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Errors Vs Fraud
Auditing standards distinguish between
two types of misstatements: errors and fraud.
Either type of misstatement can be material or
immaterial. An error is an unintentional
misstatement of the financial statements,
whereas fraud is intentional. Two examples of
AUDITORS RESPONSIBILITIES errors are a mistake in extending price times
The overall objectives of the auditor are: quantity on a sales invoice and overlooking older
(a) To obtain reasonable assurance about raw materials in determining the lower of cost or
whether the financial statements as a whole are market for inventory.
free from material misstatement, whether due to For fraud, there is a distinction between
fraud or error, thereby enabling the auditor to misappropriation of assets, often called
express an opinion whether the financial defalcation or employee fraud, and fraudulent
statements are prepared, in all material respects, financial reporting, often called management
in accordance with an applicable financial fraud. An example of misappropriation of assets
reporting framework; and is a clerk taking cash at the time a sale is made
(b) To report on the financial statements, and and not entering the sale in the cash register.
communicate as required by auditing standards,
in accordance with the auditors findings.
Professional Skepticism immaterial. However, there are well-known
Auditing standards require that an audit examples of extremely material misappropriation
be designed to provide reasonable assurance of of assets by employees and management,
detecting both material errors and fraud in the similar to the Adelphia fraud described in the
financial statements. To accomplish this, the shaded box at the top of this page.
audit must be planned and performed with an
attitude of professional skepticism in all aspects There is an important distinction between
of the engagement. Professional skepticism is the theft of assets and misstatements arising
an attitude that includes a questioning mind and from the theft of assets. Consider the following
a critical assessment of audit evidence. three situations:
1. Assets were taken and the theft was covered
Auditors Responsibilities for Detecting by misstating assets. For example, cash
Material Errors collected from a customer was stolen before it
Auditors spend a great portion of their was recorded as a cash receipt, and the account
time planning and performing audits to detect receivable for the customers account was not
unintentional mistakes made by management credited. The misstatement has not been
and employees. Auditors find a variety of errors discovered.
resulting from such things as mistakes in 2. Assets were taken and the theft was covered
calculations, omissions, misunderstanding and by understating revenues or overstating
misapplication of accounting standards, and expenses. For example, cash from a cash sale
incorrect summarizations and descriptions. was stolen, and the transaction was not recorded.
Or, an unauthorized disbursement to an
Auditors Responsibilities for Detecting employee was recorded as a miscellaneous
Material Fraud expense. The misstatement has not been
Auditing standards make no distinction discovered.
between the auditors responsibilities for 3. Assets were taken, but the misappropriation
searching for errors and fraud. In either case, the was discovered. The income statement and
auditor must obtain reasonable assurance about related footnotes clearly describe the
whether the statements are free of material misappropriation.
misstatements.
In all three situations, there has been a
Fraud Resulting from Fraudulent Financial misappropriation of assets, but the financial
Reporting Versus Misappropriation of Assets statements are misstated only in situations 1 and
Both fraudulent financial reporting and 2. In situation 1, the balance sheet is misstated,
misappropriation of assets are potentially whereas in situation 2, revenues or expenses
harmful to financial statement users, but there is are misstated.
an important difference between them.
Fraudulent financial reporting harms users by Auditors Responsibilities for Discovering
providing them incorrect financial statement Illegal Acts
information for their decision making. When Illegal acts are defined as violations of
assets are misappropriated, stockholders, laws or government regulations other than fraud.
creditors, and others are harmed because Two examples of illegal acts are a violation of
assets are no longer available to their rightful federal tax laws and a violation of the federal
owners. environmental protection laws.
Usually, but not always, theft of assets is
perpetrated by employees and not by
management, and the amounts are often
Direct-Effect Illegal Acts necessary to determine whether the suspected
Certain violations of laws and regulations illegal act actually exists:
have a direct financial effect on specific account 1. The auditor should first inquire of
balances in the financial statements. For management at a level above those likely to be
example, a violation of federal tax laws directly involved in the potential illegal act.
affects income tax expense and income taxes 2. The auditor should consult with the clients
payable. legal counsel or other specialist who is
knowledgeable about the potential illegal act.
Indirect-Effect Illegal Acts 3. The auditor should consider accumulating
Most illegal acts affect the financial additional evidence to determine whether there
statements only indirectly. For example, if the actually is an illegal act.
company violates environmental protection laws,
financial statements are affected only if there is Actions When the Auditor Knows of an Illegal
a fine or sanction. Potential material fines and Act
sanctions indirectly affect financial statements The first course of action when an illegal
by creating the need to disclose a contingent act has been identified is to consider the effects
liability for the potential amount that might on the financial statements, including the
ultimately be paid. adequacy of disclosures. These effects may be
complex and difficult to resolve.
Evidence Accumulation When There Is No
Reason to Believe Indirect-Effect FINANCIAL STATEMENT CYCLES
Illegal Acts Exist Audits are performed by dividing the
Many audit procedures normally financial statements into smaller segments or
performed on audits to search for errors and components. The division makes the audit more
fraud may also uncover illegal acts. Examples manageable and aids in the assignment of tasks
include reading the minutes of the board of to different members of the audit team.
directors and inquiring of the clients attorneys
about litigation. The auditor should also inquire
of management about policies they have
established to prevent illegal acts and whether
management knows of any laws or regulations
that the company has violated.
Timing
An audit of financial statements usually
covers a period such as a year. Normally an
audit is not completed until several weeks or
months after the end of the period. The timing of
audit procedures can therefore vary from early in
the accounting period to long after it has ended.
Audit Program
The list of audit procedures for an audit
area or an entire audit is called an audit
program. The audit program always includes a
list of the audit procedures, and it usually
includes sample sizes, items to select, and the
timing of the tests. Normally, there is an audit
program, including several audit procedures, for
AUDIT EVIDENCE DECISIONS each component of the audit. Therefore, there
A major decision facing every auditor is will be an audit program for accounts receivable,
determining the appropriate types and amounts one for sales, and so on.
of evidence needed to be satisfied that the
clients financial statements are fairly stated. Reliability, and therefore
There are four decisions about what evidence to appropriateness, depends on the following six
gather and how much of it to accumulate: characteristics of reliable evidence:
1. Which audit procedures to use
2. What sample size to select for a given 1. Independence of provider.
procedure Evidence obtained from a source outside
3. Which items to select from the population the entity is more reliable than that obtained from
4. When to perform the procedures within. Documents that originate from outside the
clients organization, such as an insurance policy,
Audit Procedures are considered more reliable than are those that
An audit procedure is the detailed originate within the company and have never left
instruction that explains the audit evidence to be the clients organization, such as a purchase
obtained during the audit. It is common to spell requisition.
out these procedures in sufficiently specific 2. Effectiveness of clients internal controls.
terms so an auditor may follow these instructions When a clients internal controls are
during the audit. effective, evidence obtained is more reliable than
when they are weak.
Sample Size 3. Auditors direct knowledge.
Once an audit procedure is selected, Evidence obtained directly by the auditor
auditors can vary the sample size from one to all through physical examination, observation,
the items in the population being tested. recalculation, and inspection is more reliable
than information obtained indirectly.
4. Qualifications of individuals providing the 1. Physical Examination
information. Physical examination is the inspection or
Although the source of information is count by the auditor of a tangible asset. This type
independent, the evidence will not be reliable of evidence is most often associated with
unless the individual providing it is qualified to do inventory and cash, but it is also applicable to the
so. verification of securities, notes receivable, and
5. Degree of objectivity. tangible fixed assets. There is a distinction in
Objective evidence is more reliable than auditing between the physical examination of
evidence that requires considerable judgment to assets, such as market able securities and cash,
determine whether it is correct. and the examination of documents, such as
6. Timeliness. cancelled checks and sales documents.
The timeliness of audit evidence can
refer either to when it is accumulated or to the 2. Confirmation
period covered by the audit. Evidence is usually Confirmation describes the receipt of a
more reliable for balance sheet accounts when it direct written response from a third party
is obtained as close to the balance sheet date as verifying the accuracy of information that was
possible. requested by the auditor. The response may be
in electronic or paper form. The request is made
TYPES OF AUDIT EVIDENCE to the client, and the client asks the third party to
In deciding which audit procedures to use, respond directly to the auditor.
the auditor can choose from eight broad
categories of evidence, which are called types of 3. Documentation
evidence. Every audit procedure obtains one or Documentation is the auditors inspection
more of the following types of evidence: of the clients documents and records to
substantiate the information that is, or should be,
included in the financial statements. The
documents examined by the auditor are the
records used by the client to provide information
for conducting its business in an organized
manner, and may be in paper form, electronic
form, or other media.
4. Analytical Procedures
Analytical procedures use comparisons
and relationships to assess whether account
balances or other data appear reasonable
compared to the auditors expectations.
Analytical procedures are used extensively in
practice, and are required during the planning
and completion phases on all audits.