FRAUD & ERROR (iSA 240) Notes

AUDIT SAMPLING (iSA 530) Notes

INTRODUCTION

When the auditor is carrying out his work, he comes across deviations or misstatements in the financial statements. These misstatements may be due to an unintentional error or one that was committed with intent thus. The misstatements may also be due to non compliance with laws and regulations or due to fraud. During the planning of the audit, the auditor should expect to detect material misstatements in the financial statements due to fraud or error if any. This chapter is covered by iSa 240 on The Auditor’s Responsibility To Consider Fraud In An Audit Of Financial Statements .

When planning and performing audit procedures, evaluating and reporting the results thereof, the auditor should consider the risk of misstatement in the financial statements resulting from fraud or error.  The objective of an audit is to report o whether the financial statements are free from material misstatements. This implies that if there are material misstatements as a result of fraud or error and the auditor fails to detect and report on this, then his opinion would be wrong.

KEY TERMS

Error: It is an unintentional mistake in the financial information, which can occur any time during processing and recording of transactions.

Fraud: This refers to intentional misrepresentation of financial information by one more individuals among management, employees or third parties.

irregularity: is the deliberate distortion of information together with the related misappropriation of assets.

What is An Error?

An error is an unintentional mistake in presenting the financial information which can occur at anytime during processing and recording of transactions. These include

  • Mathematical or clerical mistakes
  • Oversight or misrepresentation of facts
  • Misapplication of accounting policies

Types of errors

  1. Errors of commission. These are errors that do not show in the trial balance because it still balances. This is where the correct amount for a transaction is recorded but in the wrong person’s account e.g. for debtors the correct class of accounts may be used but the wrong personal entries entered.
  2. Errors of omissions. This is where transactions are completely omitted from books of accounts.
  3. Errors of principle. This is where an item is entered in the wrong class of account e.g. a fixed asset is debited to the expense account.
  4. Compensating errors. This is where errors cancel each other out. The errors occur usually on opposite sides of the accounts i.e. on credit and debits sides with equal amounts and are totally independent from each other.

V. Errors of original entry. These occur when the original figure is incorrect and the double entry system is still observed.

vi. Complete reversal entries. These occurs where correct accounts are used but each items shown on wrong side of the account e.g. crediting sales in debtors account and debiting sales account.

What is Fraud?

A fraud is an intentional misrepresentation of financial information by one or more individual among management, employees and third parties involving use of deception to obtain unjust or illegal advantage. The main difference between a fraud and error is that a fraud is intentional and aimed at either misleading people or misappropriating company assets. There are two types of intentional misstatements i.e. misstatements resulting from fraudulent financial reporting and misstatements resulting from misappropriation of company assets. Fraudulent financial reporting involves management’s override of controls that otherwise appear to operating efficiently.

Common types of fraud include:

  • Manipulating, forgery, alteration or falsification of accounting records or supporting documents from which financial statements are prepared.
  • Misappropriation of company assets e.g. using a company vehicle for private undertakings, stealing physical assets and embezzling receipts.
  • Misapplication of accounting policies e.g. classifying a capital expenditure and revenue expenditure.
  • Inappropriate adjusting assumptions and changing judgments used to estimate account balances. E.g. the management may insist on providing a 5% provision for bad and doubtful debts even where past debt collection history shows that the actual default rate is about 15%.
  • Suppression  or omission of effects of a transaction on accounting record e.g. placing a genuine debtor well known bad debts in the balance sheet thus misrepresenting the financial position of the company.

FRAUD & ERROR (iSA 240) Notes

Fraudulent financial reporting may be committed because management is under pressure from outside or inside the entity to report unrealistic profit levels. A perceived opportunity for fraudulent financial reporting or misappropriation of company assets may exist when an individual believes that an internal control can be overridden. This could be because an individual is in a position of trust or has knowledge of specific weaknesses in the internal control system.

The distinction  between fraud and error is of little importance so far as audit procedure are concerned. This is because the audit procedure used to detect errors is the same used to detect fraud. The only difference may arise where the auditor may be required by law to disclose certain illegal acts to the regulatory authority.

Responsibility for detection of fraud and error

The primary responsibility for the detection and prevention of fraud and error rests with the management of the company. This responsibility is fulfilled through the implementation and continuous operation of adequate system of internal controls. Such system reduces but does not eliminate the possibility of fraud and error. The auditor on his part seeks reasonable assurance that fraud and error which may be material to the financial statements has not occurred or if it has occurred, the effect is properly reflected in the financial statements. At this point, the auditor should plan his work so that he has reasonable expectation of detecting material misstatements in the financial information resulting from fraud and error. It is important to emphasis that the auditor cannot be held responsible for failing to detect errors and frauds. however, he is expected to carry out his work in a manner that he is in a position to detect material errors and frauds. Failure to detect such material errors implies that the financial statements are materially misstated.

Expectations  gap

This is the gap that exists between external auditor’s understanding of their role and duty and the expectations of various users of the financial statements and the general public regarding the process and the outcome of the external audit. I.e. the expectation by users of financial statements that auditor should detect and prevent error and fraud as a duty, while actually it is not his duty but of the directors.

The public may conceive the auditor’s role  as including;

  • Protecting the company against fraud and irregularities
  • Providing early warning of future insolvency i.e. certifying the company as a going concern.
  • Providing useful general assurance of the financial wellbeing of the company and its continued profitability.

Most users of financial statements believe that the auditor has prepared the statements and should therefore be in a position to explain the performance results of the company. Some other users of the financial statements do not understand the audit opinion issue. Possible means of reducing the expectations gap include:

Expanding the audit report to include more information explaining what auditors actually do. iSa 700 (audit reports on financial statements) now requires auditors to include a paragraph explaining the nature and scope of the audit conducted and also explaining the respective responsibility of management and auditor in relation to preparation of the financial statements.

it has also been suggested that the role of the auditor should be broadened especially in areas of fraud. ISA 240(fraud and error), requires that the auditor should report to the users of the financial statements if there is material misstatements as a result of fraud and any other irregularities.

There should be attempts to improve the knowledge and understanding of auditor’s role and responsibility through public education.

Risk of fraud and error

In addition to weaknesses in the accounting and internal control system, events which also increase risk of fraud and error are:

  • Questions regarding the integrity and competence of management. Where management is not honest and could misappropriate company assets, the risk of fraud and error increases.
  • Unusual pressure within the company e.g. pressure on organization to attain a certain level or profitability. This could tempt the managers to manipulate the financial statement so as to achieve the set profit level.
  • Unusual transactions. Such could be carried out with intention of manipulating the financial performance of the company e.g. a very large purchase of stock at the year end to increase level of closing stock and subsequently increase profits.

Difficulties in obtaining sufficient, appropriate audit evidence especially where management is reluctant to provide the necessary information to the auditor.

If circumstances indicate possible existence of fraud and error, the auditor should consider the potential effect of financial statements. If the effect is material, the auditor should perform additional procedures to dispel the suspicion. Where fraud or error is confirmed, the auditor should satisfy himself that the effect of fraud or error is properly reflected in the financial statements or the error corrected. The auditor should communicate his findings to management on timely basis if:

  • He/she believes fraud may exist even if the potential effect would be immaterial.
  • Fraud or error is actually found to exist.

Inherent Limitations of an Audit

An audit is subject to the avoidable risk that some material misstatements will not be detected, even though the audit is properly planned and performed in accordance with iSas. The risk of not detecting misstatements resulting from fraud is higher than the risk of not detecting material misstatements resulting from errors. This is because fraud involves acts designed to conceal it such as forgery and deliberate failure to record transactions. When the audit reveals evidence to the contrary, the auditor is entitled to accept representations from management as truthful and documents as genuine. however, the auditor should plan and perform his work with professional skepticism, recognizing that conditions or events may be found that indicate that fraud or error may exist. Existence of a strong internal control system reduces the probability of misstatements in the financial reporting occurring due to fraud or error but there is always a risk that the system may fail to operate as designed.

The following procedures could be applied as general leads to where fraud or error may have occurred.

  • Comparison of the company’s current balance sheet with those of previous years.
  • Calculation of profitability, leverage, activity and performance ratios for the current and previous years.
  • Using search inquiry to pose questions to management and accounting staff.
  • Auditing in depth to establish the audit trail. This facilitates checking a transactions recording process from initial to final stage.
  • Using surprise checks and visits.
  • Comparing budgeted and actual results of the company and investigating any variances noted.

Errors and frauds in specific areas in business

Sales & debtors

Potentials errors

  • Goods dispatched without being invoiced, services rendered without being  invoiced, goods in transit or a consignment not recognized in books.
    • Goods being sold to bad credit risk customer.
    • Overdue accounts without follow up.
    • Sales invoiced but not recorded in the books.
    • Cash sales not being recorded.
    • Improper crediting of debtor account.

Implications

  • Understated sales, wrong management accounts, loss of assets of the company and accounts without true and fair view.
    • bad debts
    • Misappropriation of cash, exposure to theft and loss of interest due to delayed banking.
    • Unreliable records and disputes between the company and customers
    • .
  • Purchases and Creditor.

Potential errors

  • Liabilities being set up for goods not received or not authorized
    • Liabilities being incurred but not recorded.
    • Making payments without proper documents and authorization.
    • Misallocation of funds to the wrong general ledger accounts
    • Goods being returned without being recorded.

Implications

  • Loss of company resources because of paying for goods never received.
    • Understanding of liabilities hence disputes with suppliers. •      paying for services and goods not received
    • Overstatement of expenses and creditors.
    • Misstatement of various expense accounts hence unreliable records.
    • Overstatement of purchases
  • Wages

Potential errors

  • Dummy workers in the payroll or fraudulent double payment of workers, payment for work not done and unclaimed wages being misappropriated.
    • Occurrence of payroll errors.
    • Improper deductions being made or being misappropriated
    • Inflation of the payroll in other ways.

Implications

  • Overvaluation of stocks because using wrong labour costs.
    • Overstatement of stocks
    • Misstatement of various expense accounts
    • Unreliable records.
  • Supervision. This serves to prevent fraud or error by boosting the awareness of senior employees who will refrain from committing fraud and error by virtue of constant review of operations.
    • Physical controls. These limit access to the assets of the company thus preventing them from damage, misuse or theft.
    • Segregation of duties. This boosts automatic checks, accountability and supervision at all stages of processing transactions, minimizing chances of error and fraud.
    • Arithmetic and accounting controls. proper recording of transactions according to the principles of iSas will prevent errors and frauds such an manipulation of accounts.
    • Personnel. Engaging qualified, competent and efficient personnel will reduce chances of errors. The company’s staff should be motivated and properly remunerated to prevent temptations of fraud.
    • routine and automatic checks. These minimize fraud by boosting awareness that work will be continuously checked, accountability will be increased and importance of being

SUMMARY

Error is an unintentional mistake in the financial information, which can occur any time during processing and recording of transactions.  These include:

  • Mathematical or clerical mistakes; •               Oversight or misrepresentation of facts;
    • Misapplication of accounting policies.

Fraud refers to intentional misrepresentation of financial information by one more individuals among management, employees or third parties.

Irregularity is the deliberate distortion of information together with the related misappropriation of assets.  An irregularity becomes a fraud when it involves criminal deception that is seeking unjust advantage leading to misleading information.

The primary responsibility for the prevention and detection of fraud rests with management. The auditor is and cannot be held responsible for the prevention of fraud and error.

AUDIT EVIDENCE (ISA 500) Notes

AUDIT PLANNING, CONTROL & RECORDING (iSA 300) NOTES