FRAUD AND ERRORS

DR EVANS FRIMPONG-MANSO
 FRAUD AND ERRORS

• Misstatements in the financial statements can arise from either

fraud or error.
• The distinguishing factor between fraud and error is whether the
underlying action that results in the misstatement of the financial
statements is intentional or unintentional.
FRAUD AND ERRORS

• Although fraud is a broad legal concept, for the purposes

of auditing, the auditor is concerned with fraud that causes
a material misstatement in the financial statements
FRAUD AND ERRORS

• Two types of intentional misstatements are relevant to the

auditor –
• misstatements resulting from fraudulent financial
reporting and
• misstatements resulting from misappropriation of assets.
FRAUD AND ERRORS

• Although the auditor may suspect or, in rare cases, identify

the occurrence of fraud, the auditor does not make legal
determinations of whether fraud has actually occurred.
FRAUD AND ERRORS

• Fraud, whether fraudulent financial reporting or

misappropriation of assets, involves incentive or pressure
to commit fraud, a perceived opportunity to do so, and
some rationalization of the act
• 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.
FRAUD AND ERRORS

• 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 deficiencies in internal
control.
 FRAUD AND ERRORS

•· 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.
 FRAUDULENT FINANCIAL
REPORTING
• It involves intentional misstatements including omissions of
amounts or disclosures in financial statements to deceive financial
statement users.
• It can be caused by the efforts of management to manage earnings in
order to deceive financial statement users by influencing their
perceptions as to the entity’s performance and profitability
FRAUDULENT FINANCIAL REPORTING

Fraudulent financial reporting may be accomplished by the

following:
•· Manipulation, falsification (including forgery), or alteration
of accounting records or supporting documentation from which
the financial statements are prepared.
•· Misrepresentation in or intentional omission from the
financial statements of events, transactions or other significant
information.
•· Intentional misapplication of accounting principles relating
to amounts, classification, manner of presentation, or disclosure.
FRAUDULENT FINANCIAL REPORTING

• Fraudulent financial reporting often involves management

override of controls that otherwise may appear to be operating
effectively. Fraud can be committed by management overriding
controls using such techniques as:
•· Recording fictitious journal entries, particularly close to
the end of an accounting period, to manipulate operating
results or achieve other objectives.
•·
FRAUDULENT FINANCIAL REPORTING

• Inappropriately adjusting assumptions and changing

judgments used to estimate account balances.
•· Omitting, advancing or delaying recognition in the
financial statements of events and transactions that have
occurred during the reporting period.
FRAUDULENT FINANCIAL REPORTING

• Concealing, or not disclosing, facts that could affect the amounts

recorded in the financial statements.
•· Engaging in complex transactions that are structured to
misrepresent the financial position or financial performance of
the entity.
•· Altering records and terms related to significant and
unusual transactions
MISAPPROPRIATION OF ASSETS

• It involves the theft of an entity’s assets and is often perpetrated

by employees in relatively small and immaterial amounts.
• However, it can also involve management who are usually
more able to disguise or conceal misappropriations in ways that
are difficult to detect.
MISAPPROPRIATION OF ASSETS
Misappropriation of assets can be accomplished in a variety of
ways including:
•· Embezzling receipts (for example, misappropriating
collections on accounts receivable or diverting receipts in
respect of written-off accounts to personal bank accounts).
•· Stealing physical assets or intellectual property (for
example, stealing inventory for personal use or for sale, stealing
scrap for resale, colluding with a competitor by disclosing
technological data in return for payment).
MISAPPROPRIATION OF ASSETS
• · Causing an entity to pay for goods and services not received
(for example, payments to fictitious vendors, kickbacks paid by
vendors to the entity’s purchasing agents in return for inflating
prices, payments to fictitious employees).
•· Using an entity’s assets for personal use (for example, using
the entity’s assets as collateral for a personal loan or a loan to a
related party).
CONSIDERATIONS SPECIFIC TO
PUBLIC SECTOR ENTITIES
• The public sector auditor’s responsibilities relating to fraud may
be a result of law, regulation or other authority applicable to
public sector entities or separately covered by the auditor’s
mandate.
• Consequently, the public sector auditor’s responsibilities may not
be limited to consideration of risks of material misstatement of
the financial statements, but may also include a broader
responsibility to consider risks of fraud.
RESPONSIBILITY FOR THE PREVENTION AND
DETECTION OF FRAUD
• The primary responsibility for the prevention and detection of fraud
rests with both those charged with governance of the entity and
management.
• It is important that management, with the oversight of those
charged with governance, place a strong emphasis on fraud
prevention, which may reduce opportunities for fraud to take place,
and fraud deterrence, which could persuade individuals not to
commit fraud because of the likelihood of detection and
punishment
 RESPONSIBILITY FOR THE PREVENTION
AND DETECTION OF FRAUD
• The primary responsibility for the prevention and detection of fraud
rests with both those charged with governance of the entity and
management.
• It is important that management, with the oversight of those charged
with governance, place a strong emphasis on fraud prevention,
which may reduce opportunities for fraud to take place, and fraud
deterrence, which could persuade individuals not to commit fraud
because of the likelihood of detection and punishment by those
charged with governance.
RESPONSIBILITY FOR THE PREVENTION
AND DETECTION OF FRAUD
• Oversight by those charged with governance includes
considering the potential for override of controls or other
inappropriate influence over the financial reporting process,
such as efforts by management to manage earnings in order to
influence the perceptions of analysts as to the entity’s
performance and profitability.
RESPONSIBILITIES OF THE AUDITOR

• An auditor conducting an audit is responsible for obtaining

reasonable assurance that the financial statements taken as a
whole are free from material misstatement, whether caused by
fraud or error?
• Owing to the inherent limitations of an audit, there is an
unavoidable risk that some material misstatements of the financial
statements may not be detected, even though the audit is properly
planned and performed
AUDITOR’S CIVIL AND CRIMINAL LIABILITY

• Auditors may be liable for professional negligence.

• In recent years, this has become an issue of great concern to
auditors.
• Some audit firms have resorted to taking professional indemnity
insurance to safeguard their business, which, in no certain terms,
does not solve the problem.
AUDITOR’S CIVIL AND CRIMINAL LIABILITY

• Auditors can also be liable under statute and can face penalty under
the criminal law for deception and reckless negligence.
• It is also not uncommon for auditors to be held liable under civil
law for damages.
AUDITORS LIABILITY UNDER CONTRACT LAW

• When auditors accept appointment, they enter into a contract which

imposes certain obligations on them.
• These obligations arise from the terms of the contract.
• Both expressed and implied terms of contract impact upon auditors.
• In the case of a statutory audit, the Companies Act prescribes the
auditors duties, responsibilities and rights and express terms of the
audit contract cannot override the Companies Code provisions.
AUDITORS LIABILITY UNDER CONTRACT
LAW

The implied terms which the law will impute into an audit contract
are as follows:
•· The auditors have a duty to exercise reasonable care
•· The auditors have a duty to carry out the work required with
reasonable expediency
•· The auditors have a right to reasonable remuneration
THE AUDITOR’S DUTY OF CARE

• The most important of the implied terms of contract of audit

assignment is the auditor’s duty to exercise reasonable care.
• Regrettably, however, nowhere in the Companies Act does it clearly
state the manner in which the auditor should discharge his duty of
care; neither is it likely that this would be clearly spelt out in any
contract setting out the terms of an auditor’s appointment.
THE AUDITOR’S DUTY OF CARE

• Fortunately, however, as regards auditor of limited company, there

are a number of celebrated judicial judgments that set precedence
of how his duty of care has been measured at various times.
AUDITOR’S CIVIL LIABILITY

• Auditors may be liable for financial damages in respect of civil

offences of misfeasance and breach of trust.
• This normally happens when the auditors have misused their
position of authority for personal gains.
AUDITOR’S CIVIL LIABILITY
• A third party (i.e. a person who has no contractual relationship with
the auditor) may sue the auditor under the tort of negligence for
damages or financial award.
In the tort of negligence, the plaintiff must prove that:
•· The auditor owes a duty of care; and
•· The auditor has breached the appropriate standard of care ;
and
•· The plaintiff has suffered loss as a direct result of the
defendant’s breach.
AUDITOR’S CIVIL LIABILITY
• Generally, in any proceedings for negligence, default or breach of
duty or breach of trust against an officer or an auditor of a company,
the court may relief him wholly or in part from his liability on such
terms as it thinks fit if it appears to the court that:
• a) he is or may be liable ; but
• b) he acted honestly and reasonably; and
• c) having regard to all circumstances of the case, including those
connected with his appointment, he ought fairly to be excused for
the negligence, default etc
AUDITOR’S CIVIL LIABILITY

• This means that a duty of care will only exist if:

•· It is reasonably foreseeable by the defendant that the
statements will be relied on by the plaintiff;
•· There is a ‘relevant degree of proximity’ between the parties;
and
•· It is just and reasonable to impose a duty of care in the
circumstances.
AUDITOR’S CRIMINAL LIABILITY

• An auditor who makes a misleading statement and/or falsifies

records with the intent of deceiving, may face criminal liability.
AUDITOR’S CRIMINAL LIABILITY

• Generally an auditor faces criminal liability if he:

•· Destroys, defaces, conceals or falsifies any account or any
record or document made or required for any accounting purpose;
or
•· Furnishes information for any purpose, produces or makes of
any account, or any such record or document , which to his
knowledge is or may be misleading, false or deceptive;
AUDITOR’S CRIMINAL LIABILITY CONT’D
• · Knowingly makes a false statement or deceptive forecast with
the intent to deceive, and /or induce another person to enter into
or offer to enter into any agreement for the dealing in securities or
lending or depositing money with a financial institution or issuing
house
•· Misappropriate a client’s property
•· Publishes a misleading statement intended to deceive
members or creditors
AUDITOR’S CRIMINAL LIABILITY CONT’D

• The legal/statutory remedy for a criminal offence, (if guilt is

established by court of law) may be the payment of a fine,
imprisonment or both.
• In addition, the professional body that regulates accountants and
auditors may impose sanctions such as warnings, reprimands, fines,
exclusion from membership, etc.
MEANS OF RESTRICTING AUDITORS’
LIABILITY

• In recent times, professional auditing firms take certain measures to

reduce their negligence liability exposure. Among them are the
following:
•· Tightening procedures of screening potential audit clients to
ensure that they accept assignments which have reasonably low
and manageable risks,
 MEANS OF RESTRICTING AUDITORS’
LIABILITY CONT’D
• Formalising the issuance of letter of engagement so as establish in a
written form the respective duties and responsibilities of the auditor
as well as of the directors;

• Carrying out audit assignments with the highest possible level

of professional skepticism;

•· Instituting clauses in audit reports to disclaim liability to third

parties
•· Securing expert legal advice where necessary
MEANS OF RESTRICTING AUDITORS’
LIABILITY
• Taking out professional indemnity insurance;
•· A financial cap on liability: This could be a fixed amount or in a
multiple of the audit fee.
•· Incorporating audit firms as limited liability partnerships (now
permitted in United Kingdom under the Limited Liability
Partnerships Act 2000)
•· Permitting auditors to agree the limits of their liability with
their clients
•· Modification of the joint and several liability principles