Auditing Theory
Chapter 12
Fraud and Error
PSA 240 – “The Auditor’s Responsibility to Consider
Fraud in an Audit of Financial Statement”
 Policies and procedures relating to FRAUD and
ERROR
Misstatements can arise from both error and fraud.
Difference: intention
Error – unintentional
Fraud – intentional; more difficult to detect
Auditor is only concerned with fraud that cause
MATERIAL misstatement in the FS.
Auditor DOES NOT make LEGAL DETERMINATIONS of
fraud occurrence even though he may suspect/identify
fraud.
Primary responsibility for prevention/detection of fraud:
MANAGEMENT and THOSE CHARGED WITH
GOVERNANCE
Two types of intentional misstatement
1. Management Fraud/ Fraudulent Financial
Reporting
 Omissions in disclosures to DECEIVE FS
users
 Manipulation, falsification + forgery,
alteration of accounting records for
which FS are prepared
 Misrepresentation/omission of
transactions and significant information
 Intentional misapplication of accounting
policies
 Management overriding control
techniques:
 Fictitious journal entries at end
of reporting period
 Inappropriate adjustments to
judgment of estimates
 Omission, ADVANCING or
DELAYING of recognition of
transactions
 Concealing facts
 Altering records
2. Employee Fraud/ Misappropriation of Assets
 THEFT of entity’s assets by EMPLOYEES
 Often in relatively IMMATERIAL
amounts
 May involve MANAGEMENT who can
easily conceal
 Often accompanied by
FALSE/MISLEADING records
 Ways to misappropriate:
 Embezzling receipts
 Stealing PHYSICAL ASSETS (even
scrap) or INTELLECTUAL
PROPERTY (collusion with
competitor)
 Causing entity to pay for goods
and services not received
(fictitious vendors, kickbacks
paid to purchasing agents in
return for inflating prices,
payments to fictitious
employees)
 Using entity’s assets for
PERSONAL USE (e.g. as
collateral for a loan)
Risk Factors/ Elements of Fraud
Cabrera, AT, p.532-538 for examples
1. Pressure/Incentive
 Pressure towards management to
achieve unrealistic targets
 Pressure to misappropriate assets for
living beyond their means
2. Perceived opportunity
 Individual believes he can override
controls
3. Rationalization
 Attitude, characteristic, ethical values
that allow them to KNOWINGLY commit
a dishonest act
 Even honest individuals can commit
fraud in the presence of sufficient
pressure
Emerging theory: fraud diamond
4th element: CAPABILITY
1. Position: almost same with opportunity;
difference- person’s position may furnish
opportunity
2. Intelligence - someone who understands
internal control and can exploit
3. Ego - someone who understands internal
control and can exploit
4. Coercion – someone who has power to coerce
other to commit or conceal e.g. manager
 5. Deceit
6. Stress
Auditor’s Responsibility as per PSA 200: to provide
reasonable assurance that the FS are free from material
misstatement, whether caused by FRAUD or ERROR.
Auditor must practice PROFESSIONAL SKEPTICISM.
(1) In planning, auditor must perform risk
assessment.
(2) Design procedures to provide reasonable
assurance that material misstatements will be
detected.
(3) Obtain evidence that fraud has not occurred.
(4) If fraud did occur, reflect in FS or correct the
error.
(5) Due to inherent limitations, an audit is subject
to unavoidable risk that some MM will not be
detected (higher possibility of not detecting)
(6) Unless audit reveals evidence to the contrary,
auditor is entitled to accept representations as
truthful and records and documents as
genuine
If auditor identifies presence of conditions that increase
MM potential, he must:
1. Increase level of professional skepticism
2. Assign personnel able to commensurate risk
3. Give additional consideration to selection of
accounting procedures
4. Consider controls and management’s ability to
override controls
5. Obtain more reliable or corroborative evidence
6. Conduct tests closer to year-end
Conditions/events that increase risk of error/fraud:
(Considerations in risk assessment)
 Weakness in internal control
 Noncompliance with controls
 Questionable management integrity
 Unusual pressures
 Unusual transactions
 Difficulty in obtaining sufficient appropriate
evidence
Types of Errors/Fraud in Transaction Cycles
A. Sales and Collections
Errors:
- Mechanical errors
- Bookkeeper’s failure to understand accounting
procedure
Fraud
Sales: fraudulent financial reporting
- Overstatement of sales (e.g. recording
succeeding period sales, deposits,
consignments, operating leases, sales with likely
returns, deferred revenue as sales)
- Understatement of sales returns
Collections: misappropriation of assets
- Skimming – withholding cash receipts without
recording them
- Lapping – conceal abstraction of cash;
overlapping an inconsistency with another; to
uncover: routine testing of details of collections
compared with validated bank deposits
- Kiting – counting cash twice by using the float in
the banking system. (Float: gap between check
is deposited and the time the check clears) to
uncover: analyze and verify cash transfers at
year-end
B. Acquisitions and Payment – auditor must
consider risks at ENGAGEMENT level in
assessing inherent misstatements in this cycle;
greater risk that LIABILITIES are misstated when
entity has LIQUIDITY problems or when in NEAR
VIOLATION of a loan agreement
Errors:
- Wrong period (cutoff errors)
- Goods received as consignment as purchases
- Misclassifying purchases of assets and expenses
- Failing to record a cash payment
- Recording a payment twice
- Prepaid expenses not recorded as assets
Fraud:
- Paying for fictitious purchases
- Receiving kickbacks (refund payable to the one
who purchased) to reduce likelihood: make
vendors submit BIDS
- Purchasing goods for personal use thru access
to blank receiving reports and purchase
approvals; goes unnoticed w/o perpetual
system
C. Payroll and Personnel – historically, largely
undetected
Errors:
 - Paying E @ wrong rate
- Paying E for more than hours worked
- Charging payroll expense to wrong accounts
- Keeping TERMINATED E. On the payroll
Fraud:
- Fictitious employees – one of the most
common; auditors perform surprise payoff, turn
check distribution to another supervisor, check
employee files, time cards
- Excess payments to employees – increased pay
for more than hours worked; reduced by:
requiring personnel dept. officials to authorize
changes in pay rate and thru monitoring;
analytical procedures on cost per unit
- Failure to record payroll – usually for companies
with difficulty in managing costs; DIFFICULT TO
HIDE unless similar amount of revenue or
receipts has been omitted;
- Inappropriate assignment of labor costs to
inventory – detect through: compare cost vs
budget; verify inventory valuation
D. Inventory Warehousing
Errors:
- Cutoff errors/ failure to include items in
inventory
- Mechanical errors
- Detect through: routine audit procedures
Irregularities:
- Inventory Theft – for personal use or
unauthorized sale; one sign is significant decline
in GROSS profits
- Overstatement of Inventory – common form of
MANAGEMENT FRAUD because:
Change in inv = change in income before taxes
Techniques:
 Putting filler goods
 Adding significant amount of inventory
after the auditor has observe inventory
E. Investing Activities
Factors increasing IR of investments:
- Economic conditions
- Industry changes that affect ability to use
equipment
- Age of equipment and degree of obsolescence
- Acquisition of assets thru related party
transactions
- Ability to remain as a going concern
Errors:
- Failure to follow PFRS in valuation
- Expensing PPE instead of capitalizing
- Misclassification as current/noncurrent
- Failure to properly account for financing of an
asset
- Failure to properly account for lease
- Inaccuracy of depreciation expense
- Incorrect estimates of life
Fraud:
- Usually same with fraud in acquisition
- Securities can be stolen or diverted
- To detect: compare serial numbers on securities
and client record
F. Financing Activities – should be carefully
audited because management can override
controls
Errors:
- Failure to make interest accruals/ doubling
- Accruing in the wrong period
- Making incorrect estimates in allowances for
obligations
- Failing to recognize that the entity violated a
debt agreement
- Failing to record declared dividends
Irregularities:
- Diverting proceeds
- Covering up failure to meet a debt agreement
- Failing to record obligations
- Failing to record interest
- Paying dividends to inappropriate parties
PROCEDURES WHEN ERRORS/IRREGULARITIES ARE
SUSPECTED
Altering:
 1. Engagement staffing
2. Extent of staff supervision
3. Degree of professional skepticism applied
4. Overall strategy for the expected conduct and
scope of the engagement.
RAP —> risk detected —> consider potential effect on
FS —> if material, perform appropriate/modified audit
procedures based on judgment as to:
 Types of error and fraud indicated
 Likelihood of occurrence
 Likelihood that particular F/E has a
material effect
Auditor CANNOT assume that instance of F/E is an
isolated occurrence.
If necessary, adjust NTE of substantive procedures.
Considerations at the Assertion Level
Cabrera, p. 548
- Surprise visits or tests
- Inventory count at year-end or near year-end
- Altering audit approach for the current year
- Investigating possible related parties and
financial sources of unusual transactions
- Performing analytical procedures on
disaggregated data
- Interview of personnel in high risk areas
- Discussing with Other Auditors
- Performing procedures on work done by expert
which may have significance in MM
- Analysis of opening statements
- Performing tests on procedures done at interim
periods
- Performing computer-assisted techniques
- Testing integrity of computer-produced records
- Seeking additional evidence from outside
Reporting Fraud or Error
- To management and those charged with
governance. Communicate to level ABOVE
responsible persons believed to be implicated
(if highest level is suspected, seek LEGAL
advice) as soon as practicable if:
 Auditor suspects fraud EVEN IF
potential effect is IMMATERIAL
 F/E actually exists
- To users of auditor’s report.
 F/E with material effect not reflected or
corrected in the FS - Qualified/Adverse
opinion
 Auditor PRECLUDED from obtaining
sufficient appropriate evidence –
Qualified opinion or disclaimer on the
basis of limitation on the scope
 Unable to determine whether F/E has
occurred because of circumstance or
entity – consider effect on auditor’s
report
- To regulatory and enforcement authorities.
 Auditor’s duty of confidentiality
PRECLUDES reporting to a THIRD PARTY
 In certain circumstances, duty is
OVERRIDDEN by statute, law, courts of
law)
 E.g. Bangko Sentral; within 30 days:
 Report fraud or dishonesty
 Adjustments/potential losses
which amount to AT LEAST 1%
of bank capital funds
 Finding that total bank assets
on a going concern basis are no
longer adequate to cover
creditor claims
 Seek legal advice giving due
consideration to public interest
Documentation
- As per PSA 315:
 Significant decision reached re:
susceptibility to MM
 Identified and assessed RMM due to
fraud @FS and assertion level
Withdrawal from the Engagement
1. Determine professional and legal
responsibilities applicable in the circumstances,
including reporting to person who made the
audit appointment or to regulatory authorities
2. Consider whether it is appropriate to withdraw
from the engagement, where legally permitted
3. If auditor withdraws:
 Discuss with appropriate level of
management and those charged with
governance re: withdrawal and reasons
 Determine if there is a
professional/legal requirement to
report
Auditor may conclude that WITHDRAWAL is necessary
when entity does not take remedial action re: fraud that
the AUDITOR CONSIDERS NECESSARY even if it is NOT
MATERIAL
When proposed auditor inquires, existing auditor
should advise whether there are professional reasons
why he should not accept. Extent = depends on client’s
permission; legal and ethical constraints.
reported on and on which the auditors have
issues an APPROPRIATE OPINION
- Arises from: litigation, adverse publicity/
damage to reputation
- Even when business risk is low, auditor SHOULD
NOT change audit procedures

If client DENIES permission to discuss affairs, DISCLOSE

to proposed editor that the client denied.

Selective testing in accordance with PSAs is SUFFICIENT

to fulfill auditor’s responsibility, even though complete
testing is more apt.

Management Representations
Auditor shall obtain written representations that:
- It acknowledges responsibility for internal
control
- It has disclosed to the auditor its results of risk
assessment
- It has disclosed its knowledge of fraud
involving:
 Management
 Employees with role in internal control
 Others where fraud could have material
effect
- It has disclosed knowledge of allegations of
fraud or suspected fraud communicated by
employees, former employees, analysts,
regulators

Client’s Illegal Acts

- Illegal acts: violations of laws
- Normally BEYOND the scope of auditor’s
professional competence
- PSA 250 “Consideration of Laws and
Regulations in an Audit of Financial
Statements”: auditor’s procedures should give
reasonable assurance of detecting ILLEGAL ACTS
having DIRECT MATERIAL EFFECT on the
determination of FS amounts (same with errors
and irregularities)

Business Risk *auditor’s perspective*

- Auditor’s risk of LOSS or INJURY from events
arising in connection with FS that have been