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AAA – BY KASHIF KAMRAN

LECTURE 5- BLOCK 1
Topic 4: Auditor and fraud
Objective: Auditor and fraud
Learning outcome:

 You will understand- the split of management and auditor responsibilities for fraud
 You will also understand- how the auditor should plan and perform the audit realizing the fact that the
FS could be materially misstated
 Practice of past paper- understand the exam rigor.
Earning management / window dressing of FS/ massaging the figures/ fraudulent financial reporting/
creative accounting

 Risk of management bias in manipulating the FS to present better results to shareholder. This risk is
linked with management rewards and bonus ( self –interest)
 Earning management =
o Deliberate misstatement
o Falsification of accounting records
o Intentionally breaching an accounting standard
o Knowingly omitting a:
 Disclosure
 Transaction
 ISA-240(R)- Incentive or pressure to commit fraudulent financial reporting / earning management can
come from sources inside and outside the entity
o Inside the entity- target set at the start of the year becomes pressure for management if actual
results are far away from target. Normally the last quarter of the financial year is risky for earning
management.
o Outside the entity- (Listed entity- the pressure comes from stock market expectations) and
normally these expectation from stock market add pressure on the board of directors to present
better results to meet the expectation.
 In times of economic recession or economic downturn, there is an opportunity for earning management.
For e.g. lots of company in economic recession can face material uncertainties relating to going concern
but the management will deliberately omit disclosure relation to the uncurtaining from the FS to
present a better picture of company
EXAMPLE: ALPHA COMPANY
There is an economic recession. The sales of the company has gone down by 5.8% over the last year. The
company has lost several customer contracts as a result of economic recession.
Is there a risk that revenue could be misstated?
Thinking point- (this is the way the auditor should think!)- What if the decline in sales is more that 5.8% and
the management has fabricated to show a decline of just 5.8%.? Is the sales overstated? Yes could be.
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How should the auditor respond to earning management? – Auditor responsibilities for fraud.

 Management is primarily responsible for preventing and detecting a fraud be ensuring effective
internal controls in place including the internal audit department.
 Auditor is not responsible to prevent a fraud! However the fact that an annual audit will be carried
might work as a deterrence (Fear) for management.
 However, auditor should plan and perform the auditor with an attitude of professional skepticism
realizing the fact that the financial statements could be material misstated (earning management).
 The auditor has limitation – namely, audit is done on sample basis and auditor focuses on material aspects
of financial statement and also has a time pressure.
Auditor responsibilities for responding to fraud!
1. Use of professional scepticism
2. Discussion among engagement team- this is planning meeting whereby the partner/ manager
discussed the key areas of FS where risk is high so that the team is mentally alert before the start of
audit where to focus on.
3. Evaluate the accounting policies- to ensure that accounting policies are in line with IAS/ IFRS and there
is no breach with the relevant standards.
4. Completeness of disclosures- auditor should carefully evaluate the notes to the financial statements to
ensure complete disclosure required by financial reporting standard and applicable national laws are
given.
5. Communication to TCWG- if there auditor identifies any material misstatement / breach of standard etc.
the auditor should on a timely basis communicate the matter to Audit committee and then to the Board
of directors so that an action can be taken to rectify the issue. ( Question management integrity)
6. Audit report- the auditor should consider the implication of an unresolved misstatement on the audit
report
7. Other reporting requirement – the auditor should also communicate any fraud in the FS/ or any
misstatement in the FS to the relevant national authority if that is required by the national laws
Student note – Read article- massaging the figure to have excellent knowledge of exam paper
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Past papers
June 16- Q3a
3 (a) According to ISA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements:
‘When identifying and assessing the risks of material misstatement due to fraud, the auditor shall, based on a
presumption that there are risks of fraud in revenue recognition, evaluate which types of revenue, revenue
transactions or assertions give rise to such risks.’
Required:
Discuss why the auditor should presume that there are risks of fraud in revenue recognition and why ISA
240 requires specific auditor responses in relation to the risks identified. (7 marks)

Why auditor should presume there is a risk of fraud in revenue recognition? – 2 marks to discuss each !
Presumption
 Revenue is the top line of income statement and any manipulation in the top line will have a trickle-
down effect on the profitability so it is easier for management to manipulate revenue for window
dressing the financial statement (2)
 Because the revenue recognition criteria can be wrongly applied and revenue can be recognized early
even when performance obligation is not met which will overstate the revenue (2)
 The number of transactions within revenue throughout the year is significantly higher which means the
management can easily use the volume of transaction within the sales ledger, to create fictitious
transaction or falsification of records to overstate revenue (2)
 Most of the time management rewards or bonuses are linked with sales growth and market share and
this also increase the chances of fraud of revenue (2)

Why ISA 240 requires specific responses in relation to risk? – 2 marks for each why!

 So that the auditor may detect a material misstatement by using the responses in an effective manner
(2)
 The responses given in ISA240 are standardized responses which will be used by all audit firm globally
which will result in more standardization approach of how to deal with fraud in the financial
statement(2)
 Specific responses will help the auditors to plan and perform the auditor is a more appropriate manner
helping them to realize that FS could be materially misstated. (2)
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3B(ii)
Legal dispute

At the year-end York Co reversed a provision relating to an ongoing legal dispute with an ex-employee who was
claiming $150,000 for unfair dismissal. This amount was provided in full in the financial statements for the year
ended 30 November 2014 but has now been reversed because Mr Smith believes it is now likely that York Co
will successfully defend the legal case. Mr Smith has not been available to discuss this matter and no
additional documentary evidence has been made available since the end of the previous year’s audit. The
audit report was unmodified in the previous year. (6 marks)

Required:
Evaluate the implications for the completion of the audit, recommending any further actions which
should be taken by your audit firm.

Brainstorming
 Evaluate – implication of the legal dispute for the completion of audit ( 2 marks)
 Recommend- the action to be taken ( 1 mark each)
 6 mark
Notes:
 Reversal of provision – alert ! the auditor should exercise professional skepticism asking management
reason why
 $150,000 has been reversed- means the expenses are understated and profit is overstated ( technique
for creative accounting )
 Mr. Smith- is the owner – believe is an assumption which could be wrong unless sufficient appropriate
audit evidence is gathered
 Mr Smith is Unavailable to discuss the matter
 No documentary evidence is provided.

Implication for completion of audit

The likely implication for completion of audit knowing the fact that there has been a reversal of provision by Mr.
Smith is a follow:
 The auditor is failing to gather sufficient appropriate audit evidence to conclude whether the
reversal is right or wrong due to the fact that Mr. Smith is unavailable and there is no documentary
evidence provided to the auditor for Mr. Smith believe.
 Due to the behaviour of Mr. Smith hiding from the auditor and is absent to face the auditor, it bring into
doubt the client integrity and also raises question mark on rest of the evidence gathered during audit
from Mr. Smith.
 Further the likelihood that Mr. Smith is involve is fraudulent financial reporting as demonstrated by the
characteristics of Mr. Smith and the reversal of provision with no documentary evidence, the auditor
should consider the implication for the audit report and further implication for reporting the instance
to any regulatory authority if that is required so.

Action (is to find a solution to the problem given in case)

1. Correspond directly with the legal advisor dealing with case to find evidence in absence of Mr. Smith
2. Review any correspondence during the year from the ex-employee do identify any change in the legal
dispute circumstance
3. Discuss with matter with any other person in top management in absence of Mr. Smith
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Sep/Dec 2019 - Q3c

(c) The audit committee members have expressed their dissatisfaction that the company’s auditor did not identify the
fraud.
Required:
Explain the difficulties arising for management and for the auditor with respect to discovering fraud. (5 marks)

Marking scheme- for each difficulty – you will fetch 2 marks.

Management: (write in para form –each is worth 2 marks)

 Concealment of information / fraud is done with perfection

 Collusion between different department / employees
 If the fraud is done by top management (directors)

Auditor:

 Time pressure
 Sampling basis of audit – not 100% transactions are verified
 Material basis of auditor- auditor don’t focus on immaterial things.
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Assignment- Lecture 5

 Read the article- massaging the figures

 Attempt the Q2(A)(i)- March 2020- for 6 marks and email me at aaamock@gmail.com
 Read and plan Q1e Dec 18 – for 6 marks

What’s coming next in Lecture-6

 Doing Dec 18 Q1e – 6 marks at the start of lecture 6

 New topic- Topic 5 auditor responsibility for laws and regulations