CHAPTER-5 FRAUD AND RESPONSIBILITIES OF THE AUDITOR IN

THIS REGARD

FRAUD
an intentional act by one or more individuals among management, those charged with governance, employees,
or third parties, involving the use of deception to obtain an unjust or illegal advantage”.
Although fraud is a broad legal concept, for the purposes of the SAs, the auditoris concerned with fraud
that causes a material misstatement in the financial statements.
Two types of intentional misstatements are relevant to the auditor–
 misstatements resulting from fraudulent financial reporting and
 misstatements resulting from misappropriation of assets

Fraud, whether fraudulent financial reporting or

misappropriation of assets, involves incentive or
pressure to commit fraud, a perceived opportunity to do
so and some rationalization of the act. For example:
 Incentive or pressure to commit fraudulent financial
reporting may exist when management is under pressure,
from sources outside or inside the entity, to achieve an
expected (and perhaps unrealistic) earnings target or
financial outcome.
 A perceived opportunity to commit fraud may exist 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
 Individuals may be able to rationalize committing a fraudulent act. Some individuals possess an attitude,
character or set of ethical values that allow them knowingly and intentionally to commit a dishonest act.
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.
Manipulation of Accounts: Detection of manipulation of
accounts with a view to presenting a false state of affairs is
a task requiring great tact and intelligence because
generally management personnel in higher management
cadre are associated with this type of fraud and this is perpetrated in methodical way. This type of fraud is
generally committed:
(a) to avoid incidence of income-tax or other taxes;
(b) for declaring a dividend when there are insufficient profits;
(c) to withhold declaration of dividend even when there is adequate profit
(d) for receiving higher remuneration where managerial remuneration is payable by reference to profits.
There are numerous ways of committing this type of fraud. Some of the methods are given below:
(i) inflating or suppressing purchases and expenses;
 (ii) inflating or suppressing sales and other items of income,
(iii) inflating or deflating the value of closing inventory;
(iv) failing to adjust outstanding liabilities or prepaid expenses; and
(v) charging items of capital expenditure to revenue or by capitalising revenueexpenses.
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 anaccounting period, to
manipulate operating results or achieve other objectives.
 Inappropriately adjusting assumptions and changing judgments used toestimate account
balances.
 Omitting, advancing or delaying recognition in the financial statements ofevents 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.
 Altering records and terms related to significant and unusual transactions.
Why do Management/ Employees commit fraud? What induces Management/ Employees to commit
fraud?
Following are certain instances which will help to understand these questions:
 Financial obligations/ Pressure.
 Management’s unrealistic goals.
 Dissatisfied Employees or Lack of motivation among employees.
 Name game (eg.mgmt. using power of authority by asking employeesto do something illegal).
 Opportunity to commit fraud.

Misappropriation of Assets:
It involves the theft of an entity’s assets and is often perpetrated by employees inrelatively small and
immaterial amounts. However,
it can also involve management who are usuallymore able to disguise or conceal misappropriations in ways
that are difficult to detect. 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 witha competitor by disclosing
Fig.: Thefttechnological
of Assets 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).
 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 Goods
Fraud in the form of misappropriation of goods is still more difficult to detect; for this, management has to rely
on various measures. Apart from thevarious requirements of record keeping about the physical quantities and
their periodic checks, there must be rules and procedures for allowing persons inside the area where goods
are kept.
In addition there should be external security arrangements to see that no goods are taken out without proper
authority. Goods can be anything in the premises; it may be machinery. It may even be the daily necessities of
the office like stationery.
Defalcation of Cash-Defalcation of cash has been found to perpetrate generally in the following ways:

(a) By inflating cash payments:

Examples of inflation of payments:
(1) Making payments against fictitious vouchers.
(2) Making payments against vouchers, the amounts whereof have been inflated.
(3) Manipulating totals of wage rolls either by including therein names of dummy workers or
by inflating them in any other manner.
(4) Casting a larger totals for petty cash expenditure and adjusting the excessin the totals of the
detailed columns so that cross totals show agreement.
(b) By suppressing cash receipts:
Few techniques of how receipts are suppressed are:
(1) Teeming and Lading: Amount received from a customer being misappropriated; also to
prevent its detection the money received from another customer subsequently being credited to
the account of the customer who has paid earlier
(2) Adjusting unauthorised or fictitious rebates, allowances, discounts, etc. to customer’ accounts
and misappropriating amount paid by them.
(3) Writing off as debts in respect of such balances against which cash has already been received
but has been misappropriated.
(4) Not accounting for cash sales fully.
(5) Not accounting for miscellaneous receipts, e.g., sale of scrap.
(6) Writing down asset values in entirety, selling them subsequently and misappropriating the
proceeds.
(c) By casting wrong totals in the cashbook.
DETECTION OF FRAUD AND ERROR–DUTY OF AN AUDITOR
As per SA 240 “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements”, the
primary responsibility for the prevention and detection of fraud rests with both those charged with
governance of the entity and management. It is important thatmanagement, with the oversight of those
charged with governance, place a strong emphasis on fraud prevention, which may reduce opportunities
for fraud to take place, and fraud deterrence, which could persuade individuals not to commit fraud because
of the likelihood of detection and punishment. This involves a commitment to creating a culture of honesty
and ethical behavior which can be reinforced by an active oversight by those charged with governance.
Broadly, the general principles laid down in the SA may be noted as under:
1. An auditor conducting an audit in accordance with SAs is responsible for obtainingreasonable assurance
that the financial statements taken as a whole are free frommaterial misstatement, whether caused by
fraud or error. As described in SA200, “Overall Objectives of the Independent Auditor and the
Conduct of an Auditin Accordance with Standards on Auditing,” owing to the inherent limitations
of an audit, there is an unavoidable risk that some material misstatements of thefinancial statements
will not be detected, even though the audit is properly planned and performed in accordance with the
SAs.
2. The risk of not detecting a material misstatement resulting from fraud is higherthan the risk of not
detecting one resulting from error. This is because, fraud may involve sophisticated and carefully
organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or
intentional misrepresentations being made to the auditor. Such attempts at concealment may be even
more difficult to detect when accompanied by collusion. Collusionmay cause the auditor to believe
that audit evidence is persuasive when it is, in fact, false. The auditor’s ability to detect a fraud depends
on factors such as theskillfulness of the perpetrator, the frequency and extent of manipulation, the
degree of collusion involved, the relative size of individual amounts manipulated, and the seniority of
those individuals involved. While the auditor may be able toidentify potential opportunities for fraud
to be perpetrated, it is difficult for the auditor to determine whether misstatements in judgment areas
such as accounting estimates are caused by fraud or error.
3. Furthermore, the risk of the auditor not detecting a material misstatement resulting from management
fraud is greater than for employee fraud, because management is frequently in a position to directly
or indirectly manipulate accounting records, present fraudulent financial information or override
control procedures designed to prevent similar frauds by other employees.
4. When obtaining reasonable assurance, the auditor is responsible for maintaining an attitude of
professional skepticism throughout the audit, considering the potential for management override of
controls and recognizingthe fact that audit procedures that are effective for detecting error may not
be effective in detecting fraud. The requirements in this SA are designed to assist the auditor in
identifying and assessing the risks of material misstatement due to fraud and in designing procedures
to detect such misstatement.
Fraud Risk Factors
Fraud Risk Factors may be defined as events or conditions that indicate an incentive or pressure to commit
fraud or provide an opportunity to commit fraud.

(A) Risk Factors Relating to Misstatements Arising from Fraudulent Financial Reporting: The
following are examples of risk factors relating to misstatements arising from fraudulent financial reporting-
Incentives/Pressures: Financial stability or profitability is threatened by economic,
industry, or entity operating conditions, such as (or as indicated by):
1. High degree of competition or market saturation, accompanied by decliningmargins.
2. High vulnerability to rapid changes, such as changes in technology, productobsolescence, or interest
rates.
3. Significant declines in customer demand and increasing business failures in either the industry or
overall economy.
4. Operating losses making the threat of bankruptcy, foreclosure, or hostiletakeover imminent.
5. Recurring negative cash flows from operations or an inability to generate cash
flows from operations while reporting earnings and earnings growth.
6. New accounting, statutory, or regulatory requirements.
Opportunities: The nature of the industry or the entity’s operations provides opportunities to engage in
fraudulent financial reporting that can arise from the following:
1. Significant related-party transactions not in the ordinary course of businessor with related entities
not audited or audited by another firm.
2. A strong financial presence or ability to dominate a certain industry sectorthat allows the entity
to dictate terms or conditions to suppliers or customers that may result in inappropriate or non-arm’s-
length transactions.
3. Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective
judgments or uncertainties that are difficult to corroborate.
4. Significant, unusual, or highly complex transactions, especially those close to period end that pose
difficult “substance over form” questions.
5. Significant bank accounts or subsidiary or branch operations in tax-havenjurisdictions for which there
appears to be no clear business justification.
Attitudes/Rationalizations: Communication, implementation, support, or enforcement of the entity’s values
or ethical standards by management, or thecommunication of inappropriate values or ethical standards,
that are not effective.
1. Known history of violations of securities laws or other laws and regulations.
2. Excessive interest by management in maintaining or increasing the entity’sinventory price or earnings
trend.
3. Management failing to remedy known significant deficiencies in internal control on a timely
basis.
4. An interest by management in employing inappropriate means to minimizereported earnings for
tax-motivated reasons.
5. The owner-manager makes no distinction between personal and businesstransactions.
6. The relationship between management and the current or predecessor auditor is strained, as
exhibited by the following:
 Frequent disputes with the current or predecessor auditor on accounting, auditing, or reporting
matters.
 Unreasonable demands on the auditor, such as unrealistic time constraints regarding the
completion of the audit or the issuance of the auditor’s report.
 Restrictions on the auditor that inappropriately limit access to peopleor information or the
ability to communicate effectively with those charged with governance.
 Domineering management behavior in dealing with the auditor, especially involving attempts
 to influence the scope of the auditor’s work or the selection or continuance of personnel
assigned to or consulted on the audit engagement.
Risk Factors Arising from Misstatements Arising from Misappropriation of Assets: Risk factors that
relate to misstatements arising from misappropriation of assets are also classified according to the
three conditions generally present when fraud exists: incentives/ pressures, opportunities, and
attitudes/ rationalization. Some of the risk factors related to misstatements arising from fraudulent
financial reporting also may be present when misstatements arising from misappropriation of assets
occur. The following are examples of risk factors related to misstatements arising from
misappropriation of assets-
Incentives/Pressures: Personal financial obligations may create pressure on management or employees
with access to cash or other assets susceptible to theftto misappropriate those assets.
Adverse relationships between the entity and employees with access to cash orother assets susceptible
to theft may motivate those employees to misappropriate those assets. For example, adverse relationships
may be created by the following:
1. Known or anticipated future employee layoffs.
2. Recent or anticipated changes to employee compensation or benefit plans.
3. Promotions, compensation, or other rewards inconsistent with expectations.
Opportunities: Certain characteristics or circumstances may increase the susceptibility of assets to
misappropriation. For example, opportunities to misappropriate assets increase when there are the
following:
1. Large amounts of cash on hand or processed.
2. Inventory items that are small in size, of high value, or in high demand.
3. Easily convertible assets, such as bearer bonds, diamonds, or computer chips.
4. Fixed assets which are small in size, marketable, or lacking observable
identification of ownership.
Inadequate internal control over assets may increase the susceptibility of misappropriation of those assets.
For example, misappropriation of assets may occur because there is the following:
 Inadequate segregation of duties or independent checks.
 Inadequate oversight of senior management expenditures, such as travel andother
reimbursements.
 Inadequate record keeping with respect to assets.
 Inadequate system of authorization and approval of transactions (forexample, in purchasing).
 Inadequate physical safeguards over cash, investments, inventory, or fixedassets.
 Lack of complete and timely reconciliations of assets.
 Lack of timely and appropriate documentation of transactions, for example, credits for merchandise
returns.
 Lack of mandatory vacations for employees performing key control functions.
 Inadequate management understanding of information technology, which enables information
technology employees to perpetrate a misappropriation.
 Inadequate access controls over automated records, including controls over and review of computer
systems event logs.
Attitudes/Rationalizations: Disregard for the need for monitoring or reducing risks related to
misappropriations of assets.
 Disregard for internal control over misappropriation of assets by overriding existing controls or by
failing to take appropriate remedial action on known deficiencies in internal control.
 Behavior indicating displeasure or dissatisfaction with the entity or its treatment of the employee.
  Changes in behavior or lifestyle that may indicate assets have beenmisappropriated
 Tolerance of petty theft.

Circumstances Relating to Possibility of Fraud

Examples of circumstances that indicate the possibility of fraud: The following are examples of
circumstances that may indicate the possibility that the financial statements may contain a material
misstatement resulting from fraud-

(A) Discrepancies in the accounting records, including:

 Transactions that are not recorded in a complete or timely manner or are improperly recorded
as to amount, accounting period, classification, or entity policy.
 Unsupported or unauthorized balances or transactions.
 Last-minute adjustments that significantly affect financial results.
 Evidence of employees’ access to systems and records inconsistent with that necessary to
perform their authorized duties.
 Tips or complaints to the auditor about alleged fraud.
(B) Conflicting or missing evidence, including:
 Missing documents.
 Documents that appear to have been altered.
 Significant unexplained items on reconciliations.
 Unusual discrepancies between the entity’s records and confirmation
replies.
 Large numbers of credit entries and other adjustments made to accounts receivable records.
 Missing or non-existent cancelled cheques in circumstances where cancelled cheques are
ordinarily returned to the entity with the bank statement.
 Missing inventory or physical assets of significant magnitude.
(C) Unavailable or missing electronic evidence, inconsistent with the entity’s record retention
practices or policies Problematic or unusual relationships between the auditor and mngt,
including:
 Denial of access to records, facilities, certain employees, customers,vendors, or others from
whom audit evidence might be sought.
 Undue time pressures imposed by management to resolve complex orcontentious issues.
 Unusual delays by the entity in providing requested information.
 Unwillingness to facilitate auditor access to key electronic files fortesting through the use of
computer-assisted audit techniques.
 Denial of access to key IT operations staff and facilities, including
security, operations, and systems development personnel.
 An unwillingness to add or revise disclosures in the financial statementsto make them more
complete and understandable.
  An un willingness to address identified deficiencies in internal controlon a timely basis.
(D) Other
 Unwillingness by management to permit the auditor to meet privatelywith those charged
with governance.
 Accounting policies that appear to be at variance with industry norms.
 Frequent changes in accounting estimates that do not appear to resultfrom changed
circumstances.
 Tolerance of violations of the entity’s Code of Conduct.

FRAUD REPORTING

Reporting under Companies (Auditor’s Report) Order, 2020 [CARO, 2020]: The auditor is also required
to report under clause (xi) of paragraph 3 of Companies (Auditor’s Report) Order,2020, whether
any fraud by the companyor any fraud on the Company has been noticed or reported during the year.
If yes, the nature and the amount involved is to be indicated.
The auditor is also require to report whether any report under sub-section (12) of section 143 of the
Companies Act has been filed by the auditors in Form ADT-4 as prescribed under rule 13 of Companies
(Audit and Auditors) Rules, 2014 with the Central Government; and whether the auditor has considered
whistle-blower complaints, if any, received during the year by the company.
The scope of auditor’s inquiry under this clause is restricted to following:
(a) frauds ‘noticed or reported’ during the year; reporting on filing of any report in Form ADT–4
during the year; and
(b) whistle-blower complaints, if any, received during the year
It may be noted that this clause of the Order, by requiring the auditor to report whether any fraud by
the company or on the company has been noticed or reported, does not relieve the auditor from his
responsibility to consider fraud and error in an audit of financial statements. In other words,
irrespective of the auditor’s comments under this clause, the auditor is also required to comply with
the requirements of SA 240, “The Auditor’s Responsibility Relating to Fraud in an Audit of Financial
Statements”.
Audit Procedures and Reporting under CARO:
(1) While planning the audit, the auditor should discuss with other members ofthe audit team, the
susceptibility of the company to material misstatements in the financial statements resulting from
fraud. While planning, the auditor should also make inquiries of management to determine whether
management is aware of any known fraud or suspected fraud that the company is investigating.
(2) The auditor should examine the reports of the internal auditor with a view to ascertain whether any
fraud has been reported or noticed by the management. The auditor should examine the minutes
of the audit committee, if available, to ascertain whether any instance of fraud pertainingto the
company has been reported and actions taken thereon.
The auditor should enquire from the management about any frauds on the company that it has noticed
or that have been reported to it. The auditor should also discuss the matter with other employees
including officers of the company. The auditor should also examine the minute book of the board
meeting of the company in this regard.
The auditor should also enquire from the management about any whistle- blower complaints received
during the year by the company or that have been reported to it during the year. The auditor should
also discuss the matter with other employees including officers of the company. The auditor should
also examine the minute book of the board meeting of the company in this regard.
(3) The auditor should obtain written representations from management that:
(i) it acknowledges its responsibility for the implementation and operation of accounting and
internal control systems that are designed to prevent and detect fraud and error;
(ii) it believes the effects of those uncorrected misstatements in financial statements, aggregated by
the auditor during the audit are immaterial, both individually and in the aggregate, to the
financial statements taken as a whole. A summary of such items should be included in or
attached to the written representation;
(iii) it has
(a) disclosed to the auditor all significant facts relating to any fraudsor suspected frauds
known to management that may have affected the entity; and
(b) it has disclosed to the auditor the results of its assessment of the risk that the financial
statements may be materially misstated asa result of fraud.
4. Because management is responsible for adjusting the financial statements to correct material
misstatements, it is important that the auditor obtains written representation from management that
any uncorrected misstatements resulting from fraud are, in management’s opinion, immaterial, both
individually and in the aggregate. Such representations are not a substitute for obtaining sufficient
appropriate audit evidence. In some circumstances, management may not believe that certain of the
uncorrected financial statement misstatements aggregated by the auditor during the audit are
misstatements. For that reason, management may want to add to their written representation words
such as, “We do not agree that items constitute misstatements because [description of reasons].”
The auditor should consider if any fraud has been reported by them during the year under section
143(12) of the Act and if so whether that same would be reported under this Clause. It may be
mentioned here that section 143(12)of the Act requires the auditor to have reasons to believe that
a fraud is being committed or has been committed by an employee or officer. In sucha case the,
auditor needs to report to the Central Government or the Audit Committee. However, this Clause will
include only the reported frauds andnot suspected fraud.
(i) Where the auditor notices that any fraud by the company or on the companyby its officers or
 employees has been noticed by or reported during the year, the auditor should, apart from
reporting the existence of fraud, also required to report, the nature of fraud and amount
involved. For reporting under this clause, the auditor may consider the following This clause
requires all frauds noticed or reported during the year shallbe reported indicating the nature
and amount involved. As specified the fraud by the company or on the company by its officers
or employees are only covered.
(ii) Of the frauds covered under section 143(12) of the Act, only noticed frauds shall be included
here and not the suspected frauds.
(iii) While reporting under this clause with regard to the nature and the amount involved of the
frauds noticed or reported, the auditor may also consider the principles of materiality outlined
in Standards on Auditing.

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
shall:
(a) Determine 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 whether it is appropriate to withdraw from the engagement, where withdrawal is possible
under applicable law or regulation; 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) Determine whether there is a professional or legal requirement to report to the person or
persons who made the audit appointment or, in some cases, to regulatory authorities, the
auditor’s withdrawal from the engagement and the reasons for the withdrawal.