Audit Lecture 3 Fraud

• Fraud


  An intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage
• Error


  Differs from fraud in only one respect - intent
• Types of intentional misstatements caused by fraud


  • Misstatements resulting from fraudulent financial reporting
  • Misstatements resulting from misappropriation of assets
• Primary responsibility for prevention and detection of fraud


  Rests with those charged with governance of the entity and with management
• Auditor's responsibility


  To obtain reasonable assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error
• Auditor's specific objectives


  1. Identify and assess the risks of material misstatement due to fraud

  2. Obtain sufficient appropriate evidence via audit responses to address such risks

  3. Respond appropriately to identified or suspected cases of fraud
• Audit approach


  1. Members of the engagement team should discuss the susceptibility of the entity's financial statements to material misstatement due to fraud and maintain professional scepticism

  2. The auditor should make enquiries of management regarding management's assessment of the risk that the financial statements may be materially misstated due to fraud and management's process for identifying and responding to the risks of fraud in the entity

  3. The auditor should determine management's process for identifying and responding to the risks of fraud and how such a process is communicated both to those charged with governance and to staff

  4. The auditor should enquire about any actual, suspected or alleged fraud affecting the entity including discussions about fraud with Internal Audit

  5. The auditor should obtain an understanding of how those charged with governance exercise oversight of management's processes for identifying and responding to the risks of fraud and the internal control that management has established to mitigate these risks as part of its ongoing risk management procedures
• Conditions that lead to fraud


  • An ability to rationalise the fraudulent action (Dishonesty)
  • A perceived opportunity to commit fraud (Opportunity)
  • An incentive to commit fraud (Motive)
• Attitudes/rationalisation leading to fraudulent financial reporting


  • Ineffective communication of the entity's values or ethical standards by management
  • Low morale among senior management
  • History of violations of securities laws or other laws and regulations
  • Management practice of aggressive or unrealistic forecasts
• Opportunities that lead to fraudulent financial reporting


  • Significant related-party transactions
  • Assets, liabilities, revenues or expenses based on significant estimates
  • Domination of management by a single person or small group
  • Complex or unstable organisational structure
  • Internal control components are deficient
• Incentive/pressure factors that lead to fraudulent financial reporting


  • Financial stability/profitability is threatened
  • Pressure on management to meet the expectations of third parties
  • Personal financial situation threatened by the entity's financial performance
  • Excessive pressure on management or operating personnel to meet financial targets
• Attitudes/rationalisation leading to misappropriation of assets


  • Overriding existing controls
  • Failing to correct known internal control deficiencies
  • Behaviour indication dissatisfaction with the entity
  • Changes in behaviour or lifestyle
• Opportunities that lead to misappropriation of assets


  • Large amounts of cash on hand or processed
  • Inventory items that are small in size, of high value, or in high demand
  • Inadequate internal controls over assets
• Incentive/pressure factors that lead to misappropriation of assets


  • Personal financial obligations
  • Adverse relationship between the entity and employees with access to cash or other assets susceptible to theft
• Audit approach


  1. Consider the unique position of management to perpetrate fraud via management override and journal entries and significant estimates accordingly

  2. Assess the risk of material misstatement due to fraud at both the financial statement and assertion levels

  3. Determine overall responses to address the assessed risks
• Overall responses to address assessed risks


  • Appropriate assignment and supervision of audit personnel
  • Consideration of accounting policies used by the entity
  • Incorporating unpredictability in the nature, timing and extent of audit procedures
  • Changing nature of audit procedures, e.g. more physical observation and inspection
  • Changing the timing of audit procedures away from the period end to interim figures
  • Changing the extent of procedures applied, e.g. larger sample sizes
• Procedures when misstatements are discovered


  When there is a misstatement indicative of fraud, the auditor should consider its implications in relation to other aspects of the audit, particularly the reliability of written representations
• Auditor's report when fraud is confirmed or unable to be concluded


  • Insufficient or inappropriate audit evidence - Qualified or disclaimer of opinion
  • Uncorrected fraud leading to material misstatement - Qualified or adverse opinion
• Communication of fraud or suspected fraud


  1. When the auditor identifies fraud or suspected fraud, he should communicate it to the appropriate level of management as soon as practicable

  2. Fraud should be communicated to those charged with governance where it involves management, employees who have significant roles in internal control, or others where the fraud results in a material misstatement in the financial statements

  3. The auditor should communicate to management and those charged with governance any material deficiencies of the design or implementation of internal control to prevent and detect fraud which have come to the auditor's attention

  4. The auditor may have a legal duty under national law to report fraud to regulatory and enforcement authorities
• Withdrawal from an engagement


  1. 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, then the auditor should consider the possibility of withdrawing from the engagement

  2. Such exceptional circumstances can arise when the entity does not take the appropriate action regarding fraud that the auditor considers necessary, the auditor's consideration of the risks of material misstatement due to fraud and the results of audit tests indicate a significant risk of material and pervasive fraud, or the auditor has significant concern about the competence or integrity of management or those charged with governance
• An unqualified opinion indicates that there are no material modifications required to the financial statements
• The purpose of the auditor’s report is to communicate the results of the audit, including any limitations or restrictions on the scope of the audit.
• An adverse audit report is issued when the financial statements are materially misstated and not in accordance with the applicable financial reporting framework.
• Auditor's report is the written communication from auditors to users about an audit.