Tutorial 8 – Fraud

Question 1

As the audit manager in the firm of Sekhar Tan & Associates, Chartered Accountants, you are
examining the financial statements of a fast growing technology company, InTech Berhad.
While you have previously worked on this engagement, this is your first year as the audit
manager. As you review the Audit Plan prepared by your team, you identified a number of
risk factors such as a high degree of competition in the technology industry, and the pressure
on management to meet market expectations and financial targets set by the board of
directors.
Required:
(a) Discuss the response of the auditors to the risks of fraud that the auditors identified
and the required documentation for the assessment of fraud risks. Your answer should
include a description of the fraud conditions and methods used by management to
prepare fraudulent financial statements and misappropriation of assets.
(b) If you have evidence that suggested that fraud existed, discuss the auditors’
communication responsibilities to the management and those charged with
governance.

Suggested solutions:
(a)

• The auditor has a responsibility to plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement,
whether caused by unintentional error or intentional fraud.
• Fraud is a misstatement in the financial statement caused by an intentional act.
• When fraud occurs, factors relating to pressure, opportunity and rationalisation are
present in a company.

• Management can prepare fraudulent financial statements in three ways: (1) they can
manipulate, falsify or alter accounting records used to prepare financial statements; (2)
they can misrepresent or intentionally omit events, transactions or other significant
information; and (3) they can intentionally misapply accounting principles.

Asset misappropriation occurs when employees in a company steal assets of the

• If the auditor’s assessment indicates that fraud may be present, the auditor may
respond as follows:
 i. Increase professional skepticism by questioning and critically assessing audit
evidence.
ii. Assign more experienced auditors who have the knowledge, skill, and ability
commensurate with the increased risk of the engagement.
iii. Consider management’s selection and application of significant accounting
policies, particularly those related to revenue recognition, asset valuation, or
capitalizing vs expensing.
iv. Modify the nature, timing and extent of audit procedures to obtain more
reliable evidence and use increased sample sizes or more extensive analytical
procedures.

• The auditor should document the risk of material misstatement for all material
accounts and classes of transactions. The auditor’s documentation includes the
following:
i. The nature and results of the communication among audit team members that
occurred during planning the audit regarding the risks of material misstatement
due to fraud.
ii. The steps performed in obtaining and supporting knowledge about the entity’s
business and environment. The documentation should include: the risks
identified, an evaluation of management’s response to such risks, and the
auditor’s assessment of the risk of fraud after considering the entity’s response.
iii. The nature, timing and extent of the procedures performed in response to the
risks of material misstatement due to fraud and the results of that work.
iv. Fraud risks or other conditions that caused the auditor to believe that additional
audit procedure or other responses were required to address such risks or other
conditions.
v. The nature of the communications about fraud made to management, the Audit
Committee, and other regulatory bodies.

(b)
i. If the auditor has evidence that suggest that fraud might exist, the matter should be
brought to the attention of an appropriate level of management.
ii. If fraud involves management or the fraud causes a material misstatement of the
financial statements, the auditor should report it directly to those charged with
governance.
iii. The auditor should reach an understanding with those charged with governance
regarding the expected nature and extent of communications about
misappropriations perpetrated by lower level employees.
iv. The auditor has no responsibility to disclose fraud to parties other than the entity’s
management and those charged with governance because of ethical or legal
obligations of confidentiality.
v. The auditor should recognize that he/she has a duty to disclose to outside entity to
comply with certain legal and regulatory requirements or in response to a court
order.
Question 2
Fraudulent financial reporting (also known as management fraud) is a relatively rare event.
However, when it does occur (for example, Enron, Worldcom, Tesco), the frauds can have a
significant effect on shareholders, employees and other parties. ISA 240, The Auditors’
Responsibilities Relating to Fraud in an Audit of Financial Statements, provides the relevant
guidance for auditors.

Required:
(a) Discuss the auditors’ responsibility for detecting fraud.
(b) Describe the three conditions that are generally present when fraud occurs.
(c) Discuss the objectives of the “brainstorming” meeting that is held among the audit
engagement team members.
(d) Discuss the documentation requirement to identify risk factors.

Suggested Solutions:
(a) The auditor’s responsibility for fraud is ‘to plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatements,
whether caused by error or fraud.’

(b) Three conditions are generally present when material misstatements due to fraud occur:
1. Management or other employees have an incentive or are under pressure that
provides a reason to commit fraud.

2. Circumstances exist that provide an opportunity for a fraud to be carried out.

3. Those involved are able to rationalize committing a fraudulent act. Some individuals
possess an attitude, character, or set of ethical values that allow them to knowingly
and intentionally commit a dishonest act.

(c) The objectives of the brainstorming meeting are to:

• Share insights about the entity and its environment and the entity’s business risks.
• Provide an opportunity for the team members to discuss how and where the entity
might be susceptible to fraud.
• Emphasize the importance of maintaining professional scepticism throughout the
audit regarding the potential for material misstatement due to fraud.
(d) The documentation should include:

• The risks identified, an evaluation of management’s response to such risks, and the
auditor’s assessment of the risk of error or fraud after considering the entity’s
response.
• The nature, timing and extent of the procedures performed in response to the risks
of material misstatement due to fraud and the results of that work.
• Fraud risks or other conditions that caused the auditor to believe that additional
audit procedures or other responses were required to address such risks or other
conditions.