Teaching and Learning Activity

Module: Auditing Theory and Practice (HAUD230-1)

Week number (Date): 14
Unit covered: Unit 10 (Chapter 7)

Instructions:
To enrich your learning experience at Boston even further, and to ensure that you are exposed to a
variety of resources in this module, announcements will be posted every week containing additional
materials or activities for you to work through.

It is important to note that these activities are neither compulsory nor weighted, but that it will be to your
advantage to participate. The purpose of the activities is to help you better understand the content of
your weekly unit/s of study, and it will assist in creating insight and deeper meaning.

Activity 10 is based on Unit 10 (Chapter 7) of the prescribed courseware for this module.
Solution for activity 10:

Question 1

a) A misstatement is a difference between the amount, classification, presentation or disclosure of

a reported financial statement item and the amount, classification, presentation or disclosure that
is required for the item to be in accordance with the “applicable reporting framework”.
Misstatements can arise from error or misstatement.

b) Clearly trivial.

c)

• The financial statements are the responsibility of management and are in effect the
representations of the directors. Therefore, the auditor cannot insist that the misstatement be
corrected. The only “power” the auditor has is to give a modified audit opinion where the
misstatement remains uncorrected.

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 • There are several reasons that the directors may not correct the misstatement (remember as
explained in 1 above, the financial statements are theirs.)
o The directors may disagree that there is a misstatement; there is plenty of interpretation
and estimation which goes into amounts/disclosures in the financial statements and
directors and auditors may disagree, e.g. is an asset impaired or not? Is the classification
of a lease as a financial lease, valid?
o The directors may not regard the misstatement as material. In their opinion, not correcting
the misstatement would not influence a user.
o The directors may have ulterior motives. The directors may want to present a set of
financial statements which are more favourable than they should be and correcting a
misstatement may obstruct this intention.
o The directors may regard it as “too much hassle” to make the changes; the correction
may mean changing the income statement, notes, a consolidated set of financials,
supporting schedules, etc.
o The directors may just be unconcerned about receiving a qualified audit opinion.

d) i. This factor lends weight to the need for the correction to be made; it makes the misstatement
“more” material (important to users). The fact of the matter is that the company is reflecting
a profit, when in fact a loss has been made for the first time in 11 years. Users may be
influenced by this and should be aware of it – it should not be covered up. There is a
qualitative aspect to the misstatement which increases the need for the misstatement to be
made so that the financial statements fairly present the financial position of the company.

ii. Again this situation lends weight to the need for the correction to be made. The debt
covenant requirements are very important to the providers of the finance and in a sense they
are relying on the auditor to provide assurance that the requirements of the covenant are met
(they require audited financial statements). Although the quantitative element of
misstatement does not require adjustment to achieve “fair presentation”, the qualitative
element does.

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 iii. This is not a factor which in anyway lessens the materiality of the misstatement. It is in fact
the opposite, and makes it more important that the correction be made. There is a direct
consequence of allowing this misstatement to go uncorrected (invalid bonuses paid to the
very people responsible for the proper corporate governance of the entity). Furthermore,
important disclosures relating to directors’ remuneration will be misstated.

vi. The auditor cannot be influenced by the negative affect that “doing the right thing” (requesting
the correction of the misstatement and qualifying the audit report if it is not corrected) will
have. The fact that workers will strike is not a financial reporting problem, it is a labour
problem which management must deal with.

v. The fact that this is a factual inaccuracy about a related party contributes to the materiality of
the misstatements. Because of the non-independent nature of related party relationships
there is an increased risk of the occurrence of non-arm’s length transactions and users are
particularly interested in these relationships. Providing factually incorrect information may
be a deliberate attempt to disguise the true nature of a transaction.

(Chapter 7, 7/20 – 7/30)

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Question 2

1. The distinguishing factor is whether the underlying action that results in the misstatement of the
financial statements is intentional or unintentional.

2.1 The auditor is interested because the fraud may lead to material misstatement in the
financial statements on which the auditor is reporting.

2.2 Fraud discovered on the audit may also give rise to a reportable irregularity which will result
in a duty for the auditor to report in terms of the Auditing Profession Act 2005.

3. No, the auditor does not have a duty to report fraud to the police, in fact the auditor would be in
breach of the Code of Professional conduct if he did so, (the auditor reports to the management
or those charged with governance or to the IRBA, depending on the circumstances.)

4. As the terms suggest, management fraud is fraud committed by management or those charged
with governance, whilst employee fraud is fraud involving employees of the company. The
distinction is made because the manner in which the auditor proceeds will differ, e.g. with
management fraud, an external body (IRBA) may be contacted by the auditor, but with employee
fraud the auditor deals with management.

5. Fraudulent financial reporting

5.1 Manipulation or falsification of accounting records, e.g. including fictitious sales

5.2 Intentional omission of significant information, e.g. leaving out a large contingent liability

5.3 Intentional misapplication of accounting principles – recognizing contract revenue prematurely,

by claiming that the contract is 90% complete, when it is 30% complete

5.4 Engaging in complex transactions that are structured to misrepresent the financial position, e.g.
setting up fictitious joint ventures, associated companies, etc.

Misappropriation of assets

5.5 Embezzling receipts from debtors and writing off the accounts as bad debts

5.6 Stealing physical assets, e.g. inventory

5.7 Stealing intellectual property, e.g. selling company secrets to a competitor

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5.8 Getting the company to pay for goods or services not received, e.g. payments to fictitious
suppliers

5.9 Using company assets for personal use, e.g. using the company’s trucks to run a private delivery
service at weekends.

6. They have the primary responsibility for the prevention and detection of fraud, with the emphasis
on prevention (reducing opportunities for fraud) and deterrence. They are responsible for
creating a culture of honesty and ethical behaviour which can be reinforced by an active
oversight by those charged with governance.

7. The auditor’s general responsibility is to obtain reasonable assurance that material misstatement
is not present in the financial statements, whether it be as a result of fraud or error. Thus he
must plan and perform the audit in such a manner (with the intention) that all material
misstatements will be identified. There is the unavoidable risk that some material misstatement
may not be detected even if the audit is properly planned and performed. This is due to the
inherent limitations of the audit.

8. It is really a little bit of each. In terms of ISA 240, the auditor is required to assume an attitude
of professional skepticism recognizing that circumstances may exist that cause the financial
statements to be materially misstated due to fraud. The auditor does not let himself be “led
around by the nose” but at the same time does not adopt an aggressive “bloodhound” approach.
He must be guided by his risk identification and evaluation which he is required to carry out with
an attitude of professional skepticism.

9.1 Management override is any instance where a member of the management team
overrides a control which otherwise appears to be operating efficiently, e.g. applying the normal
control procedures relating to creditworthiness of a debtor, reveal that a sale should not be made
to a particular debtor. The financial manager overrides the control by authorizing the sale
(usually for unsound reasons for example, the customer is a friend or family member.)

9.2 Management override is important in relation to fraud, because internal controls are designed
(inter alia), to prevent fraud. If the control can simply be overridden, the risk of fraud occurring,
is significantly increased.

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10.1 Material misstatements of financial statements due to fraud, often involve manipulation
of the financial reporting process, by the passing of fictitious journal entries, so as to adjust the
accounts being manipulated or to hide the fraud.

10.2 Journal entries are also an easy way of effecting management override, i.e. the system
produces figure which have been subjected to controls, but management simply overrides the
controls by passing an adjusting journal entry to produce a fictitious desired result.

(Chapter 7, 7/30 – 7/42)

Question 3

1. Fraudulent financial reporting. Deliberate overstatement of assets.

2. Misappropriation of assets … Using the company’s assets for personal gain.

3. This may well be neither as the company itself does not appear to be losing anything (in fact
they appear to be gaining big discounts). It is a “bribe” outside of the company which will most
likely be a breach of the company’s employment rules, but as it stands there is neither
misappropriation from the company nor any fraudulent financial reporting.

4. Potentially fraudulent financial reporting but if the manner in which the transaction was
accounted for was in compliance with the accounting standards and appropriate, then there is
no problem.

5. Fraudulent financial reporting. The financial director is deliberately misleading users of the
financial statements by omitting what is clearly important information. The fact that he kept
relevant information from the auditors confirms this. Because it may be “harmful to the company”
does not mean that the disclosure requirement falls away. Intentionally omitting, obscuring or
misstating disclosures required by IFRS, or which are necessary to achieve fair presentation, is
considered by ISA 240 to be fraudulent financial reporting.

6. 6.1 This amounts to a bit of both. In a sense the cash from scrap is being misappropriated
(not accounted for in the company’s bank account) but it is also being used for the benefit of the
company’s employees.

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6.2 Obviously management approves, so there is a bit of a question as to why the money is not
accounted for in the records. This would “legitimize” the practice and is an easy thing to do.

6.3 Although the financial statements will be misstated at 31 October it does not appear to be a
deliberate intention to deceive users.

6.4 Another consideration is the question of taxation payable. The proceeds from the sale of scrap
is taxable, so in a sense the failure to declare the income and not pay the taxation due could be
viewed as fraudulent financial reporting. This situation would certainly be of interest to the
auditor and a full explanation from the directors should be sought as there is something
suspicious/risky going on!

7. Fraudulent financial reporting. It is not clear what incentive the financial director had to overstate
sales revenues. He may not have had specifically fraudulent intentions but the fact remains that
he has prepared AFS which include “fictitious” sales, overstated profits and overstated accounts
receivable. It is most unlikely that this pre-invoicing was an “honest” mistake.

8. Misappropriation of assets. Theft of inventory for which the company will pay (but has never
received). Supplier, warehouse manager and administration clerk will share the proceeds of
their collusion.

(Chapter 7, 7/30 – 7/42)

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