Fraud and error

 PSA 240: The Auditor's Responsibility to Consider Fraud in an Audit of Financial

Statements
-establishes standards and provide 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
determines, that fraud and error has occurred.
Characteristics of Fraud
-Fraud is an intentionally deceptive action designed to provide the perpetrator with an
unlawful gain or to deny a right to a victim.-intentional misstatement
-fraud being a broad legal concept, auditor is concerned with fraud that causes a material
misstatement in the financial statements.
-Two types of intentional misstatements: misstatement resulting from fraudulent financial
reporting and misstatements resulting from misappropriation of assets.
Example situations:
1. Incentive or pressure to commit fraudulent financial reporting when management is
under pressure, to achieve an expected (and perhaps) unrealistic earnings target or
financial outcome.
2. Similarly, individuals may have to misappropriate assets, because they are living beyond
their means.
3. A perceived opportunity to commit fraud may exist when an individual believes internal
control can be overridden: if an individual is in a position of trust or has knowledge of
specific weaknesses in internal control
4. Otherwise honest individuals can commit fraud in an environment that imposes
sufficient pressure on them.
Fraudulent Financial Reporting
-involves intentional misstatements including omissions of amounts or disclosures in financiwl
statements to deceive the users.
-Such earning management may start with small actions or inappropriate adjustment of
assumptions and changes in judgement by the management.
-Pressure to meet market expectations or a desire to maximize compensation based on
performance that leads to a materially misstating financial statements.
- Management may be motivated to reduce earnings by a material amount to minimize tax or
inflate earnings to secure bank financing.
Fraudulent financial reporting may be accomplished by the following:
1. Manipulation, falsification (including forgery) or alteration of accounting records or
supporting documentation from which the financial statements are prepared.
2. Misrepresentation in, or intentional omission from, the financial statements of events,
transactions or other significant information
3. Intentional misapplication of accounting principles relating to amounts, classification,
manner of presentation, or disclosure.
Fraud can be committed by management overriding controls using such techniques as:
1. Recording fictitious journal entries, particularly close to the end of accounting period, to
manipulate operating results or achieve other objectives.
2. Inappropriately adjusting assumptions and changing judgement used to estimate
account balances.
3. Omitting, advancing or delaying recognition in the financial statements of events and
transactions that have occurred during the reporting period.
4. Concealing, or not disclosing, facts that could affect the amounts recorded in the
financial statements.
5. Altering records and terms related to significant and unusual transactions.

Misappropriation of assets
- Involves the theft of an entity's assets that is often perpetrated by employees in
relatively small and immaterial amounts. Il
- It can also involve management who are usually more able to disguise or conceal
misappropriations in ways that are difficult to detect.
- 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.
Common situations:
1. Embezzling receipts ( for example, misappropriating collections on accounts receivable
or diverting receipts in respect of written-off accounts to personal bank accounts)
2. Stealing physical assets or intellectual property (for example, stealing inventory for
personal use or for sale, stealing scrap for resale, colluding with a competitor by
disclosing technological data in return for payment).
3. Causing an entity to pay for goods and services not received (for example, payments to
fictitious vendors kickbacks paid by vendors to the entity's purchasing agents in return
for inflating prices, payments to fictitious employees).
4. Using an entity's assets for personal use (for example, using the entity's assets as
collateral for a personal loan or a loan to a related party).
Responsibility for the Prevention and Detection of Fraud
- The primary responsibility for the prevention and detection of fraud rests with
both charged with governance and management.
- -It is important that management, with the oversight of those charged with
governance to place a strong emphasis on fraud prevention, which may reduce
opportunities for fraud to take place, and fraud deterrence, which may persuade
individuals not to commit fraud because of the likelihood of detection and
punishment.
Responsibilities of Auditor
PSA 200: “Overall Objectives of the Independent Auditor and the Conduct of an Audit in
Accordance with Philippine Standards on Auditing.”
-Responsible to obtain reasonable assurance that financial statements are free from material
misstatements, whether caused by fraud or error.
Risk Assessment
In planning the audit, auditor should assess the risk that fraud and error may cause the financial
statements to contain material misstatements and should inquire of management as to any
fraud or significant error which has been discovered.
Conditions and events which increase the risk of fraud and error includes:
1. Questions with respect to the integrity or competence of management.
2. Unusual pressures within or on an entity.
3. Unusual transactions.
4. Problems in obtaining sufficient appropriate audit evidence.
Detection
-Based on risk assessment, auditor should design audit procedures to obtain reasonable
assurance that misstatements arising from fraud and error that are material is detected.
-auditor seeks sufficient appropriate audit evidence that fraud and error which may be material
to financial statements have not occurred or if they 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
accompanied by acts specifically designed to conceal its existence.
Inherent Limitations of an Audit
-Any accounting and internal control system may be ineffective against fraud involving collusion
among employees or fraud committed by management. Certain levels of msnsgement may be
in a position to override controls that would prevent similar frauds by other employees; for
example, by directing subordinates to record transactions incorrectly or to conceal them, or by
suppressing information relating to transactions.
Example of Fraud Risk Factors
1. Incentives/ pressure
2. Opportunities and
3. Attitude / rationalizations
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.
c. 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.
e. Recurring negative cash flows from operations or an inability to
generate cashflows from operations while reporting esrnings and
earnings growth
f. Rapid growth or unusual profitability especially compsred to that of
other companies in same industry.
g. New accounting, statutory, or regulatory requirements.
2. Excessive pressure from management to meet the requirements or
expectations of third parties due to following:
a. Profitability or trend level expectations of investment analysts,
institutional investors, significant creditors, or other external parties,
including expectations created by management in, for example, overly
optimistic press releases or annual report messages.
b. Need to obtain additional debt or equity financing to stay competitive –
including financing of major research and development or capital
expenditures.

3. Threatened personal financial situation of management or those charged with

governance relative to the entity’s financial performance due to
A. Significant financial interests in the entity
 B. Significant portions of their compensations such as bonuses, stock
options, being contingent ipon achieving aggressive targetd for
stock price, operating results, financial position, or cash flow.
C. Personal guarantees of debts of the entity.

B. Opportunities
1. Nature of the industry or the entity's operations provides opportunities to
engage in fraudulent financial reporting that can arise from
A. Significant related party transactions not in the ordinary course of
business or with related entities not audited or audited by another firm.
B. Assets, liabilities, revenues or expenses based on significant estimates
that involve subjective judgements or uncertainties that are difficult to
corroborate.
C. Significant, unusual, or highly complex transactions, especially those
close to period end that pose difficult “substance over form” questions.
D. Significant operations located or conducted across international
borders in jurisdictions where differing business environments and
cultures exist.
E. Significant bank accounts or subsidiary or branch operations in tax-
haven jurisdictions for which there appears to be no clear business
justification.
2. 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.
3. Complex and unstable organizational structure as evidenced by
A. Difficulty in determining the organization or individuals that hsve
controlling interest in the entity.
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 external reporting is
required)
B. High turnover rates or employment of accounting, internal audit, or
information technology staff are not effective.
C. Accounting and information systems that are not effective
© Attitudes and Rationalizations
1. Communication, implementations, 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.
2. Nonfinancial management's excessive participation in or preoccupation with the
selection of accounting policies or the determination of significant estimates.
3. Known history of violation of securities laws or other laws and regulations, or claims
against the entity, senior management or in charged with governance alleging fraud or
violations of laws or regulations.
4. Excessive interest by management in maintaining or increasing the entity's stock price
or earnings trend.
5. Management failing to correct known material weaknesses in internal control on a
timely basis
6. Low morale among senior management
7. The owner manager makes no distinction between personal and business trnadactions.