tt ; on) After studying this chapter, you should be able to: \ 1, Understand the:auditor*s responsibilities. relating to fraud and:e etfor in the audit of. finaticial statements. 2. , Know.the basic chatacteristics of fraud and the - incentives, opportunities, attitudes and rationalizations that could lead to their - decurtence, 3. Lear low to assess whether the risk that fraud and efror would result to material’ ‘ { misstatement of the financial statements. a 4, Describe how the auditor could dete fraud , ‘and errér. 5, Be familiar ivith the indirect limitations of an audit. 6, . Leatn the risk factors relating to misstatement arising from fraudulent,financial reporting. 7... Know the types of ertors and irregulatities in, i ; the various transaction cycles of the business ‘entity and the auditor's responsibility. Scanned with CamScanner“CHAPTER 12. , .. FRAUD AND ERROR Introduction’ : . “PSA’240 (Clarified), “The Auditor's’ Responsibility 10 Consider Fraud in an “Audit of Financial Statements” establishes’ standards and provides guidance on “the auditor's responsibilities relating to fraud and error in the audit of financial statements. - It discusses the audit procedures that the auditor should perform when he suspects or when:he determines, that fraud or error has occurred. Characteristics of Fraud Misstatements inthe financial: statements can arise from either fraud or error. The distinguishing factot ‘between’ fraud and ertor is whether the: underlying * action that résults in. the misstatement of the financial statements is intentional or unintentional; Although fraud is a broad legal concept, for the pirposes of the PSAs, the auditor is concerned with fraud that, catises a material misstatement. in the financial statemehts, Two types of intentional misstatements are, relevant to, the auditor ~ misstatements .resufting from -fraudulent:-financial, reporting’ and . misstatements resulting from misappropriation of'assets, Although {he auditor may suspect or, in rare cases, identify. the occurrehee of fraud, the auditor does not make legal determinations of whether fraud has actwally occurred; Fraud,. whether fraudulent, financial reporting or misappropriation of assets, involves incentive or pressure, to commit fraud, a perceived Opportunity. to.do so and some rationaligation of the act, .For example: * Incentive dr pressure f0,commit fraudulent finaicial 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 misappropriaté:assets, for. example, because the individvials dre living beyond their meains, : Scanned with CamScanneri 528 Chapter 12“ . * A perceived opportunity to commit fraud may exist when an individual believes intetnal control can be ‘overridden, .for example; because the individual:'is lira’ position of trust or has knowledge of specific weaknesses {n internal control, b a sai s + 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 cominit a dishonest act. However, ‘even otherwise honest individuals a fraud in an environment that imposes sufficient pressure on them): Fraudiilent, financial’ reporting jnyolves intentional’ misstatemehts including omissions of amounts or disclosures in financial statements to deceive financial statement users. It cdiy be caused by the: efforts of management to thanage eattiings. in ‘order to ,deceive financial statement users by influencing their Perveptions as to’ the: éntity’s ‘performance and, profitability., Such earnings management may start out with small actions of; inappropriate adjustment of assuiptions.and chaiiges it judgments by management. Pressures and incentives may lead: these ‘actions: to increase to. the extent that:they result in fraudulent finaticial reporting. Such a situation could ogcur when, due to pressures to meet market expectations or .a- desire to tiaximize compensation.,.based on performance, matiagement intentionally takes positions that lead to fraudulent financial reportitig by materially misstating the financial statements, In some entitles, matiagement may be motivated to reduce earnings by a material amount to minimizeitax ot inflate earnings to secure bank financing. Fraudulent financial reportitig may be accomplished by the fotlowihg: © “Manipulation; falsification (including forgery), or alteration -of accounting: records or supporting documentation from which the financial statemetits 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. financiat 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: Scanned with CamScannert Fraud and Error 529 * Recording fictitious journal entriés, particularly close to the end of an accounting period, to manipulate operating ‘yesulls or; achieve other objectives, ‘ hes * Inappropriately adjusting assumptions and‘changing judgments used to estimate account balances, a * © Omitting, advancing or delaying recognition ‘in the financial. statements of events.and transactions that have occurred during the reporting period, ) © ‘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. + pat q si ve "Altering records and, terms related to significant and unusual transactions, Misappropriation of assets involves the theft. of an-entity’s assets, and is often perpetrated by employees ’in‘relatively smal] and immaterial amounts, However, it can.also involve management who are usually: more able to disguise or ‘conceal misappropriations in ways that aré‘difficult to detect, Misappropriation’ of assets can be accompanied in’a variety of ways including: i © Embezzling receipts (for example, misappropriating’ collections: on accounts receivable, or: diverting receipts ing respect: Of" written-off 7 accounts fo personal bank accounts), ‘| ) \ * Stealing physical assets of intellectual property (for example, stealing inventory for. personal use o+ for sale, stealing serap for resale, colluding | with ‘a “competitor by ‘disclosing -technological- data. in return for payment) att i, * Causing a entity,to pay for goods and services not received (for example, payments to fictitious vendors, kickbacks. paid by yendors to the entity’$ purchasing agents in return for inflating prices, payments to 4 fiottious employees), : wa +! Using'an entity’s assets for personal use (for example, using the entity’s ‘assets as collateral for a personal logn:or a loan to a related party), Misappropriation of assets is often accompanied: by false or misleading records ‘or documents in order to conceal the fact that the assets’ are. missing or have been pledged without proper authorization; wi tpt Scanned with CamScanner» "830, Chapier'12- Responsibility for the Prevention and Detection of Fraud The primaty responsibility for the prevention and detection of fraud tests with both. thosé: charged. with: governance of the ‘entity and management. It is important that management, with the oversight of those, charged with,govefnance, place a strong eripliasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could persuade individuals not to commit fraid because ofthe likelihood of detection and} punishment, - This involves a commitment to creatitig a culture. of honesty ‘ahd ethical behavior which: can’ be reinforced’ by an active oversight by thgse charged with governance: .. In exercising oversight responsibility, those charged with governaiice consider the potential for override of controls or other inappropriate influence over the. financial reporting process, such as efforts by. management to manage earnings ih order to influence: the" perceptions of analysts as to the entity’s petformance and'profitabilitys q Pree a rae -baud fore Me reattreall Responsibilities of the Auditor” yiclenyunti © An atditot conducting an audit in accordance with PSA8 is responsible: for obtaitiing reasonable assurance that. the financial statements taken as a whole are * ‘free from material misstatemerit, whether catlsed by fraud ot error. As described in PSA-200 (Clarified), “Overall Objectives of the Independent Auditor and the Contdilct of an Audit ‘in Accordance with Philippine Standards on Auditing,” owing to, the jnhcrent, limitations of an audit, there is:atisrfiavoidable risk ‘that some material misstatements of the financial statements Will not be detected, even though the audit is properly planned and performed in accordance with the PSAs. ' : oie ‘Risk Assessment In planning the audit, the auditor should assess the risk that fraud and ertot may cause the financial: statements to contain material inisstatements and should inqitire ‘of management as to any-fratid or significant error which has beer discovered, | | In addition to weaknesses in'the design of the accounting and intetnal control systéms and noncompliance with identified inteinal controls, conditions or events which increase the risk of fraud.and error include: j © Qitestions with respect to the integrity or competence of management. Unusual presstires within or on an entity. ¢ : Unusual transactions. «Problems in obtaining sufficient approptiate auidit evidence. Scanned with CamScanner hid Gear UUdUl, Yated| Fraud and Error’ 531 Examples of these conditions ‘or events are set out in the Appendix'to PSA.240 I \ (Clarified), Q e 5 : Detection ‘ i Based on the risk assessment, the auditor should design audit: procedures to obtain reasonable assurance that misstatements arising from fraud and error that are material to the financial statements taken as a whole are detected, Consequently, the auditor seeks sufficient appropriate audit evidence that-fraud and error which may be material to the financial statements have not occurred or that, if they have occurred, the effect of fraud is properly reflected in the financial statements or the error is corrected. ‘The likelihood of detecting errors ordinarily is higher than that of detecting fraud, since fraud is ordinarily accompanied by acts specifically desighed to conceal its existence, : Due to the inherent limitations of an audit'(see’ paragraphs below) there is an unavoidable risk that material misstatements in the financial statements resulting from fraud and, to a lesser extent, error may not be detected, “The subsequent discovery of material misstatement of the financial 'stafements resulting from frud or error existing during the’period covered by the ‘auditor's report does. not, in itself, indicate that the auditor has failed to adhere to the basic. principles and ' essential procedures ,of an audit. Whether the auditor has adhered to these principles and procedures ig determined by the adequacy ’of the audit procedures undertaken jn the circumstances and the suitability of the: auditor’s report based on the results of those audit procedures, ti +; \ Inherent Limitations of ati Audit ‘ : . An audit is subject to the unavoidable risk that some material misstateménts of the financial statements will not be' detected, ever though the audit is’ properly planned and performed in accordance with PSA, ‘The risk of not detecting a material misstatement: resulting fron fraud is higher than the risk of not detecting a maierial misstatement resulting from error, because fraud ordinarily irivolves acts designed to, conceal it, such as collusion, forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor.’ Unless thé audit reveals evidence to thé contrary, the auditor is entitled to accept representations as truthful and records-and documents as genuine. However, in accordance ‘with -PSA 200, (Clarified), “Overall | Objectives of the Independent ‘Auditor and, the Conduct of. an Audit in Accordance with Philippine Standards on Auditing,” the auditor should plan and Scanned with CamScanner532__ Chapter 12 perform the audit with an attitude of professional skepticism, recognizing that conditions or events may be found that indicate that fraud or error may exist. While the existence of effective accounting and internal control systenis reduces the probability of misstatement of financial statements resulting from fraud and error, there will always be some risk of internal controls failing to operate as designed. Furthermore, any accounting and internal control system may be ineffective> against fraud involving collusion among erhployees or fraud committed by management, Certain levels of management niay be in a position to override controls that would prevent similar frauds by othr employees; for example, by directing subordinates to record. transactions incorrectly or to conceal them, or by stippressing information relating to transactions, Examples of Fraud Risk Factors -Appendix | of PSA 240 (Clarified) identified exaniples of fraud risk factors that may be faced by auditors relating to-the two types df fraud — that is, fraudulent. financial reporting and misappropriations of assets. For cach of these types of fraud, the risk factors are further classified based on three conditions generally present when material misstatement due to fraud occurs (a) incetitives / pressures (b) opportunities, and (c) attitudes / ratioializations 6 . Risk Factors Relating to Misstatement Arising from’ Fraudulent Financial Reporting A. Incentives / Pressures 1, Threatened financial stability or profitability brought about by economic, industry or entity operating conditions such as (a) High degree of competition or market saturation, accompanied by declining margins. (b) High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest rates. (©) Significant declines in customer demand .and_ increasing business failures in either the industry or overall economy, (d). Operating losses making, the threat of — bankruptcy, foreclosure, or hostile takeover imminent. Scanned with CamScannerEe Fraud and Error 533 (©) Recurring negative. cash flows. from operations or: an ‘. inability to generate cash flows from operations while ‘reporting earnings ard earnings growth. (A) Rapid growth or unusual profitability especially compared to that of other ‘companies ii the same industry’. (g) New accounting, statutory, or regulatory requirements. 4 2,. Excessive pressure from management to méet the requirements or expéctations of third parties due to the following: ' |" "(@) Profitability ‘or “trend level expectations of investment . analysts, institutional inyestors, significant creditors, or other external parties (particularly expectations that are unduly aggressive or unrealistic), ineluding expectations created by management in, for example, overly optimistic press releases _i or-annual report messages, (6) Need to obtain. additional debt or equity ‘financing. to stay competitive ~ including financing of major research and developrient or capital expenditures. 7 (©) Marginal ability. to meet exchange listing requirements or debt repayment or other debt covenant requirements. sd) Perceived or real adverse effects of reporting poor financial results on significant pending transagtions, such as business , combinations or contract awards. 3 Threatened personal financial situation of management or those charged with governance. relative: to ‘the entity's financial performance due to f (a) Significant financial interests in the entity, (sian portions. of their compensation (for example, bonuses, stock options, and earn-out arrangements) being contingent upon achieving ‘aggressive targets for stock price, operating results, financial position, or cash flow, Management incentive plans may be contingent upon achieving targets relating only to certain accounts or selected activities of:the entity, even though the’related accounts or activities may not be material tothe entity as a whole. (©) Personal guarantees of debts of the entity, Scanned with CamScanner534 Chap ter IP : wd B. Opportunities 1, Nature of the industry or “the atty’s operations provides opportunities to-engage: in fener) financial report ting that can arise from we (a) Significant related party transactions not \in, the ordinary course of business: or with’ related entities not. audited or auidited by another firm: 4a (b) A strong financial. presence or ability 0 dominate a certain industry sector; that allows the entity ‘to dictate terms or ‘conditions to suppliers or customers’ that may result, in iiiappropriate or non-arm’s'length transactions. ©) Asstts, liabilities, revetiues or expenses based on significant “estimates that involve subjective judgments or uncertainties that are difficult to corroborate, (d): Significant,’ Unusual, ot highly ° corhplex transactions, especially those. close: to period ‘end that pose difficult “substatice over form” questions. (e) Significant’ operations. located’ or. conducted across international borders in ° jurisdictions whete~ differing business environments and cultures exist. (f) Use of business intermediaries for which thete appears to be no clear business justification. ; ic ; -(g) Significant bank’ accounts or subsidiary or biZinch operations in tax-haven jurisdictions for which. there’ appears to be no clear business justification. Ineffective monitoring ‘of management due to (a) Domination of management by a single ‘person or small group (in a non owner-managed ° business) without . compensating controls, (b) Oversight by those charged’ with governance over the , financial. reporting .process and , internal ‘control is not effective. Complex and unstable organizdtional structure as evidenced by (a) Difficulty in determining the organization or individuals that have conttolliiig interest in the entity. Scanned with CamScanner‘ | ¢ Fraud and Error 535 (b) Overly complex organizational structure involving unusual legal entities or managerial lines of authority. . (c) High turnover of senior management, legal counsel, or those : charged with governance. ' 4, Deficiency in internal control components resulting from ‘ (a) Inadequate’ monitoring of controls, including automated _. controls and controls over interim financial reporting (where *S. external reporting is required). . (b) High’ turnover rates or employment of accounting, internal "audit, or information technology staff that are not effective. (c) Accounting and information systems that aré not effective, including: situations’ involying"material weaknesses in yoo ‘internal control.“ C, , Attitudes and Rationalizations f . . 1, Commninication, implementation, support, or enforcement of the entity's values ov ethical-'standards, by management, or. the commuinication'of inappropriqlé values or ethical standards, that are not effective, *~», .2. Nonfinancial. management's’ excessive. participation in or on \ "preoccupation with the selection of accounting policies or the determination of significant.es imates, nee : : 3, “Known history of violations of securities laws orvother laws ani regulations, or claims.against the'entily, its senior management, or those charged with governance alleging fraud or violations of Iqws or regulations. , 4. Excessive interest by management in maintaining or increasing ' the, entity’s.stock price.or earnings wend. \ " ‘| 5, The’ practice. by. management of committing to analysts, creditors; and other third parties: to achieve aggiessive or unrealistic forecasts, : oh Mandgement failing, to correct known material weaknesses in 7 , internal contral on a timely bas . 1, An interest by management in employing inappropriate means to minimize reported earnings for tax-njotivated reasons, Scanned with CamScanner. 8, “Low'morale amorig senior management, ©8836 © Chapher' 12" ie a 9. The. owner-ntanager makes no distitiction between personal and | business transactions.’ ‘ i 11, Rectirring attempts by mariagement to. justify marginal ‘or inappropriate accounting on the basis of imatiriality. 10. Dispute between shareholders’ a closely held entity, 12. The relationship between’ management aid the curkent or predecessor auditor is strained, as exhibited bythe following: (@) Frequent disputes with the current or predecessor auditor on accountiig, auditing, or reporting matters. (by: Unreasonable demands ¢n the auditor, stich as unrealistic timg, constraints regarding the. completion of the audit or the isstiahce of the auditor's report. \-(O) Restrictions on the, auditor that Ihiapproptiately limit access to people or information or the ability to communicate ‘ effectively with those charged with governance, (d) Domineering, managemeiit’ behavior in dealing with the, auditor, ‘especially involving attempts to influence the scope of the auditor's work or the selection or continuance of personnel assigned to or constilted on the audit engagement, Risk Factors Arising fiom Misstatements Arising from Misappropriation . os of Assets A. Incelitives'/ Préssutes 1. Personal. financial obligations . may create pressure on imanagemeitt or entployees with access to cash or other assets susceptible to theft to misappropriate those assets, 2.» Adverse relationships between the entity and employees with access to cash or other assets susceptible to theft may métivate » those employees to misappropriate those assets. For example, adverse relationships may be created by the following: (a) Known of anticipated future employee layoffs, (b) Recent or anticipated changes to employee compensation or benefit plans. Scanned with CamScannera Fiaud and Ervor * 537 (c) Promotions, compensation, or oflier rewards inconsistent » with expectations. B. Opportunities 1, Certain’ characteristics’ or circumstances may increase the susceptibility of assets to misappropriation. . For example, opportunities to misappropriate assets increase when. there are sthe following: i (a) large amounts of cash on hand or'processed, (b) inventory items that are small in size, of high value, or in high demand, (c) fixed assets’ which are small in size, marketable, or lacking observable identification of ownership. 2. Inadequate internal control over assets may increase the susceptibility of misappropriation of those assets. For example, misappropriation of assets: may occur ‘bapdiase there is the following: (a) Inadequate segregation of duties or independent checks, (b) Inadequate oversight of senior management expenditures, such travel and other reimbursements. “(c) Inadeqdate management oversight of employees responsible for assets, for example, inadequate, supervi nN or monitoring of remote locations, 1 (4) Inadequate job'applicant sereening of employees with access to assets. (e) Inadequate record keeping with respect to assets, (Dj.Inadequate- system of ‘authorization and approval of {lransaetions (for example, in purchasing). (g) “Inadequate physical safeguards over. cash, . investments, inventory, or fixed assets. * } 3 , ‘a1, (h) Lack of-complete and timely reconciliations of assets, (i) Lack of timely and. appropriate documentation. of transactions, for example, credits for merchandise returns, Scanned with CamScanner“\ Chapler 12. yf) Q)'Lack of maidatory vieations for employees performing key * control functions, (k) Inadequate inanagethent under ling of information technology, ~ which .chables information {eclynology employees to perpetrate a misappropriation, ‘ Inadequate access controls ‘over automated — records, iticluding controls over and review or compute systems. event logs. y \ @ C. Attitudes / Rationaliz Ie Disregard for the need for monitoring or reducing risks related to misappropriation of assets. , ions: , " 2u° Disregild for internal control over:misappropriation of assets by overriding existing controls or by failing, to correct known internal control deficiencies. bi Behavior indjcating displeasure or, \issatisfaction with the-entity oF its treatment of the employee. 4, Changes in behavior or liféstyle that may indicate assets have been misappropriated. “5, Tolerance of petty theft. Types of Errors’and Irregularities in the Transaction Cycles of - the Business Entity and the Auditor? Ss Responsibiligyg: o i 1. Sales and Collections Cycle 1, Errors in Sales and Collections Errors in recording sales: include’ mechanical errors, such ‘as using a wrong piece or wrong quantity, recording ‘sales in the wrong period (cutoff errors), a bookkeeper’s failure‘to understand proper accounting for a transaction, and so on. Internal controls are designed to prevent or detect many of these kinds of errors, Hence, assessment of conirol risk and appropriate tests of controls assist an atiditor in evaluating the risk of such iisstatements. The auditor determines the appropriate substantive feat based ont the assessment of inherent risk, control risk, and planned audit tisk, 4 Scanned with CamScanner540 Chapter’ 12 the amoutit recorded as a receivable. Detection of unrecorded cash receipts is very difficult; however, unexplained changes in the gross profit percentage or sales volume imay indicate that cash receipts have been withheld. é 2. Lapping \ t This technique is used to conceal ‘the fact that cash has been abstracted; the shortage in one customer’s| account is covered With a subsequent payment made by andther customer. An employee who has access to cash receipts and maintains accoutits receivable can engage in lapping, Routine testing of details of collections compared with validated bank deposit slips should tincover this fraud. 3. Kiting “\ i] This is‘ another technique used. to cover cash shortage or to inflate cash balance. Kiting involves counting the cash twice by using the float in the banking systeth. (Float is the gap between the time the check is deposited or added to an account and the time the check clears or is deducted from the account it was written on), Analyzing and'verifying cash transfers during the days surrounding year-end should reveal this type of fraud. When performing an audit of the sales and collections cycle, an auditor should be. alert to internal control weaknesses that could allow the misappropriation, of assets to occur. When weaknesses exist, an auditor should perform procedures to determine whether financial"statements are materially misstated because of misappropriations. : An auditor must consider whether conditions are present that increase the potential for financial statement misstatements, If.they do, auditors should (1) increase the level of professional skepticism, (2) assigh personnel with knowledge, skill and ability commensurate with the risk, (3) give additional consideration to the entity’s selection of accounting principles, (4) consider the controls the entity has for addressing the fraud risk and management's ability to override such controls, and: (5) obtain ‘more reliable. or corroborative evidence, conduct tests -closer to year-end, and increase the amount of.evidence gathered. The auditor should also consider such factors in assessing the inherent risk of misstatements of financial statement assertions. Major risks in the sales and collections cycle are overstating sales and withholding cash receipts. Awareness of the types of misstatements that Scanned with CamScannerFraud and Error $41 can: ovcur enables “an auditor’ to’ design an ‘audit to’ detect material Y “misstatements, : : ‘ Il, ‘Acquisitions and Payments Cycle, \ ) % : 1. Errors in the Acquisitions and Payments Cycle The following may occur in the acquisitions and payments cycle: * -* Failing to record a purchase in the proper period (cutoff errors) Ro * Reéording goods accepted on'consignment as'a purchase * Misclassifying purchases of assets and expenses *° Failing to record a cash payment pore a ee Pay Recording a payment twice * Failing to record prepaid expenses as assets : Entities normally. design controls to prevent these errors from occurring, or to detect errors if they do’ocour.” When such controls exist, auditors test the controls to assegs their: effectiveness.’ ‘If the controls are not effective, auditors should perform substantive tests to-determine that the financial statements do not contain material misstatements. that arose because of possible errors, : an j ' 2. Frauds in the Acquisitions and Payments Cycle, A \ a. Paying for Fictitious Purchases 4 This involves the perpetrator creating ‘a fictitious invoice (and sometimes a receiving report, purchase order and 30 forth) and processing the invoice for payment, ; Alternatively, the perpetrator can pay the invoice twice. b. Receiving Kickbacks ‘In this scheme, a purchasing agent may agree with a vendor to receive a kickback (refund payable to the purchasing, person on * goods or services acquired from the vendor), This is usually done in retum for the agent’s ensuring that the particular vendor receives an order from the firm.’ Often a check is made payable to the purchasing agent and mailed to the agent at a fi Scanned with CamScanner842° Chapter 12! ne ; : location other than his or her place of employment, Sometimes the * purchasing agent’ splits the kickback with the vendor’s employee for approving and paying it. Detecting kickbacks is difficult because the buyer’s records do not reflect their existence. However, when , Vendors are required to submtit bids for goods or servicés, the likelihood of kickbacks is reduced. mas ©.’ Purchasing Goods for Personal Use \ Goods or services for personal use may be purchased by exectitive ot purchasing ‘agents and charged to the compally’s account. To exectite stich a purchase, the perpetrator must have access to blank receiving repotts and purchase approvals, or must connive with another employee. Fraud involving the purchase of goods for personal use\is more likely to go unnoticed when perpetual records » are not maiittained. : Attditors must consider the risks identified: atithe engagement level when they. assess the inherent risk of misstatements in the acqui ions and payments cycle, Internal controls should prevent, or detect. many etrors, However, when an entity has liquidity problems or when it is near violation , of a loan agreement, risk is greater that, liabilities.are misstated. ih. Payroll and Personnel Cycle Historically, errors and irregularities involving payroll have been reported to. occur frequently and are largely undetected, a : . 1. Errors * . The most errors that can occur in the payroll and personnel cycle are a). paying employees at the wrong rate b) paying employees for more hours than they worked, c) charging payroll expense to the wrong accounts, and . ‘ d) keeping terminated employees on the payroll. Good Internal control can: be established to prevent these errors from occurring and to detect them If they do occur. Scanned with CamScanner2. » Fraud and Error _ 543 Franids involving Payroll The major payroll-ielated frauds inclyde a. Fictitious Employees Adding fictitious employees to the payroll is one. of the most common defalcations. Detecting fictitious employees on the payroll is very difficult; but auditors do sometimes perform a surprise payoft as a deterrent to this form of defalcation, Alternatively, the auditor may.turn the check distribution oyer to an-official not associated with preparing payroll, signing checks, or supervising workers. Personnel files and the employees’ completed time cards and time tickets may also be examined to substantiate the existence of absent employees, b, “Excess Payments to Employees Increasing the rate above that’ approved or':paying employees for. more hours than they worked are the most common. ways of paying employees more than they are ‘entitled to receive,- These practices can be substantially reduced by. reqiiring personnel. department officials to authorize changes in pay rates and by monitoring total hours worked and paid-for. Analytical procedures that focus on cost per unit of actual production can also be helpful in detecting excess payments to employees. cc, Failure to Record Payroll on : Companies having difficulty meeting, profit targets or not-for-profit ‘entities having difficully managing costs.anil expenses might fail to record a payroll. The omission’ of payroll can be difficult'to hide unless a similar amount of revenues or receipts has been omitted, Analytical procedures can be performedto,test the reasonableness of payroll cost, . \ 4, Inapprépriate Assignnent-of Labor Costs to Inventory , A company having difficulty meeting profit targets might assign to sinventory labor cost that should have been charged to expense, Analytical procedures suchas comparing costs incurred to budgeted cost and verification’ of valuation of inyentory-are some of the usefull techniques in detecting such fraud, : Scanned with CamScanner544 Chapter 12: IV. Inventory Warehousing : i 1. Errors affecting Inventory. i Cut-off etrors (failure to include items in inventory) and mechanical errors, such‘as using.a wrong price or wrong quantity are common errors affecting inventory. ‘Procedures may be designed in taking, valuing and summarizing: inventory to! prevent or detect: my of these kinds of etrors: Rolititte audit procedures can further detect dlich misstatements. yo 2. Inrégularities affecting Inveritory a. Jnventory Theft This invdives’ appropriating, inventory for personal use. or unauthorized - sale, Assigning responsibility’ for inventory and maintaining perpetual inventory records’ reduce the risk, of inventory “theft. Many factors require employee§,to walk through a gate where they are inspected. Significant decline in gross profits may also be a _ Sign of inventory theft. ; ~"'b. | Overstatenient of inventory“, : j ~“Manageinent ‘fraud ‘often takes the form of overstating inventory becatise a change in*inventory produces an equal change in income before taxes. Some of the techniques used by perpetrators to overstate inventory are food (1) Puitting: filler goods’ tos,deceive ‘aitlitars about the” : quantity of goods stocked: : . (2) Adding significant amount of inventory after the auditor has observed inventory. V. Investing Activities The factors that increase the inherent’ risk of material misstatements of “investinents are as follows: 1, Economic conditions. that significantly affect investments the entity has thade. ‘ . "2. Changes occurring in the industry that affect the entity's ability to use its equipment. Scanned with CamScanner3. 4s 5. Misstatements of investments can yore / 4 4 Io Frdiud and Error. 545 Age of the entity's equipment and the degree of obsolescence as it affects the entity’s ability to compete with othets in the industry. Acquisition of assets through related party transactions. Eittty’s ability to remain a going concer. be classified ‘as: either errors or irregularities, lL, Errors affecting Investing Transactions a), Failure to follow PFRS when recording fixed-asset additions. b) Expensing property, plant, and equipment. rather’ than capitalizing it, ' i ° ©). Misapplication of PERS to the valuation of securities. 4d) Misclassification of investments as current or nonélirrent. ¢) «Failure to account properly for the financing of an asset. ‘a leasing transaction. f) Failure to account properly f 2) Mechanical inaccuracy of depreciation expense. h) Incorrect estimate of the life of an asset, \ Major Frauds involving Investing Activities + Frauds, such as taking kickbacks, acquiring ‘goods for persdnal use, appropriating assets aijd processing fictitiotis transactions can occur in, the acquisition of property,. plant, equipment, ’ investment securities, just as they can in the acquisition of goods. Selling assets other than merchandise at inflated values to related parties results in increaged revenue and assets to the Selling entity that may never be realized. Securities can be stolen or diverted, For example, an official may make an unauthorized sale of a security for temporary cash and then purchase a replacement, . Comparing the. serial ‘numbers on securities to the serial number recorded in the client’s * ‘records can detect this form of fraud, Managers may also capitalize repairs experise or conversely, may expense an asset that should be capitalized, Analytical procedures may be effective in identifying situations in which property, plant, and equipment have been expensed as a repair and maintenance cost, Scanned with CamScanner846 Chapter 12 Vi. Financing Activities Individual finaricing transactions often have a material Impact on an entity’s financial statement, ' + ‘ f 1. Errors Related.to Financing Activities } Possible errors related to financing activities includg the following: a) Failiig to make interest accruals, ot making them twice 4 6 \ ©) Making incérrect estimates of allowances. for obligations Aceruing interest iit the wrong period d) ‘Failing te recognize that theyentity violated a debt agreement ©) Failing’to record dividends that were declared ¢ 2. Irvegularities Possible irregularities related to’ financing activities include the following: a)” Diverting proceeds from issuance of debt or equity securities 6) Covering up'a failure to meet the debt agreement ¢) Failing to record-obligations, such as notes d) Failing to record interest e). Paying dividends to inappropriate parties Because management generally has the ability to override the controls in : effect, auditors should audit financing transactions carefully. Procedures When Errors or Irregularities are Suspected When an’ auditor detects factors that increase audit risk at the financial statement level he of she should respond to such elevated risk by altering the (1) Engagement staffing, (2) Extent of staff supervision, (3) Degree of professional skepticism applied, and/or (4) Overall strategy for the expected conduct and scope of the engagement. Scanned with CamScanner0 ; : Fraud and Error 547 For example, more experienced personnel may be assigned to an engagement for which audit risk at the financial statement level is considered high. ‘The auditor- in-charge’ should spend more time supervising its planning and conduct and probably accumulate more audit evidence. When the application of audit procedures designed from the risk: assessment indicates the possible existence of fraud or error, the auditor should éonsider the potential effect.on the financial statements. If the auditor believes the indicated fraud or error could have a material effect on the financial statements, the auditor should perform appropriate modified or additional procedures, The extent of such modified or additional procedures depends on: the auditor’s judgment as to: : : (a) the types of fraud and errorindicated; (b) the likelihood of their occurrence; and (©) the likelihood. that a particular type of fraud ,or error could have a material effect on the financial statements, " ' Unless circumstances clearly indicate otherwise, the auditor cannot assume that an instance of fraud or error is aftvisolated occurrence: If necessary, the auditor adjusts the nature, timing and extent of substantive procedures, The following are examples of possible atidit procedures to address the assessed risks of material..misstatemient. due to fraud resulting from, both fraudulent financial reporting and, misappropriation of assets.. Although these procedures ‘cover a. broad range of situations,/they are only examples anid, accordingly may not be the most appropriate nor necessary in each circumstance, Also the order of the procedures provided is not intended to reflect their importatice. Consideration at the Assertion Level \ . f " Specific’ responses to the auditor's assessment.of the risks of material misstatement due to fraud will vary depending upon the types or combinations or fraud risk factors or conditions identified, and the classes of transactions, account balances, disclosures and assertions they may affect, Scanned with CamScanner548» Chapter 12: The following are specific examples of responses: ° Visiting “locations ‘or performing certain’ tests on,, a_surprise ot unatinouticed basis.’ For example, observing inventory at locations where auditor attendance has not'been previously announced or counting cash at a particular date on a surprise basis. s Requesting that inventories'be counted at the end ofthe reporting period of on a date closer to petiod end to minimize the risk of manipulation of balances in the period between the date of completion of the count and the end of the reporting period! ast % Altering the audit approach in the current year, For example, contacting major customers and suppliers orally in addition to ‘sending written cotifirmation, sehding confirmation réquests to a specific party within an organization, or, Seeking more or different information. Performing a detailed review/of the entity’s quarter-endor year-end adjusting entries and investigatirig any that appear unusual as {o nature or amount. For significant and unusual transactions, particularly those occurring at of near year-end, investigating the possibility of related:parties and the __ sources of financial resolirces supportitig the transactions, Perfoiniing substantive analytical procedures using disaggregated data. For example, ‘comparing safes and cost of sales by location, line of business or month to expectations developed by the auditor, Conducting interviews of personnel involved in areas where a risk of material misstatement due to fraud has been identified,.t8obtain their insights about the risk and whether, or how, controls address the risk. When other independent auditors are auditing the financial statements of one or more stibsidiaries, divisions or branches, discussing with them the extent or work necessary to be performed to address the assessed risk of material’ misstatement due to fraud resulting from transactions and activities among those components. If the work of an-expert becomes particular significant with respect to a financial statement item for which the assessed risk of misstatement due ~ to fraud is high, performing additional procedures relating to some or all of the expett’s assumptions, methods or findings to determine that. the findings are not, Unreasonable, or engaging another expert for that purpose. Scanned with CamScannera Fraud and Error 549 + Performing audit procedures to analyze selected opening statement of financial position accounts of previously audited financial statements to assess how certain issues involving accounting estimates and judgments, for example, an allowance for sales returns, were resolved with the benefit of hindsight. + + Performing procedures on account or other reconciliations prepared by thé entity, including considering reconciliations performed .at interim periods.” ch : ; ¢ Performing computer-assisted techniques, such as data mining to test for “anomalies'in a population. * Testing the integrity of computer-produced records and transactions, * Seeking additional ‘audit evidence from sources outside ..of: the entity being-audited. * ‘ ' ; Reporting of Fraud and Error Communication to’ Management and“ With Those. Charged with Governance Wh : To Management ; / ‘The auditor should cominunicate factual findings to management as soon as practicable ifs » “i : , \ (a) the auditor suspects fraud may exist, even,if the potential effect on the financial statements'would be immaterial; or (b) fraud or significant error is-actually found to exist, In determining.an appropriate representative of the entity. to whom: to report occurrencés of possible or actual fraud or significant error, the auditor would consider all th circumstances. ' With respect to fraud, the’ auditor. would assess the likelihood ‘of senior management inyolyement, «In most cases. involving fraud, it would be appropriate to report the matter to a level in the organization structure of the entity above that responsible for the persons * believed to be implicated. When those persons ultimately responsible for the overall direction of the entity are doubted, the auditor would ordinarily seek legal advice to assist in the determination of procedures to follow: Scanned with CamScanner850 Chapter 12°. : : ‘To Users of the Auiditor's Report on the Financial Statements If the, auditor concludes that the fralid-or error has a-material, effect on the financial statements ‘and has. not beet properly reflected of corrected in the financial, statements, the ‘auditor sholild exptess a’ qualified ‘or an’ adverse } opinion, —* i ; 4 i If the auditor is precluded by'the entity’ from obtaining sufficient appropriate ‘audit evidence to evaluate whether fraitd or ettor that may be material to the financial statements, has, or is likely to have, occurred; the auditor should express a qualified opinion or a disclaimet of opinion. on the financial i statements on the basis of alimitation oi the scope of the audit. | If the auditor, is \wable to determine’ whether fraud or ertor has occurred because, of limitations’ imposed by ihe circumstances rather than by the entity; the auditor should consider the éffect oh the-auditor’s report. ° To Regulatory and Enforcement Authorities: The auditor's duty ‘of confidentiality:wwould ordinarily. preclude. reporting { fraud or érror to a third party.’ Howevel in certain circumstances, the duty of confidentiality is overridden by statute, law or by courts of law. [for example, the Bangko Sentral ng Pilipinas (BSP) ‘requires external auditors of banks to | make a report to-BSP within 30 calendar days of discovery, during his audit field work (a) any material finding discovered during the periéd of audit involving fraud. or dishonesty; (b) adjustments or potential losses the aggregate of which amounts to at least one per cent (1%) ofthe bank capital funds; and (c) any finding to the effect that the total bank assets, on a going concern basis, are’no longer adequate to cover the total claims of creditors]. The auditor may, need to seek legal advice in such circumstances, giving due’ consideration to the auditor's responsibility to the:public interest. Documentation The: auditor’s documentation of the understanding of the entity and. its environment and the assessment of the risks of material misstatement required by PSA 315 shall include: (a) The ‘significant decisions reached during the discussion among the ! engagement team regarding the susceptibility of the entity's financial statements to material misstatement due to fraud; and Scanned with CamScannerFraud and Error 551 (b) The identified and assessed risks of material misstatement due to fraud at the financial statement level and at the assertion level, - Withdrawal from the Engagement 4 4 If, as a result of a misstatement resulting from fraud or suspected fraud, the auditor’ encounters exceptional circumstances that bring. into question, the auditor’s ability to,continue performing the audit, the auditor shall: (a) Determine the professional and Icgal responsibilities applicable in the circumstances, including whether there is a requirement for the.auditor to report to, the person or persons who made’ the audit appointment or, in some cases, to regulatory authorities; (b) Consider whether it is appropriate to withdraw from the engagement, ~ where,withdrawal from the engagement is legally permitted; and (c) If the auditor withdraws: (i) Discuss with the appropriate level’ of management and those charged with governance the auditor’s withdrawal from the engagement and the reasons for the withdrawal; and * (ii) Determine whether there is a professional or legal: requirement to report to the person oi*persons who'made the audit appointment or, ' in some cases, to regulatory. authorities, the auditor’s withdrawal from the engageinent and the reasons for the withdrawal, 1 + The auditor may conclude that withdrawal from the engagement is necessary when the entity does not take the remedial action regarding fraud that the auditor considers necessary in the circumstances, even when the fraud'is not material to F ; the financial statements. Factors’ that would: affect the auditor’s conclusion e include the implications of the involvement of the-highest authority within the f entity, which may affect the reliability of management representations, and the é effects on the auditor of continuing association with the entity. In reaching such f conclusion, the auditor would ordinarily seek legal advice. é i, On receipt'of an inquiry from the proposed auditor, the existing auditor should advise whether there are any professional reasons why the “proposed auditor should not accept the appointment.’ The extent to which an existing auditor can discuss the affairs of a client with a:proposed auditor will depend on whether the client’s permission to do so has been’ obtained and/or the legal or ethical requirements that apply-selating to such disclosure, If there are any such reasons or other matters which need to be disclosed, the existing: auditor would, taking account of the legal and ethical constraints including where appropriate Scanned with CamScanner$52." Chapter 12 permission of the client; give details of the information and'disctiss freely with the proposed auditor all matters rélevant to the appointment, If permisston from the client to discuss'its affairs, with the proposed auditor is denied by the client, that fact should be disclosed to the proposed auditor, : , ‘ \ f ‘ Selective testing (as opposed to complete testing of all transactioh$ and events) in accordance with PSAS, is sufficient to fulfill the auditar’s responsibility, even’ though complete testing is more apt to detect errors or ifrégularities: Therefore, in the absence of evidence to the contrary, an auditor ntiy reasonably rely upon the truthfulness of: management’s. representations and thespeiiuineness of records | and documents. : , . Management Representations } 1 LN nN / , The auditor shall obthin written representations from management that: (a) It acknowledges. its. responsibility foi'{the design, implementation and maintenance of internal control to preveitt and detect frauds (b) It-has disclosed to the auditor the results of its assessinent of the risk that the financial statements may be'materially misstated as a result of fraud; (c). It has disclosed to the auditor its"knowledge of fraud or suspected fraud affecting the entity involving: i | i (i), Management; (ii) Employees who have significant roles in internal conttol; of (iit) Others where the fraud> could have: a material effect on,,the- financial statements; and : ae (d) It has.disclosed to the auditor its knowledge of any allegations of fraud, or suspected fraud, affecting the entity’s financial statements communicated by employees, former employees, analysts, regulators: ot others. , Rib ee Client?s Illegal Acts Mlegal ‘acts are violations of laws’ or government regulations. Determination of the legality or illegality of specific client acts is normally beyond the scope of an independent auditor’s professional compétence and generally should be left to the lawyers. Also, the further removed a potential illegal act is from the transaction and‘ events ustially presented in the financial statements, the less’ likely the auditor Will become aware of the act, : Scanned with CamScanner4 Fraud and Error 553 However, as provided for in PSA 250 (Clarified), “Consideration of Laws and Regulations infan Audit of Financial Statements,”. an auditor’s examination carried out in accordance with PSAs should be designed to provide reasonable assurance of detecting ilfégal acts having a’ material direct effect on the determination of financial statement amounts. ‘This is the same responsibility the auditors have for material errors and irregularities. An audit does not generally provide a basis for detecting violations of law or reguilations which have an indirect effect qn financial statement amounts. The auditor however should be aleit throughout their audit for information that raises a question regarding the possibility of illegal’ acts, such as unauthorized or improperly recorded transactions, excessive or unusual payments, and investigations of governmental agencies. If the auditors have knowledge of. lishonest or clearly illegal activity by: the client, they Should attempt to assess the impact of the actions on the’ financial statements, A legal counsel or specialist may have to be,consulted, The situation will have to be discussed with top management so that proper action can be taken, including making any necessary: adjustments or disclosure to the financial statements. The auditor should withdraw from the engagement if the client fails to take: appropriate corrective, action. .. This will.clearly show that: the auditor * cann t permit their name to be associated in any’ way with dishonorable or illegal activities of the client. ess Risk Wot Bu Business Risk, in contrast to audit risk, is the auditor’s ri8k of loss or injury from events arising in connection with financial statements that hays been reported on and on which the auditors has issued an.appropriate opin The possible losses or injuries arise from litigation, and adverse publicity exists ech when an auditor follows PSAs in conducting the, engagement and in reporting the results. For example, an auditor may have ‘conducted an audit following PSAs and still be sued by a creditor of the client. ‘Even if he wins, the auditor may have incurred substantial litigation ‘costs and/or damage to his/her professidnal reputation, Auditors should therefore carefully evaluate clients in high-risk industries such as high-technology companies, companies making initial public offerings of stocks, financial institutions, insurance companies, and pre-need companies to minimize their business risk. Even when business. risk Is low, an atiditor should not change , his or ker audit procedures, But if business risk is assessed to be high, the audit should reevaluate the overall audit risk from his initial assessment and consider whether to continue serving as an auditor, Scanned with CamScanner