Chapter 7 Notes.pdf

Chapter 7 – Fraud Risk Assessment and Illegal Acts Causes of Misstatements A. Errors = UNINTENTIONAL misstatement or omission of amts in F/S B. Fraud a. Misappropriation of Assets b. Financial Reporting Definition Related to Fraud:  Fraud = KNOWINGLY making material misrepresentations of fact, with the intent of inducing someone to believe the falsehood and act upon it and thus suffer a loss or damage o Lie, cheat, steal, dupe others  Auditors are mainly considered with: o Employees misappropriating company assets o Management making false or misleading claims in F/S  Employee Fraud: Dishonestly taking money or other property from an employer – May include falsifying documents, lying, exceeding authority or violating policies  Embezzlement: Employees or non-employees wrongfully taking money or property entrusted to their care, custody and control – Often accompanied by false accounting entries and cover-up  Defalcation: Term used when somebody in charge of safekeeping the assets is doing the stealing (maybe due to corruption or misappropriation)  Fraudulent Financial Reporting: Intentional manipulation of reported financial results by: o Manipulation of accounting records or supporting documents o Misrepresentation or omission of significant information o Intentional misapplication of accounting principles  Done to portray a misstated economic picture of the firm by which the perpetrator seeks an increase in personal wealth gain (through a risk in stock price or compensation) What is Fraud? Fraud and other irregularities refer to an INTENTIONAL MISSTATEMENT in F/S, including an omission of amount or disclosure, or to a misstatement arising from theft of the entity’s assets. Fraud also involves: i. The use of deception such as manipulation, falsification, or alteration of accounting records or documentation; Keval Shah Chapter 7 – AFM 451 1 ii. Misrepresentation or intentional omission of events, transactions, or other significant information; or iii. Intentional misapplication of accounting principles relating to amount, classification, or manner of presentation of disclosure.  Note: The auditor is concerned with a suspected fraud rather than a proven one  Final determination of whether fraud has occurred is a legal issue  court Auditor’s Responsibility Related to Fraud (CAS 240.05)  An auditor is responsible for obtaining reasonable assurance that the F/S are free from material misstatement, whether caused by FRAUD or error.  Owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements of the F/S may not be detected, even though the audit is properly planned and performed in accordance with the CASs  The auditor should maintain an attitude of PROFESSIONAL SKEPTICISM throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, NOTWITHSTANDING PAST EXPERIENCE with the entity about the honesty and integrity of management and those charged with governance.(12)  Members of the engagement team should discuss THE SUSCEPTIBILITY OF THE F/S TO MATERIAL MISSTATEMENT DUE TO FRAUD (.15)  CAS 240 requires auditor to make enquiries of mgmt. about fraud and to consider fraud risk on every audit engagement  Auditor should document: o Fraud risk factors identified as being present during the auditor’s assessment process o The auditor’s response to the assessed risks of material misstatement due to fraud at the financial statement level  This includes the nature, timing and extent of audit procedures and how the procedures link to with the assessed fraud risks at the assertion level. Note:  Misappropriation of assets = Fraud AGAINST the company  Financial Statement Fraud = Fraud FOR the company. o Ponzi schemes are a misreporting fraud. Management & Audit Committee Oversight Management  Assess Risk  Respond to Risks Keval Shah Chapter 7 – AFM 451 2  Communicate Risks Audit Committee  Overseen the organization’s financial reporting and internal control procedures.  Consider the potential for MANAGEMENT OVERRIDE.  Investigates financial reporting issues. What does the Auditor Do:  Analysis  Brainstorm  Management Bias COSO Study  Major Types o Revenue recognition  Fictitious Revenue  Prematurely o Overstated Assets  Overstated inventory  Recording assets not owned o Understated expenses  Capitalizing items properly expensed Why is it difficult for AN AUDITOR to detect fraud? (More difficult than employees, mgmt) 1. the auditor’s knowledge of client’s I/C may be INFERIOR to that of employees 2. the fraud will be INTENTIONALLY CONCEALED 3. client management may have the ability to OVERRIDE internal controls  Note: Weak Internal Controls = Greater Risk of Fraud Illegal Acts Responsibility of the Client (CAS 250.3)  It is the RESPONSIBILITY OF MANAGEMENT, (and those charged with governance), to ensure that the entity's operations are conducted in accordance with the provisions of laws and regulations, including compliance with the provisions of laws and regulations that determine the reported amounts and disclosures in an entity's F/S. Illegal Acts – Auditor’s responsibilities (250.5): Identifying material misstatement of the F/S due to non-compliance with laws and regulations. Keval Shah Chapter 7 – AFM 451 3  In conducting an audit, the auditor takes into account the applicable legal and regulatory framework. Owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements in the F/S may not be detected, even though the audit is properly planned and performed in accordance with the CASs Auditor’s responsibilities - inherent limitations (250.5) 1. Many laws and regulations, relating principally to the operating aspects of an entity, that do not affect the F/S and are not captured by the entity's information systems relevant to financial reporting. 2. Non-compliance may involve conduct designed to conceal it, such as collusion, forgery, deliberate failure to record transactions, override of controls or intentional misrepresentations made to the auditor. 3. Matter for legal determination Auditor’s Responsibilities The auditor must consider the consequences of illegal acts and the best way of disclosing such consequences.  Illegal acts may be difficult to detect due to: o Efforts made to conceal them or o Questions about whether an act is actually illegal, which must be determined in a court of law.  Auditors should inform management about the limitations in detecting illegal acts in the engagement letter.  Direct-Effect Illegal Acts = Violations of laws or government legulations by the company that produce direct and material effects on dollar amts in the F/S  Indirect-Effect Illegal Acts = Violations of laws and regulations that are far removed from financial statements (i.e. securities trading)  CAS 250 requires auditors to consider the consequences of the illegal acts very broadly o If failure to disclose would result in a material misstatement, then the auditor should attempt to reduce this risk to an appropriately low level Communication with Audit Committees (or Equivalent) CAS 260 requires oral or written communication from the auditors on the following: (a) misstatements other than trivial errors; (b) fraud; (c) misstatements that may cause future financial statements to be materially misstated; (d) illegal or possibly illegal acts, other than ones considered inconsequential; and (e) Significant weaknesses in internal control. Keval Shah Chapter 7 – AFM 451 4 Materiality and Fraud  Recall: Immaterial ERRORS are suppose