Professional & Ethical considerations: Code of ethics, Fraud & Error, Professional Liability

Fraud

- You should be clear on what a misstatement is!

Types of fraud

1. Fraudulent financial reporting ( fake journal entries, manipulating estimates and judgments, omitting
transactions and events or recording them in the incorrect period, omitting or misstating F/S
disclosures, altering records and supporting documents etc.)

2. Misappropriation of assets (embezzling receipts, stealing physical assets or intellectual property,

causing an entity to pay for goods/services not received, using an entity’s assets for personal use)

Responsibilities

Management: Prevent and detect fraud through strong internal controls and a culture of honesty.

External Auditor:

1. NOT primary responsibility to detect fraud- needs to gain reasonable assurance that F/S are free from
material fraud. The auditor might not be able to detect fraud (and error) because evidence is
persuasive not conclusive, sophisticated accounting techniques may have been used to commit fraud,
collusion may have occurred, sampling is used so immaterial fraud may not be detected etc)

2. Professional skepticism

3. Discussion among the engagement team ( how and where F/S may be susceptible to fraud)

4. Risk assessment( auditor has to identify and assess risk of misstatement in F/S due to fraud)

5. Analytical procedures

6. Enquire of management: their assessment of risk related to fraud, their process of assessing risk,
whether they have knowledge of actual or suspected fraud
7. Enquire of Internal auditor: their assessment of risk related to fraud, whether they have knowledge of
actual or suspected fraud

8. Auditor has to design and implement appropriate responses to risky areas identified and when fraud is
identified

9. When fraud is discovered, auditor has to increase sample size in that area AND extend testing into
other areas and consider implications for the entire audit.

Fraud & Professional Liability---Page 1 of 3

 Professional liability

Criminal liability for negligence: breach of trust (e.g. confidentiality), breach of contract (e.g.
insufficient skills and care, late audit report), insider dealing, failure to report money
laundering, destroying documents

Specific statutory liability: arising from tax legislation, insolvency legislation tc.

Civil liability

1. An act of default

2. By a member or his employee

3. Which must lead to financial loss

4. To the client
Or
A 3rd party ( for example bank, prospective investor) to who duty of care is owed the 3rd
party informed the auditor that they will use the auditor’s report or there was
proximity: i.e. the auditor should have foreseen that F/S will be relied upon by the 3rd
party

How can auditor restrict professional liability? LEARN from SKANS Notes

Client acceptance procedures; Performance and documentation of audit work; Quality control;
External consultations;

Issue disclaimer; Use engagement letter; Capping or setting a limit on amount of liability;
Operate as an incorporation

Choosing limited liability partnership; Obtaining professional indemnity insurance

Fraud & Professional Liability---Page 2 of 3

Practice Question

You are a manager in Groom & Co, a firm of Chartered Certified Accountants. You have just attended a
monthly meeting of audit partners and managers at which client-related matters were discussed.

The audit report on the financial statements of Spaniel Co, a long-standing audit client, for the year ended 31
December 2012 was issued in April 2013, and was unmodified. In May 2013, Spaniel Co’s audit committee
contacted the audit engagement partner to discuss a fraud that had been discovered. The company’s internal
auditors estimate that $4·5 million has been stolen in a payroll fraud, which has been operating since May
2012.

The audit engagement partner commented that neither tests of controls nor substantive audit procedures
were conducted on payroll in the audit of the latest financial statements as in previous years’ audits there
were no deficiencies found in controls over payroll. The total assets recognised in Spaniel Co’s financial
statements at 31 December 2012 were $80 million. Spaniel Co is considering suing Groom & Co for the total
amount of cash stolen from the company, claiming that the audit firm was negligent in conducting the audit.

Required:
Explain the matters that should be considered in determining whether Groom & Co is liable to Spaniel Co in
respect of the fraud. (8 marks)

Fraud & Professional Liability---Page 3 of 3