CHAPTER12

FRAUDANDERROR
Questions
1.

Holding a belief that a potential conflict of interests always exists causes

auditors to perform procedures to search for errors or irregularities that would
have a material effect on financial statements. This tends to make audits more
extensive for the auditor and more expensive for the client. The situation is not
a desirable one in the vast majority of audits where no errors or irregularities
exist.

2.

Errors and irregularities: Auditors are required to plan the audit to detect errors
and irregularities that would have a material effect on the financial statements.
Clients illegal acts: Auditors are not required to search for illegal acts, but they
are warned to be alert to any that might be detected in the ordinary course of an
audit.

3.

Seven major assertions in financial statements:

a.

Existence assertion:
The practical objective is to establish with evidence that assets, liabilities
and equities actually exist and that sales and expense transactions actually
occurred. Cut-off can be considered an aspect of the existence assertion.

b.

Occurrence assertion:
The practical objective is to establish with evidence that recorded
transactions or events that occurred during a given accounting period
pertained to the entity.

c.

Completeness assertion:
The practical objective is to establish with evidence that all transactions of
the period are in the financial statements and all transactions that properly
belong in the preceding or following accounting periods are excluded.
Another term for these aspects of completeness is cut-off.

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Solutions Manual Public Accountancy Profession

Completeness also refers to proper inclusion in financial statements of all
assets, liabilities, revenue, expense, and related disclosures.
d.

Rights and Obligations assertion:

The practical objectives related to rights and obligations are to establish
with evidence that assets are owned (or rights such as capitalized leases are
shown) and liabilities are owed.

e.

Measurement assertion:
The practical objective is to establish with evidence that a transaction or
event is recorded at the proper amount and revenue or expense is allocated
to the proper period.

f.

Valuation assertion:
The practical objective is to establish with evidence that proper values have
been assigned to things (assets, liabilities, equities and related disclosures)
and events (revenues, expenses and related disclosures).
Auditing
Standards refer to the practical objective of obtaining evidence about
valuations achieved by cost allocations such as depreciation and
inventory costing methods.

g.

Presentation and Disclosure assertion:

The practical objective is to establish with evidence that accounting
principles used by management are appropriate in the circumstances and are
applied properly, and that disclosures contain all information required by
generally accepted accounting principles.

4.

Benefits of preliminary assessment of materiality:

Fine-tune the audit for effectiveness and efficiency.
Help auditors avoid surprises related to:
Finding out too late about not auditing enough.
Finding out later about auditing too much.
Is P500,000 material? Maybe.
Absolute size. If you think so, its material just because its a large
number.
Relative size.
No. If P500,000 is less than 5% of a relevant base.
Maybe. If P500,000 is between 5% and 10% of a relevant base.
Yes. If P500,000 is 10% or more of a relevant base.
Nature of the item. Yes, P500,000 is material if it arises from an illegal
act.

Fraud and Error

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5.

Yes, auditors have credited discovery of errors and irregularities to analytical

review procedures in 27.1% of the cases in a set of audits, and another 18.5%
discovery rate was attributed to prior expectations and discussions.

6.

In assessing inherent risk and control risk, the auditor must consider the types of
errors or irregularities that might occur and their impact on the financial
statements (materiality.) In evaluating materiality, the auditor should consider
the impact of errors and irregularities both individually and in the aggregate.
Auditing Standards require that the auditor design the audit to provide
reasonable assurance of detecting errors and irregularities that are material to the
financial statements. Auditing Standards require that audit risk and materiality
be considered both in planning the audit and in evaluating audit results.
Control risk and inherent risk are also directly related to the setting of
materiality thresholds. If, for example, application of analytical procedures
(inherent risk analysis) leads the auditor to suspect earnings inflation, individual
item materiality thresholds should be reduced accordingly (i.e., either the
materiality percentage or the amount of unaudited income should be decreased.)
Similarly, if control risk analysis leads the auditor to suspect numerous errors,
aggregate materiality thresholds need to be lowered accordingly.

7.

An auditors reaction to an immaterial error may differ from his or her reaction
to an immaterial irregularity. Auditors generally accumulate the amount of
individual immaterial errors to be sure that the aggregate of all errors is not
material. In addition, the auditor is concerned about whether an error came from
a misunderstanding or other cause that would have resulted in yet more errors
during the period. An auditor is expected to report all irregularities to the audit
committee or the board of directors and senior management.

8.

Refer to pages 436 to 437 of the textbook.

9.

Refer to pages 440 to 441 of the textbook.

10. Refer to page 430 of the textbook.

11. The factors that should be considered are the peso amount of the account, the
likelihood of error, and the cost of auditing the account.
12. The auditor deals with both inherent risk and control risk during the planning
phase of the audit. Inquiry of client personnel, study of the business and
industry, application of analytical procedures, and documentation of the
auditors initial understanding of internal control are all performed during the
planning phase of the audit. Further study of internal control procedures may
occur after the planning phase if the auditor wishes to further reduce the
assessed level of control risk, and considers it economically feasible to do so.

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Solutions Manual Public Accountancy Profession

Multiple Choice Questions

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

d
c
c
b
d
a
c
d
c
d

11.
12.
13.
14.
15.
16.
17.
18.
19.
20.

d
a
c
c
a
a
a
d
b
d

21.
22.
23.
24.
25.
26.
27.
28.
29.
30.

b
d
d
c
d
a
b
a
a
b

31.
32.
33.
34.
35.
36.
37.
38.
39.
40.

b
a
d
a
d
d
c
b
a
a

41.
42.
43.
44.
45.
46.
47.
48.
49.
50.

b
d
a
c
c
d
d
c
b
d

51.
52.
53.
54.
55.
56.
57.
58.
59.
60.

a
a
b
a
c
d
b
d
d
c

61. a
62. c
63. d

Cases
1.

a.

Antonios activity is an irregularity (intentional distortion of financial

statements) rather than error (unintentional mistake). It is also an illegal act
on Antonios individual part.

b.

The problem does not describe the kind of related party transactions
discussed in PSA 550.

c.

Yes, a weakness in internal control exists. It may be considered a material

weakness because the compensating control (internal auditors work on
slow-moving inventory) did not operate in a timely enough manner to detect
the irregularity before it had gotten large.
If a material weakness in internal control exists, Brava & Campos are
obligated to report it to management and/or the board of directors.

d.

The problem description indicates that this element of the audit was
conducted in a negligent manner. Theres nothing wrong about auditing a
sample of the transactions, but Campos follow-up and explanation of the
missing receiving reports leaves much to be desired. At the very least he
could have reviewed the reports produced by Antonio at a later date, and he
could have traced the purchases to the inventory records and perhaps
noticed an over-stocking condition. The auditors had some evidence that an
irregularity might exist, but they failed to apply extended audit procedures
properly.

Fraud and Error

2.

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a.

Yes. Nicolas was a party to the issuance of false financial statements and as
such is a joint tortfeasor. The elements necessary to establish an action for
common law fraud are present. There was a material misstatement of fact,
knowledge of falsity (scienter), intent that the plaintiff bank rely on the false
statement, actual reliance and damage to the bank as a result thereof. If
action is based upon fraud there is no requirement that the bank establish
privity of contract with the CPA. Moreover, if the action by the bank is
based upon ordinary negligence, which does not require a showing of
scienter, the bank may recover as a third-party beneficiary (an exception to
the strict privity requirement). Thus, the bank will be able to recover its
loss from Nicolas under either theory.

b.

No. The lessor was a party to the secret agreement. As such, the lessor
cannot claim reliance on the financial statements and cannot recover
uncollected rents. Even if he was damaged indirectly, his own fraudulent
actions led to his loss, and the equitable principle of unclean hands
precludes him from obtaining relief.

c.

Nicolas was not independent. His report is improper and he is probably

subject to disciplinary action by the professional organization or regulatory
body. According to the ethics interpretation on actual or threatened
litigation:
An expressed intention by the present management to commence litigation
against the auditor alleging deficiencies in audit work for the client is
considered to impair independence if the auditor concludes that there is a
strong possibility that such a claim will be filed.