to report the occurrence, or suspected occurrence, of non-compliance with laws and regulations to a supervisory authority. Y— Misstatements may arise from non-compliance with laws or regulations and, in some jurisdictions, the auditor may be required to report misstatements to an appropriate authority in cases where management or those charged with governance fail to take corrective action. 2. The auditor has determined reporting is an appropriate action to tespond to identified or suspected non-compliance in accordance with relevant ethical requirements; or Example (lifted from PSA 250 Revised) Y The Code of Ethics for Professional Accountants requires the auditor to identi red non-compliance with laws. take steps to respond to identified or suspects com and reguiations and determine whether further action is needed, which may include reporting to an appropriate authority outside the entity. tfthis isthe cave, such reporting would not be considered a breach of the duty of confidentiality. Pe ere ara a Believe... Claim.of Fraud, Error, and Non-compliance Chapter 8 - Consideratio’ fevant ethical requirements provide the : 3. Law, regulation or re with the right to do so. / Example (lifted from PSA 250 Revised) oe samen auditing the financial statements of financial inst, Wor may have the right under aw oF regulation to discuss mat ed non-compliance with laws and regia *h With Ut, auditor as identified or suspect a supervisory authority, To Other Auditor 7 cat The auditor shall consider the necessity of ‘communi cating identifieg . suspected non-compliance with laws and regulations to other auditors (eg. in an audit of group financial statements. To Proposed Auditor 7 On receipt of an inquiry from the proposed auditor, the existing auditor shoulg advise whether there are any professional reasons why the proposed auditor should not accept the appointment or engagement. The extent to which ay existing auditor can discuss the affairs of a client with a proposed auditor wi) depend on whether the client's permission to do so has been obtained andjcr the legal or ethical requirements that apply relating to such disclosure. DOCUMENTATION The auditor shall include in the audit documentation identified or suspected non- compliance with laws and regulations and: The audit procedures performed, the significant professional judgments made and the conclusions reached thereon; and The discussions of significant matters related to the non-compliance with management, those charged with governance and others, including how management and, where applicable, those charged with governance have responded to the matter, v The auditor's documentation of findings regarding identified or suspected no compliance with laws and regulations may include, for example: Y Copies of records or documents, 7 Minutes of discussions held with management, those charged wit governance or parties outside the entity. Furthermore, law, regulation or relevant ethical requirements may also set additional documentation requirements regarding identified or suspected " compliance with laws and regulations, Aim... Believe... Clai pags |Consideration of Fr, . ter 8 ‘aud, Erroy OmNPTER 8: SELF-TEST EXERCISES |" "4 Non-compliance “sCUSSION QUESTIONS pifferentiate error from fraud and cite rel What are the two types of fraug tian examples, el statements? evant to the audit of financial . How do attitude, character and ethical va) dishonest act? alues relate to the commission of a why is it important that management ani place emphasis on fraud prevention? 1d those charged with governance why is there an unavoidable risk t! Sen may not be detected by theveuran imsstatements resting from What can be the probing questions 5 members during fraud brainstorming mF deme eneeeinent tear 7, How do fraud risk factors relate to the auditor's risk assessment procedures? 8. What are some audit procedures that are designed to address fraud at the financial statement and assertion levels? 9, What are the required communications to those charged with governance and regulatory and enforcement authorities relating to fraud? 10. What are the responsibilities of the auditor relating to non-compliance with relevant laws and regulations? > 8-1 TRUE OR FALSE 1, The intention over an underlying action is the distinguishing factor between fraud and error. 2. Engaging in complex transactions may create pressure on employees that may lead to misappropriation of assets. 3. Rationalization of a fraudulent act occurs when an individual thinks that internal control can be overridden through knowledge of specific weaknesses in internal control. 4. The primary responsibility for the prevention of fraud is given to management while its detection rests with those charged with governance. 5. Fraud prevention and fraud deterrence are responsibilities of the management, with the oversight of those charged with governance. jing fraud is the identification and nt arising from fraud. One of the objectives of the auditor regard! assessment of risks of material misstateme!Chapter 8 - Consideration of Fraud, Error, and Non-compliance 7 ae risk of not detecting a material misstatement resulting from, a : higher than the risk of not detecting a material misstatement "eSuting in Mh fraud. 8, The auditor should make inquiries to management as to their assess, ENE o the risk that the financial statements may be materially misstateg ! . iti t indicate the . 9, Fraud risk factors are events or conditions tha Fatlonalizatony a fraudulent act. 10. Inassessing the risks of material misstatement due to fraud, the AUdItOF Uses professional judgment. 8-2 TRUE OR FALSE 1, Responses to risks of material misstatement due to fraud is only Assessed at the financial statement level as fraud always have pervasive effects, 2. In responding to management override of controls, the auditor performs tests of journal entries, review of accounting estimates and understands unusual business transactions. 3. Written representations from management relating to their responsibilty ‘over fraud would lead to less extensive of audit procedures to address risks of material misstatements arising from fraud. 4. Exceptional circumstances that affect the continuance of the audit include concerns over the competence and integrity of management or those charged with governance. 5. Normally, the appropriate level of management for communication of suspected fraud is at least one level higher than the parties involved. 6. When the auditor identifies fraud involving management, the auditor has@ professional duty to report such fraud to regulatory authorities. 7. If the auditor rebuts the presumption of risk of material misstatement due to fraud on revenue recognition, the auditor should document the reas0ts for such conclusion. 8. One of the similarities of fraud and non-compliance is that they are both intentional acts, 9. The responsibility for the prevention and detection of noncompliance ®* with the shareholders of a corporation. 10. Monitoring of compliance of employees with the Code of Conduct is on the ways in preventing noncompliance with laws and regulations. Aim... Believe... Claim... paseConsideration of Fraud, Error, a veTror, and Non ti lon-com fr the responsibllies of the audit committee include eee reporting, MonItoring Of Accounting policies ang Gg Warticht of fnancta mitigate risks with management, iscussion of policies to papter ° ‘The anaudit committee must consist of outs) 32. mpany's president. ide directors and is headed by the f annual ext i performance 0! lernal audits are n : Penagement prevent or detect fraud or suspected fayar = > which when non-compliance is identified or Suspected, the audit , the au i matter with management or those charged with gover aed discuss the « snificant related-party transactions th in 1s. ie 2 nsi at are not in the ordi business with unaudited entities may be considered a Hie ad “ g-3 MULTIPLE CHOICE QUIZZERS 4, Which ISA deals with the auditor's responsibility relating to fraud in an audit of financial statements? ‘A, 15A.200 C.ISA 250 5. ISA 240 D. ISA 330 2. The types of intentional misstatements relevant to the auditor arise from AccrnBgyE -D No Yes No Yes Error Mistake No No No Yes Fraudulent financial reporting No No Yes No Misappropriation of assets No Yes Yes No 3, The primary responsibility for the prevention and detection of fraud rests with ‘A. Those charged with governance of the entity 8. Management C. BothAandB D. None of the above —— << ee '~ Believe... Claim...“compliance i Error, and Non-comp! Chapter 8 ~ Consideration of Fraud, ¢ " 4. a auditor conducting an audit in accordance with PSAs is TeSPonsibje for A. Obtaining reasonable assurance that the financial statements taken , whole are free from material misstatement, whether causeq bY misty, or error. B. Obtaining reasonable assurance that the financial statements taken a, whole are free from misstatement, whether caused by fraud or error, C. Obtaining reasonable assurance that the financial statements taken a, whole are free from material misstatement, whether caused by fraud, error. D. Obtaining reasonable assurance that the financial statements taken aa whole are free from misstatement, whether caused by fraudulen financial reporting or misappropriation of assets or both, 5. Which of the following statements is/are correct? |. The risk of not detecting a material misstatement resulting from fraudis higher than the risk of not detecting one resulting from error. Collusion may cause the auditor to believe that audit evidence is Persuasive when it is, in fact, true. Il" The risk of the auditor not detecting a material misstatement resulting from management fraud is greater than for employee fraud Only one statement is correct C.All statements are correct Only two statements are correct D. All statements are incorrect 6. Which of the following statements are true? L The level of risk of management Override of controls will vary from entity to entity Ul.” The risk of management override is present in all entities I. Management override of controls is a risk due to fraud IV. Management override of controls is a significant risk A LIV Civ B. tu D. All statements are true itor under law, reguiation or releva" Ntity’s non-compliance with laws lude the following except: ant Suspected non-compliance with laws Additional responsibilities of the aud ethical requirements regarding an e: regulations, including fraud, may inch A. Responding to identified or regulations Disclosure of identified OF suspects Communicating identified o i ith las regulations to other ne veered a 0. Documentation req compliance with laws and regular 8 ed non-compliance, including 10% oe wirements regarding identified or suspected tions. Tir Boe CagChapter 8 — Consideration of Fraud, Error, and Non-compliance ; inancial 8. The objectives of the auditor relating to fraud in an audit of financi statements include the following, except ; A. To identify and assess the risks of material misstatement of the financial statements due to fraud 8. To obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatement due to fraud, through designing and implementing appropriate responses . To establish internal controls that are designed to prevent or detect risks of material misstatement due to fraud D. To respond appropriately to fraud or suspected fraud identified during the audit. 9. The auditor shall make inquiries of management on the following fraud- related matters, except ‘A. Management's assessment of the risk that the financial statements may be materially misstated due to fraud, including the nature, extent and frequency of such assessments 8. Management's process for identifying and responding to the risks of fraud in the entity, including any specific risks of fraud that management has identified or that have been brought to its attention, or classes of transactions, account balances, or disclosures for which a risk of fraud is likely to exist C. Management's communication, if any, to those charged with governance regarding its processes for identifying and responding to the risks of fraud in the entity D. Management's communication, if any, to customers and suppliers regarding its views on business practices and ethical behavior. 10. In relation to fraud in an audit of financial statements, required to be performed by the auditor, except A. Identify and assess the risks of material misstatement due to fraud at the financial statement level B. Identify and assess the risks of material misstatement due to fraud at the at the assertion level for classes of transactions, account balances and disclosures C. Presume that there are risks of fraud in revenue recognition D._ Treat risks of material misstatement due to fraud as high risks and obtain an understanding of the entity's related controls relevant to such risks the following are Page 311- tion of Fraud, Error, and Non-compliance - a dccrmiyn oval responses to address the assessed TiSkS Of may misstatements due to fraud at the financial statement level, the auditor ing, except ern and supers petsonnel taking account of the knowledge and ability of the individuals to be given significant engage responsibilities and the auditor’s assessment of the risks of mat misstatement due to fraud B. Obtain the general ledger listing of the entity and make Selections g journal entries exhibiting fraudulent characteristics C. Evaluate whether the selection and application of accounting Policies by the entity may be indicative of fraudulent financial reporting resutig from management's effort to manage earnings; and D. Incorporate an element of unpredictability in the selection of the nature timing and extent of audit procedures rig shal Skil Ment teria 12. The auditor's responses to address the assessed risks of materia misstatement due to fraud at the assertion level may include changing the nature, timing and extent of audit procedures in the following ways, except A. The nature of audit procedures to be performed may need to te changed to obtain audit evidence that is more reliable and relevant B. The auditor may conclude that performing substantive testing at or nea the period end better addresses an assessed risk C. The extent may vary by increasing sample sizes D. The auditor moves away from the use of computer-assisted auit techniques as fraud is, more often than not, perpetuated manually 13. Management is in a unique position to perpetuate fraud because of the ability to A Bp oc P Manipulate accounting records Yes No Yes No Override controls that otherwise appear to Yes No Yes Y% be operating effectively Set the tone at the top Yes Yes No N Create incentives or pressures jo 8 pease for Yes Yes Ne 14. The audit procedures designed to a address the ri ment ov" of controls should include the following, a a a A. Test of journal entries eee B. Review of accounting estimates C. Prospective review of mai D. Evaluation of significant nagement judgments and assumptions and unusuat business transactionsChapter 8 - Consideration of Fraud, Error, and Non-compliance 15. If the auditor’s ability to continue the engagement is questioned as a result of a misstatement arising from fraud, the auditor shall do the following except A. Determine the applicable professional and legal responsibilities B. Report the matter to regulatory authorities C._ Consideration of withdrawal from engagement D. Discuss with the appropriate level of management and those charged with governance the auditor’s withdrawal from the engagement 8-4 MULTIPLE CHOICE QUIZZERS 1. Which of the following most accurately summarizes what is meant by the term “material misstatement”? A. Fraud and direct-effect illegal acts 8. Fraud involving senior management and material fraud C. Material error, material fraud and certain illegal acts D. Material error and material illegal acts 2. Misstatement in the financial statements can arise from the 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 I. Rational or irrational A. lonly C. Both | and I B. tlonly D. Neither | nor Il 3. “Error” includes A. Engaging in complex transactions that are structured to misrepresent the financial position or financial performance of the entity. 8. Concealing, or not disclosing, facts that could affect the amounts recorded in the financial statements. C. An incorrect accounting estimate arising from oversight or misinterpretation of facts. D. Intentional misapplication of accounting policies relating to amounts, classification, manner of presentation, or disclosure. 4. Which of the following acts are considered fraud? 1. Changing of records and documents 1. Misinterpretation of facts Ill. Misappropriation of assets IV. Recording of transactions without documentation V. Clerical mistakes A. land ilonly C.1, Iiland IV only 8. IMonly D.1, Ht, Vand Vv SS Aim... Believe... Claim. Page 313iderati id, Error, and Non-compliance = Consideration of Fraud, N e te a responsibility for the prevention and detection of fa, with A. The auditor ft B. Management of the entity : C. Those charged with governance of the entity — D. Both those charged with governance ofthe entity and managemn Fes, 6. Which of the following statements concerning fraud is incorrect? A. Fraud generally involves incentive or pressure to commit frau, , perceived opportunity to do so, and some rationalization Of the act, B. Two types of misstatements relevant to the auditor include Materig misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets. C. Fraud involves actions of management but excludes the Actions of employees or third parties. D. An audit rarely involves the authentication of documentation; thus, fraud may go undetected by the auditor. Mater, 7. Which of the following statements is correct? A. Errors in the financial statements can be ignored because they are intentional. 8. Errors in the financial statements require adjustment of the clients accounting records. C. Fraud requires attention of the auditor, but errors do not. D. Fraud has serious implications only because of their monetary effect on the financial statements. 8. Fraudulent financial re Porting involves intentional misstatements including omissions of amounts or disclosures in financial statements to deceive ment users. It may be accomplished in a number of ways, including A. Embezzling receipts, Stealing physical assets or intellectual Property B. C. Usingan entity's assets for Personal use, D. Manipulation, falsification, Supporting documentation prepared. or alteration of accounting records from which the financial statements #*Chapter 8 - Consideration of Fraud, Error, and Non-compliance 9, Which of the following statements best describes an auditor's respor 10. 2 1 1. 8 sibility regarding misstatements? A. An auditor should obtain absolute assurance that material misstatements in the financial statements will be detected. B. An auditor should obtain reasonable assurance that the financial statements taken as a whole are free from material misstatements, whether caused by fraud or error. C. An auditor is responsible to detect material errors but has no responsibility to detect material fraud that is concealed through employee collusion or management override of internal control. D. An auditor's failure to detect a material misstatement resulting from fraud is an indication of noncompliance with the requirements of the Philippine Standards on Auditing. ‘An auditor should recognize that the application of auditing procedures may produce evidential matter indicating the possibility of errors or irregularities and therefore should ‘A. Design audit tests to detect unrecorded transactions. B. Extend the work to audit most recorded transactions and records of an entity. C. Plan and perform the engagement with an attitude of professional skepticism. D. Not depend on internal accounting control features that are designed to prevent or detect errors or irregularities. Because of the risk of material misstatement, an audit of financial statements in accordance with PSAs should be planned and performed with an attitude of ‘A. Impartial conservatism. B. Professional skepticism. C. Independent integrity. D. Objective judgment. |. Which of the following statements is/are correct? Statement 1: The auditor is not and cannot be held responsible for the prevention of fraud and error. Statement 2: Annual audits carried out may not act as deterrent of fraud and error. A. Only statement 1 is correct C. Both statements are correct B. Only statement 2 is correct D. Both statements are incorrect Aim... Believe... Claim... Page 315y liance id, Error, and Non-comp! SS ideration of Fraud, i 13 When ieahe auditor responsible for Sao i ; id not result from collu: he : when aes are likely to rely on the client 's financial State, : Boece cient’: system of internal control is judged by the une . When inadequate. 7 D. when the application of generally accepted auditing standards Wouly have uncovered the fraud. 14. Which of the following conditions or events may create incentive/pressurs, to commit fraud? a A. Inadequate accounting system of authorization and approval y transactions. , B. Lack of mandatory vacations for employees performing key contr, functions. | C. Excessive pressure on management or operating personnel to meet, financial targets established by those charged with governance including sales or profitability incentive goals. D. Inadequate access controls over automated records. 15. The following are examples of fraud risk factors relating to misstatements arising from misappropriation of assets, except A. Inadequate segregation of duties or independent checks. B. Inadequate physical safeguards over cash, investments, inventory, fixed asset. C. Recurring negative cash flows fro: earnings and earnings growth, D. Adverse relationship between the ent Cash or other assets, susceptible to to employee compensation or ber M operating acti jes while reporting tity and employees with access t@ theft created by recent changes mae nefit plans,Chapter 8 — Consideration of Fraud, Error, and Non-compliance 2. Whether the auditor has performed an audit in accordance with PSA is determined by A. The adequacy of the audit procedures performed in the circumstances and the suitability of the auditor’s report based on the result of these procedures. B. The absence of material misstatements C. The absence of material errors D. The Securities and Exchange Commission Which of the following characteristics most likely would heighten an auditor’s concern about risk of intentional manipulation of financial statements? ‘A. Turnover of senior accounting personnel is low. B. Insiders recently purchased additional shares of the entity's stock. C. Management places substantial emphasis on meeting earnings projections. D. The rate of change in the entity’s industry is slow. ‘When planning the audit, the auditor should make inquiries of management. Such inquiries should address the following, except ‘A. Management's assessment of the risk that the financial statements may be misstated due to fraud. B. Management's process for identifying and responding to the risks of fraud in the entity. C. Management's consideration of how an element of unpredictability will be incorporated into the nature, timing, and extent of the audit procedures to be performed. D. Management’s communication, if any, to those charged with governance regarding its processes for identifying and responding to the risks of fraud in the entity. When conducting an audit, errors that arouse suspicion of fraud should be given greater attention than other errors. This is an example of applying the criterion of A. Reliability of evidence C. Risk B. Materiality D. Dual-purpose testing Opportunities to misappropriate assets increase when there are (select the exception) A. Large amounts of cash on hand or processed B. Inventory items that are small in size, of high value, or in high demand C. Known or anticipated future employee layoffs D. Easily convertible assets, such as bearer bonds, computer chips or diamonds Page 317- i ion of Fraud, Error, and Non-compliance Chapter reas eerinaton of financial statements a Ae de disclose fraud and other irregularities although their discovery tee Normal audit procedures are more likely to detect a fraud arising from, A. Failure to record cash receipts for services rendered B. Collusion on the part of several employees C. Forgeries on company checks D. Theft of inventories Sleneg 8. When the auditor’s regular examination leading to an opinion On the financial statement discloses specific circumstances that make him Suspect that fraud may exist and he concludes that the results of such fraud, if any, could not be so material as to affect his opinion, he should A. Make a note in his working papers of the possibility of a fraud of immaterial amount so as to pursue the matter next year. B. Reach an understanding with the client as to whether the auditor othe client, subject to auditor's review, is to make the investigation necessay to determine whether fraud has occurred and, if so, the amount thereof C. Refer the matter to the appropriate representatives of the clients with the recommendations that is to be pursued to a conclusion. D. Immediately extend his audit procedures to determine if fraud has occurred and, if so, the amount thereof. 9. Which of the following statements describes why a properly designed and executed audit may not detect a material fraud? A. Audit procedures that are effective for detecting unintentional misstatements may be ineffective for an intentional misstatement thit is concealed through collusion, B. An audit is designed to provide feasonable assurance of detectiré bil errors, but there is no similar responsibility concerning mate raud. ©. The factors considered in assessing control risk indicated an ince risk of intentional misstatements, but only a low risk of unintentiom errors in the financial Statements, D. The auditor did not consider factors influencing audit risk for acout balances that have Pervasi - ive effe fi a Peete fects on the financial statem' A. It is usually easier for the audit cit Mee “a auditor to uncover errors than irregular , irregularities,” “cult for the auditor to uncover & D. None of the given statements is Correct. Aim... Believe... Claim, a6e? : 4\ Chapter 8 - Consideration of Fraud, Error, and Non-compliance 11, When an independent auditor's examination of financial statements ‘ discloses special circumstances that make the auditor suspect that material errors and irregularities may exist, the auditor's initial course of action should be to A. Recommend that the client pursue the suspected fraud to a conclusion that is agreeable to the auditor. B, Extend normal audit procedures in an attempt to detect the full extent of the suspected fraud. C. Reach an understanding with the proper client representative as to whether the auditor or client is to make the investigation necessary to determine if a fraud has in fact occurred. D. Decide whether the fraud, if in fact it should exist, might be of such a magnitude as to affect the auditor’s report on the financial statements. 12, Which of the following is correct concerning the required documentation in the working papers of the performance of the assessment of the risk of 1 material misstatements due to fraud? t A. All risk factors considered should be documented and the response to each documented. i B. Those risk factors identified and the auditor's response to them should be documented. C. The major categories of risk factors must be identified, but the particular 1 responses to risk factors identified need not be documented. D. No specific documentation is required. 13. It refers to acts of omission or commission by the entity being audited, either intentional or unintentional, which are contrary to prevailing laws or regulations. A. Noncompliance C.Deplorable acts 8. Illegal acts D. Unforgivable acts 14. A violation of laws or governmental regulations by the audited entity or its management or employees acting on behalf of the entity is called A. Anerror C. Fraud B. Anillegal act D. Fraudulent financial reporting Aim... Believe... Clair ———<< Page 319compliance Chapter 8 ~ Consideration of Fraud, Error, and Non-compliance 15, 8- 1. 2. The following statements relate to Vio tides charged ; th statemen, resulting from fraud to management and to tho: Bed wi Bovernang i 2 / nn ontior need not bring to the attention of those Chargeq with governance, any material weaknesses in internal control relate to the Prevention and detection of fraud. 7 8. If the auditor has identified a fraud, whether or not it results ina misstatement in the financial statements, the auditor communicate these matters to the appropriate level of mana, a timely basis, and consider the need to report such matte; charged with governance. C._ If the auditor has obtained evidence that indicates that fraud may exit (even if the potential effect on the financial statements would Rot be material), the auditor should communicate these appropriate level of management on a timely basis, a Need to report such matters to those charged with gov The auditor's communication with thos. be made orally or in writing. Materia) Shou) IBEMent on TS to those Matters to the ind consider the fernance. e charged with governance may 6 MULTIPLE CHOICE QUIZZERS According to PSA 250, “Consideration of Laws and Regulations in an Audit of Financial Statements’, the following are indications that noncompliance may have occurred, except A. Investigation by government departments or Payment of fines o penalties. B. Management is dominat no effective oversight by C. Unauthorized transacti D. Purchasing at prices si ‘ed by one person or a small group and there's oard or committee, ‘ons or improperly recorded transactions. ignificantly above or below market price. In order to plan the audit, the auditor shou of the legal and Id obtain a general understanding regulatory framework y applicable to the entity and ie industry and how the entity is complying with that framework, To obtain understanding, the following procedures would ordinarily be considered the auditor, except A. Use the existing understandin ity's i a 1B of th latory other external factors, = es B. Inquire of management concerning the entity's policies and proces regarding compliance with laws and Tegulations, C. Inquire of Management a:Chapter 8 - Consideration of Fraud, Error, and Non-compliance 3, When an auditor becomes aware of a possible illegal act by a client, the auditor should obtain understanding of the nature of the act to A. Increase the assessed level of control risk. 8. Evaluate the effect on the financial statements. C._ Recommend remedial actions to the audit committee. D. Determine the reliability of management's representations. 4. Ifthe auditor concludes that the noncompliance has a material effect on the financial statements, and has not been properly reflected in the financial statements, the auditor should express ‘A. Adisclaimer of opinion 8. A qualified or an unqualified opinion C. Aqualified opinion or an adverse opinion D. A qualified opinion or a disclaimer of opinion 5. An auditor who discovers that client employees have committed an illegal act that has a material effect on the client’s financial statements, most likely would withdraw from the engagement if A. The illegal act is a violation of generally accepted accounting principles. B. The client does not take the remedial action that the auditor considers necessary. C. The illegal act was committed during a prior year that was not audited. D. The auditor has already assessed control risk at the maximum level. 6. An auditor concludes that a client has committed an illegal act that has not been properly accounted for or disclosed. The auditor should withdraw from the engagement if ‘A. Auditor is precluded from obtaining sufficient competent evidence about the illegal act. B. Illegal act has an effect on the financial statements that is both material and direct. C. Auditor cannot reasonably estimate the effect of the illegal act on the financial statements. D. Client refuses to accept the auditor's report as modified for the illegal act. 7. According to PSA 260, those matters that arise from the audit of financial statements and, in the opinion of the auditor, are both important and relevant to those charged with governance in overseeing the financial reporting and disclosure process are called Auditor's findings Significant audit matters Audit matters of governance interest Material misstatements in the statements A. B. ¢ D. Page 321,Chapter 8 ~ Consideration of Fraud, Error, and Non-compliance / 8. Which of the following statements relating to communicatio, . i is incorrect? matters of governance interest is A. Audit matters of governance interest include only those Matte have come to the attention of the auditor as a result of the Perfo, of the audit. : 8. In an audit in accordance with PSAs, the auditor should desi 7 Procedures for the specific purpose of identifying matters of Bovernan, interest. C. The auditor should identify relevant persons who are char Bovernance and with whom audit matters of governance inte, be communicated. : D. The auditor's communications with those charged with Bovernance may be made orally or in writing. OF aug TS thay Many reed with TESt are ty 9. Which of the following matters an auditor is ret entity's audit committee? A. The basis for assessing control risk below the maximum. 8. The auditor’s preliminary judgments about materiality levels. C. The justification for performing substantive procedures at interim dates D. The process used by management in formulating sensitive accountng estimates. quired to communicate to the 10. Should an auditor communicate the following matters to an audit committee of a public entity? A Bc oD Significant audit adjustments recorded bythe entity Yes Yes No NO Management's consultation with other accountants about significant accounting matters Yes Yes Yes No 11. The auditor’s communication with those charged with governance may be made orally or in writing. The auditor's decision whether to communicate orally or in writing is affected by factors except: A. The nature, sensitivity and Significance of the audit matters governance interest to be communicated. B. The arrangements made with respect to periodic meetings or report"é of audit matters of Bovernance interest, C. The size, operating structure, | ications ’ » legal st mmunic Processes of the entity being a 82! structure and co ludited. D. The amount of past contact. and dialo, itor has with ho charged with Bovernance, ee eaeChapter 8 — Consideration of Fraud, Error, and Non-compliance 12. Which of the following statements is/are correct? Statement 1: The auditor should communicate audit matters of governance interest arising from the audit of financial statements with those charged with governance of an entity. Statement 2: The auditor should determine the relevant persons who are charged with governance and with whom audit matters of governance interest are communicated. A B. Only statement 1 is correct C. Both statements are correct Only statement 2 is correct D. Both statements are incorrect 13. Under PSA 260, “Communications of Audit Matters with Those Charged with Governance”, the effectiveness of communications is enhanced by developing a constructive working relationship between the auditor and those charged with governance. This relationship is developed while maintaining an attitude of A. B. a D. Objectivity and confidentiality Professional independence and confidentiality Loyalty and objectivity Professional independence and objectivity ‘14. Fraud includes all of the following except: A. B. x D. Recording of transactions without substance Suppression or omission of the effects of transactions from records or documents Mathematical or clerical mistakes in the underlying records and accounting data Misappropriation of assets 15. Which of the following is not an example of an error? A Entity personnel make mistakes in gathering or processing accounting data from which financial statements are prepared. Entity personnel alter accounting records from which financial statements are prepared. ‘ Entity personnel overlook or misinterpret facts, causing accounting estimates to be incorrect. : Entity personnel make mistakes in the application of accounting principles. 8-7 MULTIPLE CHOICE QUIZZERS ; 1. Fraud involving one or more members of management or those charged with governance is referred to as A B. Management fraud C. Employee fraud Fraudulent financial reporting __D. Misappropriation of assets cr! Aim... Believe... Claim... Page 323Chapter 8 — Consideration of Fraud, Error, and Non-compliance 2. Which of the following statements is/are correct? Statement 1: The responsibility for the prevention and detectio and error rests with the auditor through implementation of a internal control systems. Statement 2: The accounting and internal control si Possibility of fraud and error. A. Only statement 1 is correct C. Both statements are Correct B. Only statement 2 is correct D. Both statements are incorrect K Factors tha Porting? tr counting et YsteMs elimin "ate the Which of the following is least likely a category of fraud ris relate to misstatements, resulting from fraudulent financial rey A. Incentive or pressure B. Rationalization of the act C. Opportunity to commit the act D. Susceptibility of assets to misappropriation Opportunities to misappropriate assets increase when there are A. Known or anticipated future employee layoffs. 8. Promotions, compensation, or other rewards inconsistent with expectations. C. Recent or anticipated changes to employee compensation or beneft plans, D. Inventory items that are small in size, of high value, or in high demand. 5. Ifthe auditor has determined that there May be fraud that may have mated effect on the financial statements, all Of the following should be done excest A. Consider the implications for other aspects of the audit. B. Discuss the matter with the level of management where fraud mit have occurred. Try to obtain evidence to determine whether the fraud is material a what its effect will be ©n the financial statements. D. If appropriate, suggest that the client consult with legal counsel matters of law. 6. When the auditor believes that some mmittee and Ml. Seek legal advice Supervisory board, if any, A. only B. tlonly ©. Both! and 1 D. Neither | nor W Aim... Believe... ClaiChapter 8 — Consideration of Fraud, Error, and Non-compliance 7. The most likely explanation why the auditor's examination cannot reasonably be expected to bring all illegal acts by the client to the auditor's attention is that A. Illegal acts are perpetrated by management override of internal control. B. Illegal acts by clients often relate to operating aspects rather than accounting aspects. C. The client’s internal control may be so strong that the auditor performs only minimal substantive testing. D. Illegal acts may be perpetrated by the only person in the client's organization with access to both assets and the accounting records. 8. Which of the following statements is correct concerning an auditor's required communication with an entity’s audit committee? A. This communication should include disagreements with management about significant audit adjustments, whether or not satisfactorily resolved. B. If matters are communicated orally, it is necessary to repeat the communication of recurring matters each year. C. If matters are communicated in writing, the report is required to be | distributed to both the audit committee and management. D. This communication is required to occur before the auditor's report on the financial statements is issued. | | 9. The auditor shall obtain written representations from management and, where appropriate, for the following except A. They acknowledge their responsibility for the design, implementation and maintenance of internal control to prevent and detect fraud B. They have disclosed to the auditor the results of management's assessment of the risk of material misstatement due to fraud C. They have disclosed to the auditor their knowledge of fraud, or suspected fraud D. Allof the above 10. aoe of the following statements is/are correct? The auditor shall include in the audit documentation communications about fraud to management and those charged with governance Il. The auditor shall document the reasons for rebutting the presumption of risk due to fraud on revenue recognition Ill. The overall responses to the assessed risks due to fraud shall be documented A. Only one statement is correct —_C. All statements are correct B. Only two statements are correct D. All statements are incorrect Aim... Believe... Claim... Page 325Chapter 8 - Consideration of Fraud, Error, and Non-compliance 11. The auditor shall communicate with those charged with Bovernance identified or suspects fraud involving the following, except ‘A. Management B. Those charged with governance C. Employees with significant roles in internal control D. Others where the fraud results in a material misstatement heh 12. The auditor shall the document the following in relation to fraud in an aude of financial statements |, The significant decisions reached during the discussion ‘among the engagement team regarding fraud Nl. The identified and assessed risks of material misstatement due to fray at the financial statement level only A. lonly C. Both | and II B. Ilonly D. Neither | nor Il 13. If the auditor has identified or suspects a fraud, the auditor shall determine whether law, regulation or relevant ethical requirements prescribe the following: |. Require the auditor to report to an appropriate authority outside the entity. Establish responsibilities under which reporting to an appropriate authority outside the entity may be appropriate in the circumstances. A. lonly C. Both | and Il B. Nonly D. Neither | nor It 14. Fraud, whether fraudulent financial involves the following except A. High performance indicators B. Incentive or pressure to commit teporting or misappropriation of ass C. Perceived opportunity to dos? D. Rationalization of the act 15. Fraudulent financial reporting A. Manipulation, falsifi B. Misrepresentation information Forgery of supporting documentation Misapplication of. Accounting principles ing may be accomplished by the following, ication, alteration of accounting records othe! Of intentional omission of disclosures of c D. “Make your faith larger than your fears and your dreams bigger thant doubts.” ~ Robin Sharma End of Chapter