Lecture 2

Objectives and Scope of Financial Statement Audit

Learning outcomes
 Explain the objective of conducting an
audit
 Explain the auditor’s responsibility for
detecting fraud
 Explain the categories of management
assertions
 Identify and State management
assertions about items and
components in the financial
statements
 Describe and apply the audit
objectives that relate to managements
assertions
Objective of Conducting an
Audit of Financial Statements
In conducting an audit of financial statements,
the overall objectives of the auditor are:

(a) To obtain reasonable assurance about whether the

financial statements as a whole are free from material
misstatement, whether due to fraud or error, thereby
enabling the auditor to express an opinion on whether
the financial statements are prepared, in all material
respects, in accordance with an applicable financial
reporting framework; and

(b) To report on the financial statements, and

communicate as required by the ISAs, in accordance
with the auditor’s findings.
Directors’ Responsibilities

Section 248 of Companies Act stated that the

directors of every company shall present at
its annual general meeting a financial
statements for the financial years.

The financial statement of a company shall

be duly audited before they are presented in
the annual general meeting
Responsibilities of an auditor

 The auditor’s opinion on the financial

statements is based on the concept of
obtaining reasonable assurance; hence, in an
audit, the auditor does not guarantee that
material misstatements, whether from fraud
or error, will be detected.
 However, it is important to note that auditor
is still responsible to detect material fraud
and error.

5
Fraud and the auditor
( ISA240)
Management responsibilities
on fraud
 The primary responsibility for the
prevention and detection of fraud rests
with both those charged with governance
of the entity and management.
 It is important that management, with the
oversight of those charged with
governance, place a strong emphasis on
fraud prevention, which may reduce
opportunities for fraud to take place, and
fraud deterrence, which could persuade
individuals not to commit fraud because
of the likelihood of detection and
punishment
Auditor’s Responsibilities
Auditor’s Responsibilities
Some definitions review
 Misstatement
 Misstatement in F/S can arise from fraud or error,
that include omissions of an amount of disclosure
 Misstatement may consist of the following:
• A difference of amount, classification or
presentation of reported financial statement item
and the amount , classification, or presentation that
would have been reported under approved
accounting standards
• The omission of a financial statement element,
account or item
• A financial statement disclosure that is not
presented in accordance with approved accounting
standards
• The omission of information required to be disclosed
in accordance with approved accounting standards
Some definitions review
 Fraud
 Intentional act involving the use of deception to
obtain an unjust or illegal advantage
Fraud could be classified into 2 types:
• Misstatements arising from fraudulent financial
reporting
• Misstatements arising from misappropriation of
assets

 Error
 Unintentional misstatements or omissions of amounts
or disclosure
• Mistakes in gathering or processing data from which
financial statements are prepared
• Unreasonable accounting estimates arising from
oversight or misinterpretation of facts
• Mistake in application of accounting standards
Frauds relevant to auditors

Fraudulent Financial
Reporting

Management Fraud Material Misstatement

Arising From
Fraud

Misappropriation/
Theft of Assets
Employee Fraud
Management Fraud

 Management has ability to perpetrate fraud because it

is in the position to directly or indirectly manipulate
the accounting records and prepare fraudulent
financial report

 Fraudulent activity involved management override of

internal controls, collusion among the management ,
employees, or third party

 Because of the characteristic of fraud, an auditor

may unknowingly rely on audit evidence that appears
to be valid, but in fact is false and fraudulent.
Fraud Risk Identification
Process
 Communication among audit team
 Inquiries of management and others
 Identify Fraud Risk factors
 Analytical procedures
 Other information
 Communication among audit team
 ISA
315 requires a discussion among the engagement team members and a
determination by the engagement partner of which matters are to be
communicated to those team members not involved in the discussion
 The objective of the communication are to
 Providesan opportunity for more experienced engagement team members to
share their insights about how and where the financial statements may be
susceptible to material misstatement due to fraud
 Enablesthe auditor to consider an appropriate response to such susceptibility
and to determine which members of the engagement team will conduct
certain audit procedures.
 Permitsthe auditor to determine how the results of audit procedures will be
shared among the engagement team and how to deal with any allegations of
fraud that may come to the auditor’s attention.
Inquiry of management and other
 For those entities that have an internal audit function,
the auditor shall make inquiries of internal audit to
determine whether it has knowledge of any actual,
suspected or alleged fraud affecting the entity, and to
obtain its views about the risks of fraud.

 The auditor shall obtain an understanding of how those

charged with governance exercise oversight of
management’s processes for identifying and responding
to the risks of fraud in the entity and the internal
control that management has established to mitigate
these risks, whether they have knowledge of any actual,
suspected or alleged fraud affecting the entity.
Fraud Risk Factor
Fraud Risk Factor
ISA 240 The auditor’s responsibilities to
consider fraud in an audit of financial
statement

 The auditor shall evaluate whether the

information obtained from the other risk
assessment procedures and related activities
performed indicates that one or more fraud
risk factors are present.
 While fraud risk factors may not necessarily
indicate the existence of fraud, they have
often been present in circumstances where
frauds have occurred and therefore may
indicate risks of material misstatement due
to fraud
 Fraud Risk Factor

Fraud risk factors are events or conditions

that indicate an incentive, pressure or
opportunity to commit fraud
An Incentive /pressure to perpetrate fraud
An Opportunity to carry out the fraud
An attitude/ rationalization to justify the
fraudulent action
Fraud Risk Factors( Fraudulent Financial
Reporting)
Incentives/Pressures ( Not Exhaustive List)

Financial stability or profitability is threatened by economic, industry, or

entity operating conditions, such as : high degree of competition or market
saturation, accompanied by declining margins, high vulnerability to rapid
changes, such as changes in technology, product obsolescence, or interest
rates.

Excessive pressure exists for management to meet the requirements or

expectations of
third parties due to: need to obtain additional debt or equity financing to
stay competitive – including financing of major research and development
or capital expenditures.

Information available indicates that the personal financial situation of

management or those charged with governance is threatened by the
entity’s financial performance arising from: Significant 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

There is excessive pressure on management or operating personnel to

meet financial targets established by those charged with governance,
including sales or profitability incentive goals.(Para A 25, ISA240)
Fraud Risk Factors( Fraudulent Financial Reporting)
Fraud Risk Factors( Fraudulent Financial Reporting)

Attitudes/ Rationalisations( Not Exhaustive List)

Communication, implementation, support, or enforcement of the

entity’s values or ethical standards by management, or the
communication of inappropriate values or ethical standards, that are not
effective.

Nonfinancial management’s excessive participation in or preoccupation

with the selection of accounting policies or the determination of
significant estimates.

Known history of violations of securities laws or other laws and

regulations, or claims against the entity, its senior management, or
those charged with governance alleging fraud or violations of laws and
regulations.

 Excessive interest by management in maintaining or increasing the

entity’s stock price or earnings trend.
Fraud Risk Factors( Misappropriation
of Asset)

Incentives/Pressures ( Not Exhaustive List)

Personal financial obligations may create pressure on

management or employees with access to cash or other
assets susceptible to theft to misappropriate those assets.

Adverse relationships between the entity and employees

with access to cash or other assets susceptible to theft may
motivate those employees to misappropriate those assets.
Fraud Risk Factors( Misappropriation of Asset)
Opportunities ( Not Exhaustive List)

Certain characteristics or circumstances may increase the susceptibility

of assets to misappropriation. For example, opportunities to
misappropriate assets increase when there are the following:
Large amounts of cash on hand or processed.
Inventory items that are small in size, of high value, or in high demand

Inadequate internal control over assets may increase the susceptibility of

misappropriation of those assets.
Inadequate segregation of duties or independent checks.
Inadequate oversight of senior management expenditures, such as travel
and other re-imbursements.
Fraud Risk Factors( Misappropriation of Assets)

Attitudes/ Rationalisations( Not Exhaustive List)

Disregard for the need for monitoring or reducing risks
related to misappropriations of assets.
Disregard for internal control over misappropriation of
assets by overriding existing controls or by failing to take
appropriate remedial action on known deficiencies in
internal control.
Behavior indicating displeasure or dissatisfaction with
the entity or its treatment of the employee.
Changes in behavior or lifestyle that may indicate assets
have been misappropriated
Analytical Procedure & Other information

 The auditor shall evaluate whether unusual or

unexpected relationships that have been identified in
performing analytical procedures, including those
related to revenue accounts, may indicate risks of
material misstatement due to fraud.
 Other information obtained about the entity and its
environment may be helpful in identifying the risks of
material misstatement due to fraud. The discussion
among team members may provide information that is
helpful in identifying such risks. In addition,
information obtained from the auditor’s client
acceptance and retention processes, and experience
gained on other engagements performed for the entity,
for example, engagements to review interim financial
information, may be relevant in the identification of
the risks of material misstatement due to fraud.
2 Level of Assessments

 In accordance with ISA 315, the

auditor shall identify and assess the
risks of material misstatement due
to fraud at the financial statement
level, and at the assertion level for
classes of transactions, account
balances and disclosures
Auditors response to those
fraud risk factors
Overall Responses
 Increase professional skepticism
 Assign and supervise personnel taking
account of the knowledge, skill and ability
of the individuals to be given significant
engagement responsibilities and the
auditor’s assessment of the risks of material
misstatement due to fraud for the
engagement
 Evaluate whether the selection and
application of accounting policies by the
entity, particularly those related to
subjective measurements and complex
transactions, may be indicative of
fraudulent financial reporting resulting from
management’s effort to manage earnings
 Incorporate an element of unpredictability
in the selection of the nature, timing and
extent of audit procedures.
Responses at Assertion level
 The auditor’s responses to address the assessed risks
of material misstatement due to fraud at the
assertion level may include changing the nature,
timing and extent of audit procedures in the
following ways:
 The nature of audit procedures to be performed may
need to be changed to obtain audit evidence that is
more reliable and relevant
 The timing of substantive procedures may need to be
modified. The auditor may conclude that performing
substantive testing at or near the period end better
addresses an assessed risk of material misstatement
due to fraud.
 The extent of the procedures applied reflects the
assessment of the risks of material misstatement due
to fraud. For example, increasing sample sizes or
performing analytical procedures at a more detailed
level may be appropriate
Respond to the risk of
management override of controls
 Management is in a unique position to perpetrate
fraud because of management’s ability to manipulate
accounting records and prepare fraudulent financial
statements by overriding controls that otherwise
appear to be operating effectively. The following
step should be carried out
1)Test the appropriateness of journal entries recorded
in the general ledger and other adjustments made in
the preparation of the financial statements
2)Review accounting estimates for biases and evaluate
whether the circumstances producing the bias, if
any, represent a risk of material misstatement due to
fraud. In performing this review, auditor should
 Evaluate whether the judgments and decisions made by
management in making the accounting estimates included
in the financial statements, even if they are individually
reasonable, indicate a possible bias on the part of the
entity’s management that may represent a risk of material
misstatement due to fraud
Respond to the risk of
management override of controls
 Perform a retrospective review of management
judgments and assumptions related to significant
accounting estimates reflected in the financial
statements of the prior year.
3) Understanding the business rationales of
significant transaction:
For significant transactions that are outside the normal
course of business for the entity, or that otherwise
appear to be unusual given the auditor’s understanding
of the entity and its environment and other information
obtained during the audit, the auditor shall evaluate
whether the business rationale (or the lack thereof) of
the transactions suggests that they may have been
entered into to engage in fraudulent financial reporting
or to conceal misappropriation of assets.
Communication to Management, Those
Charged with Governance and Other about
fraud
 If the auditor has identified a fraud or has obtained information
that indicates that a fraud may exist, the auditor shall
communicate these matters on a timely basis to the appropriate
level of management in order to inform those with primary
responsibility for the prevention and detection of fraud of matters
relevant to their responsibilities.
 If the auditor has identified or suspects fraud involving
management, employees who have significant roles in internal
control and others, the auditor shall communicate these matters to
those charged with governance on a timely basis and discuss with
them the nature, timing and extent of audit procedures necessary
to complete the audit
 If the auditor has identified or suspects a fraud, the auditor shall
determine whether there is a responsibility to report the
occurrence or suspicion to a party outside the entity. Although the
auditor’s professional duty to maintain the confidentiality of client
information may preclude such reporting, the auditor’s legal
responsibilities may override the duty of confidentiality such as
required by law and regulatory, to successor auditor, in responses
to subpoena
Documenting &
Communicating about fraud
to management and others
Financial Statements Cycles

Audits are performed by dividing the financial

statements into smaller segments or components.
Typically, transaction cycle are shown as follow:
1)Revenue Cycle
2)Purchase Cycle
3)Human Resource Management/Payroll Cycle
4)Inventory Cycle
5)Financing Cycle
Management Assertions

 Management is responsible for the true

and fair presentation of financial
statements. Assertions are expressed or
implied representations by management
that are reflected in the financial
statements components
Management Assertions-3
categories

1. Assertions about classes of transactions and

events for the period under audit

2. Assertions about account balances at period end

3. Assertions about presentation and disclosure

Transaction Flow Example

Ledgers,
Transactions Journals Trial Balance,
and Financial
Sales Statements
Sales
journal
General ledger
and subsidiary
records
Cash Cash receipts
receipts journal
General ledger
trial balance
Acquisition
Acquisitions Financial
of goods
journal statements
and services
Transaction Flow Example

Ledgers,
Transactions Journals Trial Balance,
Cash and Financial
Cash Statements
disbursements
disbursements
journal General ledger
and subsidiary
records
Payroll
Payroll
services and
journal
disbursements General ledger
trial balance
Allocation
General Financial
and
journal statements
adjustments
Relationships Among
Transaction Cycles
General
cash

Capital acquisition
and repayment cycle

Sales and Acquisition Payroll and

collection and payment personnel
cycle cycle cycle

Inventory and
warehousing
cycle
Balance and Transactions
Affecting Balances Example

Accounts Receivable (in thousands)

Beginning balance $ 17,521

Sales $144,328 $137,087 Cash receipts

Sales returns
$ 1,242 and allowances

Charge-off of
$ 3,323 uncollectible
accounts

Ending balance $ 20,197

 Management Assertions for
Each Category of Assertions

Assertions About Classes Assertions About Assertions About

of Transactions and Events Account Balances Presentation and Disclosure
Occurrence Existence Occurrence and rights
and obligations
Completeness Completeness Completeness
Accuracy Valuation and Accuracy and
allocation valuation
Classification Classification and
understandability
Cutoff
Rights and
obligations
Management Assertion about class of
transactions and events/ Transaction
related audit objectives

All transactions and events that

Occurrence have been recorded have occurred

All transactions and events that should

Completeness be recorded have been recorded

Amount and other data relating to

Accuracy transactions and events have been
recorded appropriately
Management Assertion about class of
transactions and events/ Transaction
related audit objectives

.
Transactions and events have been
Classification recorded in proper accounts.

Transactions and events have been

Cut -off recorded in the correct accounting period.
 ABC Sdn Bhd
(Applied to Sales Transactions)

Management Assertions General Transaction- Specific Sales Transaction-

About Classes of related Audit related Audit Objectives
Transactions and Events Objectives

Occurrence Occurrence Recorded sales are for

shipments made to
Non fictitious customers
Completeness Completeness Existing sales
transactions are recorded
Accuracy Accuracy Recorded sales are for
the amount of goods
shipped and are correctly
billed and recorded
 ABC Sdn Bhd.
(Applied to Sales Transactions)

Management Assertions General Transaction- Specific Sales Transaction-

About Classes of related Audit related Audit Objectives
Transactions and Events Objectives

Accuracy Accuracy Sales transactions are

properly included in the
master file and are
correctly summarized
Classification Classification Sales transactions are
properly classified
Cutoff Cut off Sales transactions are
recorded on the correct
accounting period.
Assertions About Account Balances
/ General Balance-Related Audit Objectives

Asset, liabilities and equity interest

Existence exist

All assets, liabilities and equity interest

Completeness that should have been recorded
have been recorded

Assets, liabilities and equity interest are

Valuation and included in the financial statement
at appropriate amount and any resulting
allocation valuation or allocation adjustment are
appropriately recorded
Assertions About Account Balances
/ General Balance-Related Audit Objectives

The entity holds and control

Right and the rights to assets,
Obligation and liabilities are the obligation of entity
 ABC Sdn Bhd.
(Applied to Inventory)

Management Assertions General Balance- Specific Balance-related Audit

About Account Balances related Audit Objectives Applied to Inventory
Objectives
Existence Existence All recorded inventory exists
at the balance sheet date
Completeness Completeness All existing inventory has
been counted and included
in the inventory summary
 ABC Sdn Bhd
(Applied to Inventory)

Management Assertions General Balance- Specific Balance-related Audit

About Account Balances related Audit Objectives Applied to Inventory
Objectives
Valuation and Accuracy Inventory quantities on the
allocation client’s perpetual records
agree with items physically
on hand
Prices used to value
inventories are materially
correct
Extensions of price times
quantity are correct and
details are correctly added
 ABC Sdn Bhd.
(Applied to Inventory)

Management Assertions General Balance- Specific Balance-related Audit

About Account Balances related Audit Objectives Applied to Inventory
Objectives
Valuation and Detail tie-in Total of inventory items
allocation agrees with general ledger
Realizable Inventories have been written
value down where net realizable
value is impaired
Rights and obligations Rights and The company has title to all
obligations inventory items listed
Inventories are not pledged
as collateral
Assertions About Presentation and Disclosure

Disclose events, transactions, and other

Occurrence and
matters have been occurred and
right and obligation pertain to the entity

All disclosed event

that should have been included in the
Completeness financial Statement
have been included

Classification and Financial information is appropriately

understandability presented , described and disclosures
are clearly expressed
Assertions About Presentation and Disclosure

Accuracy and Financial and other information are

Valuation Disclosed fairly and appropriate amount
End of Lecture