Fraud and Behaviours Flashcards
Defining financial statement fraud and auditor responsibility - What is fraud in the context of audit?
Auditor is concerned with fraud that causes a _____________ ______________ in the ______________ ________________, resulting from: (2)
What is the objective of an audit?
What is an error?
What is fraud?
Auditor is concerned with fraud that causes a material misstatement in the financial statements, resulting from:
- Fraudulent financial reporting
- Misappropriation of assets
Remember the objective of an audit …. “To obtain reasonable assurance that the financial statements as a whole are free from material misstatement, whether due to fraud of error ….”
Error
- “an unintentional misstatement in the financial statements, including omission of an amount or a disclosure”.
Fraud
- “an intentional act by one or more individuals (internal or external to the company) involving the use of deception to obtain and unjust or illegal advantage”.
Defining financial statement fraud and auditor responsibility - Fraud and the auditor – who is responsible?
Primary responsibility for _______________ and ______________ of fraud =?
What should they do (2)?
The Premise on which an audit is conducted …. management and where appropriate ________, ________________ and understand their _________________, including (3)
What is not the auditors responsibility and what are their responsibilities (3)
Inherent limitations of audit (3)
Primary responsibility for detection and prevention of fraud = those charged with governance of an entity and the management they oversee
- Create a culture of honesty and ethical behaviour
- Put in place appropriate controls
The Premise on which an audit is conducted …. management and where appropriate TCWG, acknowledge and understand their responsibilities, including:
- Preparation of financial statements
- For internal controls that are necessary to enable the preparation of financial statements that are free from material misstatement, whether caused by fraud or error
- To provide the auditor with information and access as needed
Auditor responsibility to detect fraud is a major issue in the gap between expectations of those who rely on the audit function and what the auditor is responsible for.
It is not the auditors responsibility to detect or prevent fraud! It is the auditors responsibility to:
- To identify and assess the risks of material misstatement of the financial statements due to fraud;
- To obtain sufficient appropriate audit evidence regarding the assessed risks….
- To respond appropriately to fraud or suspected fraud during the audit
Inherent limitations of audit; the auditor is not expected to obtain absolute assurance; they cannot eliminate audit risk because:
- The nature of financial reporting
- The nature of audit procedures
- The need for the audit to be conducted within a reasonable time frame and at a reasonable cost
Defining financial statement fraud and auditor responsibility - Inherent limitations in audit
The ____________ effect of inherent limitations, and _____ of ____-______________ are particularly ______________ when considering the possibility of _______ compared to ________
Why? (6)
However?
The potential effect of inherent limitations, and risk of non-detection, are particularly significant when considering the possibility of fraud compared to error
Why?:
- Sophisticated and carefully planned schemes
- Designed to conceal/intention to deceive
- Possible collusion
- Difficulty in determining if a misstatement in judgement areas (e.g. accounting estimate) are caused by fraud or error
- Where management is involved compared to employees, even more difficult
- Audit procedures effective for detecting errors may be ineffective at detecting fraud
However - Unless the auditor has reason to believe that a material misstatement due to fraud exists, the auditor may accept records and documents as genuine …. otherwise, the auditor shall investigate further
Defining financial statement fraud and auditor responsibility - Auditor requirements
________________ ______________ is very important, must be _______________
Key elements (5)
Procedures and activities (4/1,2,1,1)
Professional scepticism is very important, must be maintained and it means:
Auditors must approach their work with a questioning mindset, being alert to potential fraud or misstatements.
Key Elements:
- Perform risk assessment and design tailored audit procedures.
- Assume audit evidence is genuine, but stay alert for signs of fraud or errors.
- Avoid bias: Collect all evidence, including potentially contradictory data.
- Question management, the board (or Those Charged With Governance - TCWG), and internal audit about their fraud risk assessments and processes.
- Follow up on inconsistent or implausible responses during the audit.
Procedures and activities
Obtaining Understanding:
- Understand management’s approach to identifying, assessing, and addressing fraud risks, including the frequency and extent of these assessments.
Communication & Oversight:
- Examine how management communicates its fraud risk policies to the board (TCWG) and employees, promoting ethical behavior.
- Assess how the board oversees and monitors management’s processes regarding fraud risk.
Analysing Relationships:
- Look for unusual or unexpected relationships within the financial statements that could indicate fraud.
Fraud Risk Factors:
- Evaluate risk factors, such as opportunities for fraud, pressures on management, and potential rationalizations for fraudulent behavior.
Defining financial statement fraud and auditor responsibility - Auditor requirements
Respond to assessed risks of material misstatement due to fraud accordingly - How is this done? (5)
Respond to assessed risks of material misstatement due to fraud accordingly
- Assign audit team with knowledge, skill and experience based on assessment
- Increase scope and variety of testing as necessary, corroborate evidence
- Evaluate accounting policies; focus on areas involving management judgement or where management have –considerable influence
- Incorporate unpredictability in nature, timing and extent of audit procedures
- Use experts where necessary, automated tools where available
Defining financial statement fraud and auditor responsibility - Auditor requirements
Fraud Considerations (3)
Professional and Legal Implications (2)
Communication (2)
Audit Documentation
Fraud Considerations:
Assess the likelihood of fraud by evaluating:
- Characteristics of key personnel, such as directors and managers.
- Susceptibility to fraud due to management’s opportunity to override controls.
- Opportunities for collusion within the entity.
Professional and Legal Implications:
If fraud prevents auditors from continuing the engagement:
- Evaluate whether withdrawing from the engagement is appropriate.
- Determine who the auditors can or should report to (e.g., regulators, governing authorities).
Communication:
- Maintain effective communication with Those Charged With Governance (TCWG) to ensure transparency.
- If fraud is identified, auditors must alert the appropriate authority, as required by law, regulations, or ethical guidelines.
Audit Documentation:
- Ensure the audit work is fully documented and covers all relevant findings related to fraud.
- Complete documentation is critical for evidence, accountability, and legal compliance.
Defining financial statement fraud and auditor responsibility - Auditor requirements
Obtain ______________ ________________ ________ from ____________
- Acknowledging the _____________ and _________________ concerning any _____________ ________ raised during the ________
The auditor’s report example?
Obtain written representation letter from management
Acknowledging the premise and representations concerning any particular issues raised during the audit
The auditor’s report
As required by ISA (UK) 700 (Revised November 2019), the auditor’s report shall explain to what extent the audit was considered capable of detecting irregularities, including fraud. This explanation shall be specific to the circumstances of the audited entity and take account of how the auditor planned and performed procedures to address the identification and assessment of the risks of material misstatement.
Refer to the Audit Report of a FTSE100 company
Auditors responsibility in relation to fraud – contested area!
Fraud risks, audit procedures and red flags - Financial statement frauds – How?:
Some examples of accounting techniques: (7)
Accomplished by: (4)
Some examples of accounting techniques:
Fictitious Sales:
- Creating fake revenue transactions to inflate sales figures.
Improper Expense Recognition:
- Misstating or delaying the recognition of expenses to boost profit.
Incorrect Asset Valuation:
- Overstating the value of assets like inventory or property to mislead stakeholders.
Hidden Liabilities:
- Concealing debts or obligations to make the financial position appear healthier.
Unsuitable Disclosures:
- Withholding or misrepresenting critical information in financial disclosures.
Cookie-Jar Accounting:
- Understating profits in good years to save reserves (“cookies”) for future periods.
Total Fabrication:
- Completely falsifying financial statements, as seen in extreme cases like Bernard Madoff’s fraud.
Accomplished by:
Manipulation of Records:
- Altering accounting records or systems to hide irregularities.
Misrepresentation/Omission:
- Withholding information about transactions or financial events.
Misapplication of Principles:
- Using accounting standards incorrectly or inconsistently.
Inappropriate Disclosures:
- Omitting or falsifying required disclosures in financial reports.
Corporate Scandals (Examples)
Notable cases where these methods were used include:
Enron: Massive fraud through off-the-books transactions.
WorldCom: Inflated assets by billions via improper expense capitalization.
Parmalat: Fabricated accounts to hide its insolvency.
Carillion: Misstated profits to cover financial difficulties.
Patisserie Valerie: Fictitious bookkeeping entries.
BHS & Tesco: Misrepresentation of financial health or overstated profits.
Fraud risks, audit procedures and red flags - Financial statement frauds – Risk factors:
Fraudulent financial reporting risk factors (3/3,4,2)
Incentives/Pressures
Situations or conditions that increase the likelihood of fraud due to external or internal pressures. Examples include:
- Threats to the entity’s financial stability or profitability.
- Excessive pressure on management to meet financial goals or expectations.
- Personal financial difficulties faced by management or employees, which could push them to commit fraud.
Opportunities
Circumstances that allow fraud to occur due to weaknesses in the entity’s operations or systems. For instance:
- The nature of the entity’s operations providing avenues for manipulation.
- Ineffective monitoring or oversight of management activities.
- A complex or unstable organisational structure that hides irregularities.
- Weak or deficient internal control systems, making it easier to commit fraud without detection.
Attitudes/Rationalisation
Mindsets and ethical justifications that make fraud seem acceptable. This could involve:
- Inappropriate values or ethical standards within the organisation.
- Rationalising unethical actions as necessary for business or personal survival.
Fraud risks, audit procedures and red flags - Financial statement frauds – Risk factors:
Misappropriation of assets (3/2,3,1)
Incentives/Pressures
These are personal or situational factors that create motivation for committing fraud:
- Personal Financial Situation: Financial struggles or needs can drive individuals to misappropriate assets.
- Work-Related Pressures: Examples include anticipated layoffs, restructuring of pay, or negative expectations about promotions.
Opportunities
Circumstances that enable fraud to occur due to weaknesses or characteristics in the organisation:
- Cash Business: Handling a significant amount of cash increases the risk of theft or fraud.
- Small, High-Value Inventory: Items that are easy to steal, valuable, and in high demand are particularly vulnerable.
- Inadequate Internal Controls: Lack of proper management oversight or effective controls creates opportunities for asset misappropriation.
Attitudes/Rationalisation
These refer to the mindset or justifications that individuals use to commit fraud:
- Inappropriate Values and Ethical Standards: A workplace culture that does not prioritise ethics can encourage rationalisation of fraudulent behaviour.
Fraud risks, audit procedures and red flags - Financial statement frauds – red flags:
4 red flags
Indicators of the possibility of fraud you may come across while auditing, for example:
Discrepancies in Accounting Records:
- When entries in the financial records don’t reconcile properly, or there are unexplained adjustments or irregularities.
Conflicting or Missing Evidence:
- Situations where documentation to support transactions is inconsistent, unavailable, or contradictory.
Problematic or Unusual Relationships Between Management and Auditors:
- Examples include management withholding information, exerting undue pressure, or avoiding questions from auditors.
Unexpected Judgements, Behaviour, or Lifestyle of Management/Employees:)
- Observations like sudden, extravagant spending or unusual decision-making patterns may hint at fraudulent activity.
Essential Auditor Behaviours - The importance of professional judgement
What is Professional judgment
___________ behaviour of any auditor and ____________ ___________ of all _____________ ___________, defined as:?
Key Areas Requiring Professional Judgement: (3/1,2,1)
If not…?
What is Professional judgment
Critical behaviour of any auditor and fundamental requirement of all auditing standards, defined as:
- The application of relevant training, knowledge and experience….. in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement (ISA 200)
Key Areas Requiring Professional Judgement:
Audit Procedures:
- Deciding on the nature, timing, and extent of procedures, especially in more nuanced areas.
Resourcing the Audit:
- Allocating team members with the right skills for specific tasks.
- Ensuring adequate time and timing for each phase of the audit.
Quality Management:
Implementing robust systems within the audit firm to uphold high standards.
If not….
Audit quality may suffer significantly
Essential Auditor Behaviours - The importance of the auditor mindset
(5/2,1,3+2,2,2)
Mindset especially relevant for exercising professional judgement
Appreciate the Purpose and Public Interest Benefits of Audit
- Purpose of Audit: Audits aim to enhance the confidence and understanding of the intended users in the financial statements (FS). By providing assurance that the FS are accurate, auditors help stakeholders make informed decisions.
- Public Interest Benefit: Audits support the functioning of the economy, extending benefits beyond just the intended users of financial statements to the wider public. A trustworthy audit process promotes transparency and accountability within organisations.
Exercise Professional Scepticism
Definition (as per ISA 200): Professional scepticism involves:
- An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence (ISA 200)
May be especially relevant when gathering and analysing evidence and effectively challenging management
The auditor mindset is especially relevant for exercising professional judgement
Understanding of biases and other relevant psychological factors
Biases include:
- availability: Giving undue weight to easily available or recent information.
- confirmation: Seeking or prioritising evidence that supports pre-existing beliefs.
- automation: Over-reliance on automated systems or tools without questioning their accuracy.
Factors include:
- groupthink,
- overconfidence
Sensitivity to Uncertainty
- Auditors must be attuned to areas of uncertainty in their work and identify specific areas requiring professional judgement (PJ).
- This involves being critical and flexible in evaluating evidence and making decisions.
Commitment to Quality
- Auditors should maintain a strong commitment to audit quality, ensuring their work is driven by ethical principles and aligned with the public interest benefit of audit.
- Ethical training and understanding the broader purpose of audits motivate auditors to apply effective professional judgement.
Essential Auditor Behaviours - The importance of auditor independence
Key Quote from the FRC Ethical Code?
What does it mean?
Audit is a vital element in achieving ________________, and _______________ can only be effectively given by persons (_____________) who are _______________ of the subject matter being audited.
(5)
Key Quote from the FRC Ethical Code
“A fundamental objective of the audit engagement is that the intended users trust and have confidence that the audit opinion is professionally sound and objective. This in turn should enhance the credibility for users of the information the opinion covers.”
This highlights that the purpose of independence is to ensure users, such as shareholders and other stakeholders, can rely on the auditor’s opinion.
Audit is a vital element in achieving accountability, and credibility can only be effectively given by persons (auditors) who are independent of the subject matter being audited.
- Accountability - From who, for what, to whom, by what means
- An Account – published financial statements
- A holding to account – shareholders holding directors to account for the financial statement information disclosed
- Auditors audit the financial statements prepared by management/directors and report their opinion to shareholders (members) as to the truth and fairness of financial statements
- Other stakeholders?
Essential Auditor Behaviours - What is Independence?
4 different defitinions
IFAC Code (2)?
Difficult to define:
- “the cornerstone of auditing” (Stewart)
- “an elusive quality .. hard to define” (Lee)
- “…Objective, … uncompromised by vested interest in the outcome or consequences …Unbiased and uninfluenced by consideration extraneous to the matter at issue”
- An attitude of mind which does not allow the viewpoints and conclusions of its possessor to become reliant on or subordinate to the influences and pressures of conflicting interests
IFAC Code: defines independence of mind and appearance:
(a) Independence of mind – the state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity, and exercise objectivity and professional scepticism.
(b) Independence in appearance – the avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude that a firm’s, or an audit team member’s, integrity, objectivity or professional scepticism has been compromised
Therefore, the auditor must be, and appear to be, independent
