FRAUD AND ERROR FRAUD AND ERROR
Questions Questions
1.
1. HoHoldldining g a a bebelilief ef ththat at a a popotetentntiaial l coconfnflilict ct of of ininteterereststs s alalwayways s exexisists ts cacaususeses auditors to perform procedures to search for errors or irregularities that would auditors to perform procedures to search for errors or irregularities that would have a material ef
have a material effect on financial fect on financial statements. statements. This tends to make audiThis tends to make audits morets more extensive for the audit
extensive for the auditor and more expensive for the clor and more expensive for the client. ient. The situation is notThe situation is not a desirable one in the vast majority of audits where no errors or irregularities a desirable one in the vast majority of audits where no errors or irregularities exist.
exist. 2.
2. Errors and irregularitie Errors and irregularitiess: : uditors are re!uireuditors are re!uired to plan the audit to detect errorsd to plan the audit to detect errors and irregularities that would have a material effect on
and irregularities that would have a material effect on the financial statements.the financial statements. Clients’ illegal acts
Clients’ illegal acts : : uditors are not re!uiuditors are not re!uired to search for illred to search for illegal acts" but theyegal acts" but they are warned to be alert to any that might be detected in the ordinary course of an are warned to be alert to any that might be detected in the ordinary course of an audit.
audit. #.
#. $even $even major major asseassertiortions ns in in finafinanciancial sl statetatementsments:: a.
a. Existence Existence assertion:assertion:
The practical objective is to establish with evidence that assets" liabilities The practical objective is to establish with evidence that assets" liabilities and e!uities actually exist and that sales and expense transactions actually and e!uities actually exist and that sales and expense transactions actually occurred.
occurred. %ut&off can be considere%ut&off can be considered an aspect of the existence assed an aspect of the existence assertion.rtion. b.
b. OccurrenceOccurrence assertion: assertion: The
The prapractictical cal objobjectective ive is is to to estestablablish ish witwith h evievidendence ce thathat t recrecordordeded trans
transactiactions ons or or evenevents ts that occurrethat occurred d duriduring ng a a givegiven n accoaccountinunting g perioperiodd pertained to the entity.
pertained to the entity. c.
c. CompletenessCompleteness assertion: assertion:
The practical objective is to establish with evidence that all transactions of The practical objective is to establish with evidence that all transactions of the period are in the financial statements and all transactions that properly the period are in the financial statements and all transactions that properly belon
belong g in the in the precpreceding or eding or follfollowing accountowing accounting ing periperiods are ods are excluexcluded.ded. nother term for these aspects of
%ompleteness also refers to proper inclusion in financial statements of %ompleteness also refers to proper inclusion in financial statements of allall assets" liabilities" revenue" expense" and
assets" liabilities" revenue" expense" and related disclosures.related disclosures.
d.
d. Rigts and Obligations Rigts and Obligations assertion: assertion:
The practical objectives related to rights and obligations are to establish The practical objectives related to rights and obligations are to establish with evidence that assets are
with evidence that assets are o!nedo!ned 'or rights such as capitali(ed leases are 'or rights such as capitali(ed leases are shown) and liabilities are
shown) and liabilities are o!edo!ed.. e.
e. Measurement Measurement assertion: assertion:
The practical objective is to establish with evidence that a transaction or The practical objective is to establish with evidence that a transaction or event is recorded at the proper amount and revenue or expense is allocated event is recorded at the proper amount and revenue or expense is allocated to the proper period.
to the proper period. f.
f. "aluation"aluation assertion:assertion:
The practical objective is to establish with evidence that proper values have The practical objective is to establish with evidence that proper values have been assigned to things 'assets" liabilities" e!uities and related disclosures) been assigned to things 'assets" liabilities" e!uities and related disclosures) and event
and events s 're'revenvenuesues" " exexpenpenses and ses and rerelatlated ed disdiscloclosursures)es). . ududititinging $tand
$tandards refer to ards refer to the practicthe practical al objeobjective of ctive of obtaiobtaining evidence aboutning evidence about *va
*valualuatiotionsns+ + achachievieved ed by by coscost t allallocaocatiotions ns sucsuch h as as depdeprecreciatiation ion andand inventory costing methods.
inventory costing methods. g.
g. Presentation and #isclo Presentation and #isclosuresure assertion: assertion: The
The prapractictical cal objobjectective ive is is to to estestablablish ish witwith h evievidendence ce thathat t accaccounountintingg principles used by management are appropriate in the circumstances and are principles used by management are appropriate in the circumstances and are applied properly" and that disclosures contain all information re!uired by applied properly" and that disclosures contain all information re!uired by generally accepted accounting principles.
generally accepted accounting principles. ,.
,. -enef-enefits its of of prelpreliminaiminary ry assesassessment sment of of matermaterialiiality:ty: ine&tune the audit for
ine&tune the audit for effectiveness and efficiency.effectiveness and efficiency. Help auditors avoid surprises related to:
Help auditors avoid surprises related to: inding out too late about
inding out too late about not auditing enougnot auditing enoug.. inding out later about
inding out later about auditing too mucauditing too muc.. /s 0
/s 0" material3 " material3 4aybe.4aybe. Absolute
Absolute si$esi$e. . /f you think so" it5/f you think so" it5s materis material just becaal just because it5s a larguse it5s a largee number.
number. Relati%e si$e Relati%e si$e..
6o.
6o. /f 0" is les/f 0" is less than 7 of a s than 7 of a relevant base.relevant base. 4aybe.
4aybe. /f 0" is betwee/f 0" is between 7 and 17 of a n 7 and 17 of a relevant base.relevant base. 8es.
8es. /f 0" is 17 /f 0" is 17 or more of a relor more of a relevant base.evant base. &ature of te item
&ature of te item. . 8es" 0" is material if i8es" 0" is material if it arises from an illet arises from an illegalgal act.
.
. 8es8es" " audauditoitors have credirs have credited discted discoveovery of ry of errerrors and irreors and irregulgulariaritieties s to analyto analyticticalal review procedures in 29.17 of the cases in a set of audits" and another 1.7 review procedures in 29.17 of the cases in a set of audits" and another 1.7 discovery rate was attributed to
discovery rate was attributed to *prior expectations+ and *discussions.+*prior expectations+ and *discussions.+ ;.
;. /n asse/n assessing issing inherenherent risk annt risk and contrd control riskol risk" the aud" the auditor muitor must consst consider tider the typehe types ofs of err
errors ors or or irrirreguegularlaritiities es thathat t migmight ht occoccur ur and and thetheir ir impimpact act on on the the finfinancancialial statements 'materi
statements 'materiality.) ality.) /n evaluating materia/n evaluating materiality" the auditor should conlity" the auditor should considersider the impact of errors and irregularities both individually and in the aggregate. the impact of errors and irregularities both individually and in the aggregate. ud
uditiiting ng $ta$tandandards rds re!re!uiruire e thathat t the the audauditoitor r desdesign ign the the audaudit it to to proprovidvidee reasonable assurance of detecting errors and
reasonable assurance of detecting errors and irregularitiirregularities that are es that are material to thematerial to the financial state
financial statements. ments. uditing $tandards re!uuditing $tandards re!uire that audit risk anire that audit risk and materialityd materiality be considered both in planning the
be considered both in planning the audit and in evaluating audit results.audit and in evaluating audit results. %on
%ontrotrol l risrisk k and inherand inherent ent risrisk k are also are also dirdirectectly ly relrelateated d to to the settithe setting ng ofof mater
materialiiality thresholty thresholds. ds. /f" for /f" for exampexample" applicatle" application of ion of analanalyticytical procedural procedureses 'inherent risk analysis) leads the
'inherent risk analysis) leads the auditor to suspect earnings inflation" auditor to suspect earnings inflation" individualindividual item material
item materiality thresholity thresholds ds shoushould ld be be reducreduced ed accoraccordingldingly y 'i.e." either the'i.e." either the materiality percentage or the amount of unaudited income should be decreased.) materiality percentage or the amount of unaudited income should be decreased.) $imilarly" if control risk analysis leads the auditor to suspect numerous errors" $imilarly" if control risk analysis leads the auditor to suspect numerous errors" aggregate materiality thresholds need to be
aggregate materiality thresholds need to be lowered accordingly.lowered accordingly. 9.
9. n audin auditor5tor5s reacts reaction to an iion to an immatemmaterial erial error marror may diffy differ froer from his or her rm his or her reactieactionon to an
to an immateimmaterial irrerial irregulargularity. ity. udituditors generors generally accumually accumulate the amount oflate the amount of individual immaterial errors to be sure that the aggregate of all errors is not individual immaterial errors to be sure that the aggregate of all errors is not material.
material. /n addition" the auditor i/n addition" the auditor is concerned about whether an errs concerned about whether an error came fromor came from a misunderstanding or other cause that would have resulted in yet more errors a misunderstanding or other cause that would have resulted in yet more errors during the period.
during the period. n auditor is expected to report all irren auditor is expected to report all irregularities to the auditgularities to the audit committee or the board of
committee or the board of directors and senior management.directors and senior management. .
. <ef<efer ter to pago pages ,es ,#; t#; to ,#o ,#9 of 9 of the the textextbotbook.ok. =.
=. <ef<efer ter to pago pages ,es ,, t, to ,,o ,,1 of 1 of the the textextbotbook.ok. 1.
1. <efer <efer to pagto page ,# e ,# of thof the texte textbook.book. 11.
11. The factoThe factors that shours that should be considld be considered are the peso amoered are the peso amount of the accouunt of the account" thent" the likelihood of error" and the cost
likelihood of error" and the cost of auditing the account.of auditing the account. 12.
12. The auditThe auditor deals with both inheor deals with both inherent risk and contrent risk and control risk durirol risk during the planning the planningng pha
phase of se of the audithe audit. t. /n!/n!uiruiry y of clienof client t perpersonsonnelnel" " stustudy of dy of the busithe businesness s andand ind
industustry" ry" applapplicaicatition on of of anaanalytlyticaical l proprocedcedureures" s" and and docdocumeumentantatiotion n of of thethe auditor5s initial understanding of internal control are all performed during the auditor5s initial understanding of internal control are all performed during the planning phase of t
planning phase of the audit. he audit. urther study of inurther study of internal control prternal control procedures mayocedures may occ
occur ur aftafter er the plannthe planning ing phaphase se if if the auditthe auditor or wiswishes to hes to furfurthether r redreduce theuce the assessed level of control risk" and considers it
Multiple Choice Questions Multiple Choice Questions
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1. a.a. nntotoninio5o5s s acactitivivity is an ty is an irirreregugulalaririty 'inty 'intetentntioionanal l didiststorortition of on of fifinanancnciaiall statements) rather th
statements) rather than error 'unintentional mistan error 'unintentional mistake). ake). /t is also an illegal act/t is also an illegal act on ntonio5s individual part.
on ntonio5s individual part. b.
b. ThThe e prproboblelem m dodoes es nonot t dedescscriribe be ththe e kikind nd of of rerelalateted d papartrty y trtranansasactctioionsns discussed in 0$ .
discussed in 0$ . c.
c. 8es" 8es" a weaa weakneskness in s in inteinternal rnal contcontrol erol existxists. s. /t m/t may be ay be consiconsideredered a md a materaterialial weakn
weakness ess becaubecause se the the compencompensatisating ng contrcontrol ol 'int'internaernal l audiauditors5 work tors5 work onon slow&moving inventory) did not operate in a
slow&moving inventory) did not operate in a timely enough manner to detecttimely enough manner to detect the irregularity before it had gotten large.
the irregularity before it had gotten large.
/f a material weakness in internal control exists" -rava > %ampos are /f a material weakness in internal control exists" -rava > %ampos are obligated to report it to management and?or the
obligated to report it to management and?or the board of directors.board of directors. d.
d. ThThe e prproboblelem m dedescscririptptioion n inindidicacatetes s ththatat tis tis elemeelement nt of the audof the audit wasit was conducted in a ne
conducted in a negligent manner. gligent manner. There5s nothing wrong There5s nothing wrong about auditing aabout auditing a sample of the transactions" but %ampos5 follow&up and explanation of the sample of the transactions" but %ampos5 follow&up and explanation of the missing receiving r
missing receiving reports leaves much to be deeports leaves much to be desired. sired. t the very least het the very least he could have reviewed the reports produced by ntonio at a later date" and he could have reviewed the reports produced by ntonio at a later date" and he cou
could ld havhave e tratraced ced the the purpurchachases ses to to the the ininvenventortory y recrecordords s and and perperhaphapss noticed an over&sto
noticed an over&stocking condition. cking condition. The auditors had some evideThe auditors had some evidence that annce that an irregularity might exist" but they failed to apply extended audit procedures irregularity might exist" but they failed to apply extended audit procedures properly.
2.
2. a.a. 8es8es. . 6ic6icolaolas was was a s a parparty ty to tto the he ississuanuance ce of of falfalse se fifinannanciacial sl stattatemeements nts and and asas such is a joint tor
such is a joint tortfeasor. tfeasor. The elements necessarThe elements necessary to establish an acty to establish an action forion for common law fraud are pr
common law fraud are present. esent. There was a material There was a material misstatement of fmisstatement of fact"act" knowledge of falsity 'scienter)" intent that the plaintiff bank rely on
knowledge of falsity 'scienter)" intent that the plaintiff bank rely on the falsethe false stat
statementement" actual reli" actual reliance and damagance and damage to the bank as e to the bank as a result thea result thereofreof. . /f/f action is based upon fraud there is no re!uirement that the bank establish action is based upon fraud there is no re!uirement that the bank establish priv
privity of contrity of contract with the %0. act with the %0. 4ore4oreover" if the actiover" if the action by the bank ison by the bank is bas
based ed upoupon n ordordininary ary negnegligligencence" e" whiwhich ch doedoes s not re!uinot re!uire re a a shoshowinwing g ofof scienter" the bank may recover as a third&party beneficiary 'an exception to scienter" the bank may recover as a third&party beneficiary 'an exception to the stric
the strict privitt privity re!uirey re!uirement)ment). . Thus" the bank will be able to recover itsThus" the bank will be able to recover its loss from 6icolas under either theory.
loss from 6icolas under either theory. b.
b. 6o. 6o. The The leslessor sor was was a paa partrty to y to the the secsecret ret agragreemeementent. . s ss suchuch" the " the leslessorsor can
cannot not claclaim im relrelianiance ce on on the the finfinancancial ial stastatemtementents s and and cancannot not recrecoveoverr uncollected rents
uncollected rents. . @ven if he was damaged indi@ven if he was damaged indirectly" his own fraudulerectly" his own fraudulentnt act
actionions s led led to to his his losloss" s" and and the the e!ue!uitaitable ble priprincinciple ple of of *un*uncleclean an hanhands+ds+ precludes him from
precludes him from obtaining relief.obtaining relief. c.
c. 6ic6icolaolas was ns was not inot indepdependendentent. . His rHis repoeport is irt is imprmpropeoper and hr and he is pre is probaobablybly subject to disciplinary action by the professional organi(ation or regulatory subject to disciplinary action by the professional organi(ation or regulatory bod
body. y. ccccordording to ing to the ethithe ethics cs intintererprepretattation on ion on actactual or ual or thrthreateateneenedd litigation:
litigation:
*n expressed intention by the present management to commence litigation *n expressed intention by the present management to commence litigation again
against the st the auditauditor alleging deficieor alleging deficienciencies s in in audit work audit work for the for the clieclient nt isis considered to impair independence if the auditor concludes that there is a considered to impair independence if the auditor concludes that there is a strong possibility that such a claim will be
