Management fraud (e. g., fraudulent financial reporting) is a relatively rare ev

Question

Management fraud (e. g., fraudulent financial reporting) is a relatively rare event. However, when it does occur, the frauds (e. g., Enron and WorldCom) can have a significant effect on shareholders, employees, and other parties. AU 240, Consideration of Fraud in a Financial Statement Audit, provides the relevant guidance for auditors.

Required:
a. What is the auditor's responsibility for detecting fraud?
b. Describe the three conditions that are generally present when fraud occurs?
c. What are the objectives of the " brainstorming" meeting that is held among the engagement team members?
d. What is the required documentation for identified risk factors?

Explanation / Answer

a. Auditor's responsibility for detecting fraud

   An auditor conducting an audit in accordance with GAAS is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error. Due to the inherent limitations of an audit, an unavoidable risk exists that some material misstatements of the financial statements may not be detected, even though the audit is properly planned and performed in accordance with GAAS.

When obtaining reasonable assurance, the auditor is responsible for maintaining professional skepticism throughout the audit, considering the potential for management override of controls, and recognizing the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud.

b. Three conditions that are generally present when fraud occurs

i) when management is under pressure, from sources outside or inside the entity, to achieve an expected (and perhaps, unrealistic) earnings target or financial outcome—particularly because the consequences to management for failing to meet financial goals can be significant. Similarly, individuals may have an incentive to misappropriate assets (for example, because the individuals are living beyond their means)

ii)  when an individual believes internal control can be overridden (for example, because the individual is in a position of trust or has knowledge of specific deficiencies in internal control).

iii) individuals possess an attitude, character, or set of ethical values that allow them knowingly and intentionally to commit a dishonest act.

c. objectives of the " brainstorming" meeting that is held among the engagement team members

Objective of the discussion is exchange of ideas or brainstorming among the engagement team members about how and where the entity's financial statements might be susceptible to material misstatement due to fraud, how management could perpetrate and conceal fraudulent financial reporting, and how assets of the entity could be misappropriated. The discussion should occur setting aside beliefs that the engagement team members may have that management and those charged with governance are honest and have integrity,and should address

a. known external and internal factors affecting the entity that may create an incentive or pressure for management or others to commit fraud, provide the opportunity for fraud to be perpetrated, and indicate a culture or environment that enables management or others to rationalize committing fraud;

b. the risk of management override of controls;

c. consideration of circumstances that might be indicative of earnings management or manipulation of other financial measures and the practices that might be followed by management to manage earnings or other financial measures that could lead to fraudulent financial reporting;

d. the importance of maintaining professional skepticism throughout the audit regarding the potential for material misstatement due to fraud; and

e. how the auditor might respond to the susceptibility of the entity's financial statements to material misstatement due to fraud.

d. Required documentation for identified risk factors

   i) The auditor should include in the audit documentation13 of the auditor's understanding of the entity and its environment and the assessment of the risks of material misstatement required by section 315 the following:14 a. The significant decisions reached during the discussion among the engagement team regarding the susceptibility of the entity's financial statements to material misstatement due to fraud, and how and when the discussion occurred and the audit team members who participated

b. The identified and assessed risks of material misstatement due to fraud at the financial statement level and at the assertion level

ii) The auditor should include in the audit documentation of the auditor's responses to the assessed risks of material misstatement required by section 330 the following

a. The overall responses to the assessed risks of material misstatement due to fraud at the financial statement level and the nature, timing, and extent of audit procedures, and the linkage of those procedures with the assessed risks of material misstatement due to fraud at the assertion level

b. The results of the audit procedures, including those designed to address the risk of management override of controls .

iii) The auditor should include in the audit documentation communications about fraud made to management, those charged with governance, regulators, and others. .

iv) If the auditor has concluded that the presumption that there is a risk of material misstatement due to fraud related to revenue recognition is overcome in the circumstances of the engagement, the auditor should include in the audit documentation the reasons for that conclusion

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