QUESTIONS AND ANSWERS Auditing Help

The general manager of your client company has set up his own firm as supplier of goods.

Fictitious invoices were sent to the company and the firm was paid without supplying goods to the company.

The general manager’s duties included matching of invoices with goods received notes. Upon his initials on the invoice indicating that a matching has been performed the accountant has entered the invoices in the purchases day book. The company does not maintain perpetual inventory records.

The fraud involved Rs.5.6 million which is material was discovered after the audit. The auditor could not detect fraud. The managing director sued the auditor for negligence. How the auditor could have minimized the liability for negligence?

The auditor could have minimized the charge for negligence had he
carried out following steps.

Analytical procedures, particularly unusual changes in gross profit margins.
• Whether new suppliers approved by the managing director?
• Were references obtained for new suppliers from credit agencies?
• Report the weaknesses in the internal control system.
• Inspect purchase orders and goods received notes.

Company suspects that a manager receives commission from suppliers on purchase of goods. State how such a fraud can be detected?

Following matters should be considered:

• Comparison of invoices with entries in stock records. Supplier may be giving short delivery.
• Inspection of quality of goods supplied. Sub standard quality might have been supplied.
• Inquire whether sufficient number of quotations have been received.
• Study criteria for selecting the supplier.
• Investigate if order is not placed with the supplier offering lowest bids.
• Independent verification of prices from the market.
• High volume of purchases for a supplier.

What course of action will you take if you detect a fraud committed by a director?

The amount involved is not material and the fraud has been rectified on you recommendation.

Report the matter to Board / audit committee. Consider the client as high risk client. Modify nature, timing and extent of substantive procedures. Consider reliability of management representations.

You are the auditor of a manufacturing company for year ended December 31, 20 x 9. The client produces specialized equipment. You have discovered that the client has used substandard material in contravention of contract specifications on one of the major job order.

The equipment has been delivered to the customer on December 15, 20 x 9. No complaint has yet been received from the customer.

Discuss your duties as regard use of sub standard material by your client on a job order.

You are not sure about the degree of seriousness of the matter.

Matters to be considered in this case include:

Obtain an understanding of the circumstances in which non compliance of contract has occurred.

Obtain sufficient other information to evaluate possible effect on the financial statements such as fines, penalties, enforced discontinuation of operations and litigation …

Consider whether potential financial consequences require disclosure.

After evaluation of seriousness of noncompliance with contract, consider whether a true and fair view is impaired.

Document the findings and discuss with management.

If adequate information is not available from management, discuss legal consequences of using sub standard material with the company lawyers and what further action the auditor should take.

Consider the implication of non compliance in relation to other aspects of the audit, particularly the reliability of management representations.

The auditor should communicate the matter to audit committee.

If the auditor considers that non compliance has a material effect on
financial statement, the auditor should express a qualified or adverse opinion.

What are auditor’s duties as regards immaterial frauds?

The auditor is not responsible for not detecting immaterial fraud, unless he has carried out examination on immaterial items and the audit procedures are not satisfactory.

If the auditor has detected a fraud which is not material, he should immediately report it to management so that management may investigate the matter.

If the management does not take any action, it is possible that the management is also a party to such fraud. In such case the auditor should report the fraud to audit committee.

What do you understand by “Earnings management”

Earnings management imply manipulation of profits to deceive the users of financial statements.

It includes creating secret reserves to equalize profits.

IAS 37 provides that caution is needed in making judgments under conditions of uncertainty, so that income or assets are not overstated. However uncertainty does not justify the creation of excessive provisions or a deliberate overstatement of liabilities.

In certain cases it may be difficult to draw a line between earnings management and prudent accounting, Here the auditor will have to use his professional judgement to assess whether the misstatement represents earning management.

Describe characteristics of fraud

Financial statements may be materiality misstated due to fraud or error. Fraud involves international misstatement.

Misstatements due to fraud arise either from:

(a) Fraudulent financial reporting
(b) Misappropriation of assets.

Both types of fraud involve:

(a) Incentive or pressure to commit fraud

For example, management may be given bonus based on achieving certain goals or may be penalized for not achieving goals.

(b) Opportunity to commit fraud

Where a person can override control or is aware of deficiencies in internal control he may use such opportunity.

(c) Justification to commit fraud

People may commit fraud and justify the act on the grounds that they believe that management has been unfair with them.

Fraudulent financial reporting involves:

– International misstatement
– Omission of amounts or disclosures to deceive users of financial statements
– Manipulation to maximize management’s compensation based on performance.
– Overstate earnings to obtain bank loans
– Understate earnings to save tax
– Alteration of accounts
– Misapplication of accounting policies.

Misappropriation of assets involve:

– Misappropriation of cash collection from debtors by teeming and leading.
– Stealing cash or inventory.
– Disclosing confidential information of entity in return for payment
– Using entity’s assets for example cars for personal use
– Use of dummy employees
– Payment to suppliers for goods not supplied
– Payment to workers for work not done
– Kickbacks for favouring a supplier.

ISA 315, Identifying and assessing the risks of material misstatement through understanding the entity and its environment, requires a discussion among the engagement team members about the susceptibility of the financial statements to misstatement. What are the objectives of such discussions? Give some examples of matters to be covered in such discussions.

The discussion among engagement team service following objectives.

(a) Assistants will be in a better position to understand possible risks due to fraud, in their respective areas so that they may modify
nature, timing and extent of audit procedures.
(b) Exchange of ideas among team members will be useful in identifying risk areas.
(c) Assistants get more in depth knowledge about the client from the
partners.

Examples of matters to be discussed include:

a) Areas susceptible to falsification of accounts or misappropriation
b) How the manipulation or misappropriation can be concealed
c) Circumstances that would lead the management to inflate or understate the profits.
d) Incentives and pressures on management to commit fraud.
e) Any unusual changes noted in the lifestyle of certain employees.
f) Management override of controls
g) Be alert that financial statements may be misstated due to fraud.
h) Consider whether change in the nature of audit procedures, in contrast to normal routine procedures may be more effective.

Discuss risk assessment procedures relating to fraud

Risk assessment procedures relating to fraud include:

(a) Inquiry from management and those charged with governance:

– Management assessment that the financial statements may be misstated due to frauds.
– Management process to identify the frauds
– Actions of management to prevent the frauds
– Actions of management against actual frauds detected
– Communication of code of ethics.

(b) Analytical procedures

Unusual trends and ratios may indicate existence of fraud.

(c) Other information

– Discussions with engagement team
– Discussions with internal auditor
– Need to obtain additional financing
– Incentives and pressures.

Discuss auditor’s duties as regards identification of the risks of material misstatement due to fraud.

The auditor should obtain understanding as to what controls exist to
prevent, detect and correct misstatements in financial statements due to fraud. For example, what controls exist to identify overstatement or understatement to revenues.

Describe how the auditor should respond to the assessed risk of material misstatement due to fraud.

Responses to the assessed risk of material misstatement due to fraud fall under two categories:

(a) Overall response
Overall risk of material misstatements relates to weak control environment and factors affecting financial statements as a whole e.g., lack of integrity of management, unusual pressures on management, incompetent management and nature of business.

Overall response includes:

  1. Greater degree of professional skepticism.
  2. Assigning more qualified and experienced to the engagement.
  3. More close direction, supervision and review.
  4. Expended substantive procedures.
  5. Element of unpredictability in the selection of audit procedures:
    – Changes in sampling selection method
    – Reduction in materiality level
    – Surprise visit.

(b) Response at assertion level

Response at assertion level includes modification in the nature, timing and extent of audit procedures.

Nature, for example:

– Detailed test rather than analytical procedures
– Direct confirmation rather than the confirmations through entity
– Positive confirmations, rather than negative confirmations
– Use of CAATs to gather more reliable evidences.
– Use of evidences obtained from various sources or nature.

Timings, for example performing certain procedures at or near end rather than before or after year-end.

Extent, that is, increasing sample size.

How the management override of control can be used to commit frauds?

Management may override controls to achieve following:

– Recording transactions in unusually complex manner
– Recording invalid entries
– Misuse of judgment
– Misuse of estimates
– Omission or delaying the recording of transactions and events.

Discuss audit procedures regarding risk related to management override

1. Consider presence of fraud risk factors
2. Consider controls over journal entries and other adjustments
3. Consider lack of audit trail in case of IT environment
4. Give particular consideration to those journal entries which involve:

– Rounds sums
– Prepared by persons who do not normally prepare the entries
– Use of usual accounts
– Entries with little or no narrations
– Entries made immediately before or after year end
– Significant estimates
– Frauds committed in previous years
– Unusual differences between reconciliations.

5. Review reasonableness of accounting estimates:

(a) Possible management bias
(b) Past experience with the client
(c) Subsequent events review for transactions recorded on the basis of estimates.

6. Lack of business rationale of transactions:

(a) Special purpose entities
(b) Inadequate documentation
(c) Substance differs from form.

Discuss auditor’s duties as regards evaluation of audit evidence

Evaluation of audit evidence involves consideration of following matters:

1. Carry out analytical procedures at the final review stage to as certain whether the financial statements are consistent with the auditor’s understanding of the entity (as obtained at risk assessment stage).
2. Use professional judgments whether the misstatement is fraud or error. If the circumstances indicate a fraud, the auditor should re valuate the integrity of management and evaluate the effect that this may have on the reliability of other representations obtained.
3. Also, if senior management is involved in fraud, even if the fraud is relatively not material, the auditor should consider impact on other representations of management.

What matters the auditor should consider in withdrawl from audit engagement if a material fraud is detected and management takes no action the fraud.

The auditor should consider following matters in withdrawl from audit engagement if a material fraud is detected and management takes no action to rectify the fraud:

(a) Professional and legal responsibilities
(b) Significance of impact on financial statements
(c) Integrity of management
(d) Seeking legal advice.

On what matters the auditor should obtain representation from
management as regards frauds.

The representation should state that the management has disclosed to auditor:

(a) Management’s assessment of risk that the financial statements may be materially misstated as a result of fraud.
(b) Management’s knowledge of actual and suspected fraud.

What are auditor’s duties as regards communication of fraud of
management.

The auditor should consider following matters:

(a) If the fraud is committed by a lower management level, the fact should be brought to the attention of next higher level.
(b) If senior management is involved in fraud the matter should be communicated to those charged with governance.
(c) If those charged with governance are involved in fraud the auditor should obtain a legal advice.

The auditor should also communicate to those charged with governance: following matters:

– Refusal management to implement weaknesses in internal control
– Lack of integrity and competence of management
– Inadequate entity’s risk assessment procedures
– Indications that management has deliberately manipulated accounts for earnings management.
– Unauthorized transactions.

During the course of audit an auditor is expected to be vigilant enough to develop understanding about the propriety of important transactions and to determine whether or not such transactions have appropriate business rationale.

Required
Briefly describe the situations in which a transaction is indicative of fraud or an attempt to conceal fraud or fraudulent reporting.

Some of the situations which are indicative of fraud or an attempt to
conceal fraud or fraudulent financial reporting are as follows:

– Significant transaction, that are outside the normal course of business or that otherwise appear to be unusual.
– Where a transaction appears overly complex.
– Management has not discussed the nature of and accounting for such transactions with those charged with governance of the entity and there is inadequate documentation.
– Management is placing more emphasis on the need for a particular accounting treatment than on the underlying economics of the transaction.
– Transactions that involve non-consolidated related parties, including special purpose entities and have not been properly reviewed or approved by those charged with governance of the entity. .
– The transactions involve previously unidentified related parties or parties that do not have the substance or the financial strength to support the transaction without assistance from the entity under audit.

What action the auditor should take if he has detected (a) material fraud? (b) immaterial fraud.

(a) Material fraud:

1. Communicate to management
2. Consider whether audit strategy and audit plan needs revision.
3. Perform further audit procedures to re-evaluate amount of possible misstatement.
4. Should not assume that it is an isolated instance.

(b) Immaterial fraud:

If the misstatement in financial statements is immaterial, the auditor need not further investigate the matter. The auditor should, however, communicate the fraud to management for investigation.

You are the Audit Manager on the audit of AI-Salam Pakistan Limited (ASPL) for the year ended June 30, 2010. ASPL is engaged in the manufacture of a wide range of plastic products. While reviewing the initial work performed by the audit team, the following matters have come to your notice:

(i) The quantity of material scraped during the year is material is different from the quantity of scrap sold. The company’s records show nil balance both at the beginning and at the close of the year. No reconciliation for the difference has been provided to the company.

(ii) Sales for the year have increased by 7% over the previous year. However, it has been noted that sales in the last two weeks of June 2010 have .been exceptionally high and represent 15% of the annual sales. The audit working papers carry the following observations in respect of the above:

• 70% of the sales in the last two weeks of June were made to two new customers whose credit assessment has not been formally documented.
• A significant portion of the goods sold to the above referred customers were returned in the first week of July 2010; and
• Management bonuses are linked to the operating performance of the company.

(iii) During the year, ASPL purchased a machine for Rs. 25 million. The payment voucher is duly supported by the invoice from the supplier. However, the fixed assets schedule provided by the client shows the amount capitalized as Rs. 2.5 million. Depreciation has been charged on this amount. The difference of Rs. 22.5 million is appearing in the Bank Reconciliation Statement.

Required
(a) Analyze each of” the above situations and assess whether it
represents a fraud or an error.
(b) What action would you take to deal with the above matters?

(a)

(i) In the absence of any valid explanations from the management, it
would be considered as misappropriation of assets i.e. fraud as it seems to involve the theft of an entity’s assets.
(ii) It is a case of fraudulent financial reporting as it seems that management has tried to inflate the sales in order to deceive financial statement users. An apparent intention behind this
action is the management bonuses which are linked to the operating performance of the company.
(iii) It is an error on the part of accountant. The underlying records such as the invoice etc. have not been altered and even ‘the voucher has been prepared with the correct amount which shows that it is an unintentional misstatement.

(b)

(i)&(ii) If we have identified a fraud or has obtained information that indicate that a fraud may exist, we should communicate these matters on a timely basis to the appropriate level of management. This is so even if the matter might be considered immaterial. We should consider whether there are matters related to fraud to be discussed with- those charged with governance of the entity. Matters may include:
• Concerns about the nature, extent and frequency of management’s assessments of the controls in place to prevent and detect fraud and of the risk that the financial statements may be misstated.
• A failure by management to appropriately address identified significant deficiencies in-internal control, or to appropriately respond to an identified fraud.
• Our evaluation of ASPL’s control environment, including questions regarding the competence and integrity of management.
• Actions by management that may be indicative of fraudulent financial reporting, such as management’s effort to manage earnings in order to deceive financial statement users by influencing their perceptions as to the entity’s performance and profitability.
• Concerns about the adequacy and completeness of the authorization of transactions that appear to be outside the normal course of business. Based on the discussion and our overall understanding of the matter, we should:
• Ask the management to reverse the sales made;
• Revise its risk assessment of the entity’s control environment and modify the further planned audit procedures accordingly;
• Consider the impact on audit report.

(iii) Since this seems to be an error, the appropriate level of management should be informed about it and the relevant adjustments in fixed assets and depreciation account should be made.

You suspect that the accountant of one of your clients has passed through fictitious purchase invoices from suppliers not included in the list of approved suppliers.

What procedures would you perform to confirm the fraud?

The procedures to be performed to confirm the fraudulent invoices
include:

1. Obtain list of approved suppliers from the top management.
2. Identify purchases from unauthorized suppliers.
3. Match suppliers’ invoices with purchase orders and goods received notes.
4. Inspect statement of accounts received from suppliers. It is highly possible that suppliers’ invoices from fictitious suppliers will be missing.
5. Discuss the fraud with senior management.

Give a few examples as to how can a computer fraud take place. Also recommend some measures to detect computer frauds.

Computer fraud

A person cannot commit computer fraud unless he has access to computer or terminal, data files, computer programmes, systems information or time and opportunity to convert assets to personal use. Unauthorized access and inadequate segregation of duties in some instances have caused following frauds.

Examples

• A bank employee credited current account cheques to his personal account instead of appropriate revenue account.
• A programmer of a large bank wrote a programme for identifying and reporting all overdrawn accounts. The programmer was also an operator of bank computer. He was able to insert a “patch” in the programme causing the computer not to list his overdrawn balance, he then withdrew large sum of balances. The fraud was only when incidentally detected the computer broke down and the listing had to be prepared manually.

Leakage of confidential information.

In a manual system it is not easy to take away books of accounts from office. In a computer system copies of removable discs can be taken away just putting them in the pocket.

Following techniques may be useful in detecting computer fraud:

• Direct confirmation with receivables and payables
• Analytical review
• Service of computer specialist
• Two operators per shift. This may prevent irregularities unless there is collusion.

Mr. Ansari who represents ABC & Company, Chartered Accountants, is the manager responsible for the first year audit of Stello Limited (SL) for the year ending December 31, 2009. Previously the financial statements were audited by a very well reputed audit firm. ABC & Company has now been appointed as the auditors, in pursuance of SL’s policy according to which the statutory auditors are to be rotated after every five years.

While reviewing the working papers at the planning stage, Mr. Ansari became aware of the following facts:

Background:
The main business of the company is the operation of smelting plants that produce steel from iron ore. The company was founded almost five years ago by a group of enter presents. Its managing director is Mr. Sami who has vast experience of working in reputed national and international companies. Since inception, the company has experienced exceptional growth. To generate funds for some of its future plans, the management is considering to get the company listed before December 2010. The management expects to raise Rs. 700 million by issuing 50 million ordinary shares at a premium ofRs. 4 per share.

Management Policies:
The company has developed a sound system of Corporate Governance. Most of the executive heads are experienced professionals. The company believes in employing a satisfied workforce. In addition to competitive market based salaries, it also offers performance based bonuses at all level, including the senior management.

System of Accounting and Controls
The review of working papers indicates that the company has developed a sound accounting and reporting system. The company has recently installed a state of the art accounting software. However, as regards the system of disposal of scrap, the concerned engagement team member had made the following observations:

• The sale and disposal of scrap is managed by Mr. Sultan who is an Assistant Manager and reports to the Senior Manager Marketing.
• The scrap generated is collected by a local merchant on a daily basis. The rate is negotiated by Mr. Sultan once every three months.
• Only Mr. Sultan is authorized to sign the gate pass but quite often, in his absence, it is signed by the delivery clerk.

Operating Results and Projections:
The compound annual growth in company’s earnings over the last three years has exceeded 20% per annum and the projected earnings growth for the year ending December 31, 2009 is in excess of 35%. The growth is mainly on account of profitable contracts which the company has occured with two local manufactures.

Some of the important events that have taken place during the current year are as follows:

Acquisition of Neptune Enterprise:
On July 1,2009 Stello Limited acquired 80% shares of Neptune Limited, a company based in Argentina. This company manufacturers steel products that are sold in its local market. The purchase was finance by means of a foreign currency loan. The loan is repayable in five equal annual installments, commencing on July 1,2010. The financial year-end of Neptune Limited is June 30.

Major Capital Expenditure:
The company has increased the production capacity of one of its plant. Land was acquired for the purpose from a company in which a friend of Mr. Sarni is the majority shareholder. Plant and machinery was supplied by Big Manufacturer (Pvt.) Ltd. (BMPL). Although a lower quote was received from another supplier, the Board decided in favour of BMPL as it had a long standing business relationship with Stello whereas the other supplier was considered to be too inexperienced.

Required
(a) Evaluate the above situation and briefly discuss the key risk
areas that Mr. Ansari should consider while planning the audit.

(b) List three key audit procedures which the auditors may like to undertake, in the above circumstances, in respect of each of the following:

(i) Foreign currency loan
(ii) Capital expenditure.

(a) Key risk areas:

– First year’ audit, risk of material misstatement in opening balances
– Scrap sales lack segregation of duties
– New computer system, possibility of errors
– Plans to get listed on stock exchange, risk of manipulation of financial statements to show better profitability, liquidity and solvency.
– Performance based bonus may lead to pressures and incentives to manipulate the results.
– Sales to a few major customers. Risk is that the company may loose some of these customers.
– Misstatements of financial statements relating to consolidation adjustments.
– Different year end of Argentina subsidiary.
– Misstatement in the application of IAS 21, foreign currencies.
– Purchase of land from a company in which a friend of
– Mr. Sami is the majority shareholder. Transaction may not have been entered at fair value.
– Risk of overtrading.
– The Argentina company operates in an environment of significant currency devaluation and highly inflationary economy.
– Intercompany transactions.
– Foreign currency risk
– Rapid growth may result in need of further financing.
– This may incline the entity to manipulate financial statements in order to obtain financing.

(b) Foreign currency loan:

– Obtain direct confirmation from lender.
– Consider compliance with exchange regulations.
– Review loan agreement.

Capital expenditure:

– Consider hiring an expert for independent valuation of land.
– Consider whether the transaction is arm’s length.
– Carry out physical inspection.

Posted on November 2, 2015 in The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements

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