City University College Department of Accounting and Finance

6. ERROR, FRAUD AND THE AUDITING PROCESS

Many people believe that an audit is meant for detection of frauds and
errors and it is a guarantee that there is no undetected fraud or error.
But it must be understood that different types of audit have different
objectives. Accordingly, the objective of an independent financial audit is
to determine whether the financial statements present a true and fair
view of the financial position and working results of an enterprise.
Therefore, the auditor’s approach for conducting an independent external
audit are directed towards achievement of this objective rather than
towards detection of frauds and errors, though detection of fraud and
error is an incidental result of such an audit.
The misunderstanding of some users of financial statements regarding
the role of an audit stated above is also known as the expectation gap.
Error
 May be defined as inaccuracy or incompleteness in the
measurement or presentation of a fact.
 Is unintentional and may arise due to negligence or genuine
misunderstanding
 Extent of errors can be minimized by employing appropriate means
 Careful judgment is required to balance the costs involved in
controlling minor errors against the benefits derived
Fraud
 May be defined as the successful practice of deception or artifice
with the intention of cheating or injuring another person
 Involves an intention or motive to cheat or injure another person
Errors affecting financial statements
Such errors may be classified as:
 Errors of omission
 Errors of commission
 Errors of principle

Auditing Principles I 6. Error, Fraud and the Auditing Process 1

Asrat Bekele
City University College Department of Accounting and Finance

Errors of Omission
 Occurs when a transaction entirely or partly omitted from being
recorded
Errors of Commission
Involve the following:
 Wrong posting of an amount
o Errors of transposition
 Posting on wrong side
 Posting in wrong account
Compensating Errors
 Are those errors which offset each other in such a manner that
either:
o There is no effect on the total of the two sides of the trial
balance
o The total of both sides is increased or reduced by the same
amount
Frauds affecting financial statements
Frauds affecting financial statements or other financial information may
involve the following.
 Manipulation, falsification or alteration of accounts or other
records or documents
o A common method of perpetrating fraud
 Misappropriation of assets
 Suppression or omission of the effect of transactions from books of
accounts
o Not recording sales to show a higher inventory value and
better current ratio to obtain working capital loan
o Suppress profit to pay lower tax
 Recording of transactions without substance
o False sales to an associated enterprise

Auditing Principles I 6. Error, Fraud and the Auditing Process 2

Asrat Bekele
City University College Department of Accounting and Finance

 Misapplication of accounting policies

Detection of Fraud and Error

Responsibility
 The responsibility to prevent, detect and correct errors and frauds
rests with the management
 The management may establish an adequate system of internal
control to this end
 The internal control system, however, cannot totally eliminate the
possibility of all fraud and error
Audit
 The auditor seeks to obtain reasonable assurance that the
financial statements are properly stated in all material respects
 Financial statements cannot be said to be properly stated if they
contain material misstatements
 Thus, if there is a high risk of fraud, the probability of material
misstatements in the financial statements would be increased
 The impact of this to the audit program would be:
o Reduction of the materiality level
o Increased level of testing in suspected areas
o Reduced reliance on evidence internally generated
o Increased focus on externally generated evidence
 The auditor should always maintain an attitude of professional
skepticism, which involves recognizing there is a possibility that
material misstatements due to fraud could exist and involves:
o Having a questioning attitude
o Supporting conclusions with appropriate relevant evidence
o Safeguarding against threats to independence and objectivity

Auditing Principles I 6. Error, Fraud and the Auditing Process 3

Asrat Bekele
City University College Department of Accounting and Finance

 Responsible for detecting material fraud that may lead to a

material misstatement
 No specific responsibility regarding immaterial fraud
 Immaterial errors reported if found but no duty to identify them
 Risk in respect of fraud is higher than error as there could be
concealment and collusion
Reporting of fraud
If fraud is identified the auditor should report to:
 The audit committee, if one exists
 To the highest level of management
 The shareholders if:
o the fraud is committed by the highest level of management
and
o No audit committee is in place

Auditing Principles I 6. Error, Fraud and the Auditing Process 4

Asrat Bekele