Chapter 12 Fraud and Errors

Chapter 12 Fraud and Errors
The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements Introduction

1. The purpose of this Philippine Standard on Auditing (PSA) is to establish basic principles and
essential procedures and to provide guidance on the auditor’s responsibility to consider fraud in
an audit of financial statements1 and expand on how the standards and guidance in PSA 315,
“Understanding the Entity and its Environment and Assessing the Risks of Material
Misstatement” and PSA 330, “The Auditor’s Procedures in Response to Assessed Risks” are to
be applied in relation to the risks of material misstatement due to fraud. The standards and
guidance in this PSA are intended to be integrated into the overall audit process.
II. Characteristics of Fraud
Misstatements in the financial statements can arise from fraud or error. The distinguishing factor
between fraud and error is whether the underlying action that results in the misstatement of the
financial statements is intentional or unintentional..
The term “error” refers to an unintentional misstatement in financial statements, including the
omission of an amount or a disclosure, such as the following:
 A mistake in gathering or processing data from which financial statements are prepared
 An incorrect accounting estimate arising from oversight or misinterpretation of facts.
 A mistake in the application of accounting principles relating to measurement,
recognition, classification, presentation or disclosure.
III. Fraudulent financial reporting involves intentional misstatements including omissions of
amounts or disclosures in financial statements to deceive financial statement users.
Fraudulent financial reporting may be accomplished by the following:
 Manipulation, falsification (including forgery), or alteration of accounting records or
supporting documentation from which the financial statements are prepared.
 Misrepresentation in, or intentional omission from, the financial statements of events,
transactions or other significant information.
 Intentional misapplication of accounting principles relating to amounts, classification,
manner of presentation, or disclosure.
Fraudulent financial reporting often involves management override of controls that otherwise
may appear to be operating effectively. Fraud can be committed by management overriding
controls using such techniques as:
 Recording fictitious journal entries, particularly close to the end of an accounting
period, to manipulate operating results or achieve other objectives;
 Inappropriately adjusting assumptions and changing judgments used to estimate account
balances;
 Omitting, advancing or delaying recognition in the financial statements of events and
transactions that have occurred during the reporting period
 Concealing, or not disclosing, facts that could affect the amounts recorded in the
financial statements;
 Engaging in complex transactions that are structured to misrepresent the financial
position or financial performance of the entity; and
 Altering records and terms related to significant and unusual transactions.
IV. Misappropriation of assets
Misappropriation of assets can be accomplished in a variety of ways including:
Embezzling receipts (for example, misappropriating collections on accounts receivable or
diverting receipts in respect of written-off accounts to personal bank accounts);
 Stealing physical assets or intellectual property (for example, stealing inventory for
personal use or for sale, stealing scrap for resale, colluding with a competitor by
disclosing technological data in return for payment);
 Causing an entity to pay for goods and services not received (for example, payments to
fictitious vendors, kickbacks paid by vendors to the entity’s purchasing agents in return
for inflating prices, payments to fictitious employees); and
 Using an entity’s assets for personal use (for example, using the entity’s assets as
collateral for a personal loan or a loan to a related party). Misappropriation of assets is
often accompanied by false or misleading records or documents in order to conceal the
fact that the assets are missing or have been pledged without proper authorization.
V. Responsibilities of Those Charged With Governance and of Management
The primary responsibility for the prevention and detection of fraud rests with both those
charged with governance of the entity and with management. The respective responsibilities of
those charged with governance and of management may vary by entity and from country to
country. I
VI. Responsibilities of the Auditor for Detecting Material Misstatement Due to Fraud
An auditor conducting an audit in accordance with PSAs obtains reasonable assurance that the
financial statements taken as a whole are free from material misstatement, whether caused by
fraud or error. An auditor cannot obtain absolute assurance that material misstatements in the
financial statements will be detected because of such factors as the use of judgment, the use of
testing, the inherent limitations of internal control and the fact that much of the audit evidence
available to the auditor is persuasive rather than conclusive in nature.
VII. Risk Assessment Procedures
As required by PSA 315, to obtain an understanding of the entity and its environment, including
its internal control, the auditor performs risk assessment procedures. As part of this work the
auditor performs the following procedures to obtain information that is used to identify the risks
of material misstatement due to fraud:
(a) Makes inquiries of management, of those charged with governance, and of others within the
entity as appropriate and obtains an understanding of how those charged with governance
exercise oversight of management’s processes for identifying and responding to the risks of
fraud and the internal control that management has established to mitigate these risks.
(b) Considers whether one or more fraud risk factors are present
. (c) Considers any unusual or unexpected relationships that have been identified in performing
analytical procedures.
(d) Considers other information that may be helpful in identifying the risks of material
misstatement due to fraud.
Examples of fraud risk factors related to fraudulent financial reporting and misappropriation of
assets are presented in Appendix 1 to this PSA. These illustrative risk factors are classified based
on the three conditions that are generally present when fraud exists: an incentive or pressure to
commit fraud; a perceived opportunity to commit fraud; and an ability to rationalize the
fraudulent action. Risk factors reflective of an attitude that permits rationalization of the
fraudulent action may not be susceptible to observation by the auditor. Nevertheless, the auditor
may become aware of the existence of such information. Although the fraud risk factors
described in Appendix 1 cover a broad range of situations that may be faced by auditors, they are
only examples and other risk factors may exist. The auditor also has to be alert for risk factors
specific to the entity that are not included in Appendix 1. Not all of the examples in Appendix 1
are relevant in all circumstances, and some may be of greater or lesser significance in entities of
different size, with different ownership characteristics, in different industries, or because of other
differing characteristics or circumstances.
VIII. Communications With Management and Those Charged With Governance
If the auditor has identified a fraud or has obtained information that indicates that a fraud may
exist, the auditor should communicate these matters as soon as practicable to the appropriate
level of management.
IX. Auditor Unable to Continue the Engagement
If, as a result of a misstatement resulting from fraud or suspected fraud, the auditor encounters
exceptional circumstances that bring into question the auditor’s ability to continue performing
the audit the auditor should:
(a) Consider the professional and legal responsibilities applicable in the circumstances,
including whether there is a requirement for the auditor to report to the person or persons who
made the audit appointment or, in some cases, to regulatory authorities;
(b) Consider the possibility of withdrawing from the engagement; and
(c) If the auditor withdraws:
(i) Discuss with the appropriate level of management and those charged with governance the
auditor’s withdrawal from the engagement and the reasons for the withdrawal; and
(ii) Consider whether there is a professional or legal requirement to report to the person or
persons who made the audit.

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Chapter 12 Fraud and Errors

The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements Introduction

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