- Expression of opinion
His business is to ascertain and state the true financial position of the company at the time of the audit and his duty is confined to that.”
(Note : Appendix I deal with summary of certain leading case laws. A careful reading of such case laws would not only provide you a peep into the historical evolution of auditing but enable you to master the subject of auditing by developing understanding about audit objective, role of an auditor, scope of an audit and how an auditor should proceed about his work).
The AAS-2 “Objective and Scope of the Audit of Financial Statements” states that the objective of an audit of financial statements, prepared within a framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable an auditor to express an opinion on such financial statements. Further it clarifies that “the auditor’s opinion helps determination of the true and fair view of the financial position and operating results of the enterprise. The user, however, should not assume that the auditor’s opinion is an assurance as to the future viability of an enterprise or the efficiency or effectiveness with which the management has conducted the affairs of the enterprise”. So it follows from above that it is no part of the auditor’s duty to probe into the propriety of business conduct. This contention has been held perfectly valid as it has been asserted that the conventional financial audit is concerned with examination of the transactions to ascertain the true and fair nature of
the financial statements. The auditor is merely concerned with evaluating the evidence in support of transactions but need not examine the regularity and prudence of various decisions taken by the management.
However, of late, this has undergone a change as some of the requirements of law introduced in the past require the company auditor to go beyond the functions of reporting and express an opinion about the propriety or prudence of certain transactions in certain specific areas. Sub-sections (1A) and (4A) of the section 227 of the Companies Act, 1956 contain various such matters. It may also be clarified that the usage of words “true and fair” is restricted to certain countries such as U.K. while in other countries like United States the expression “full and fair” is prevalent. However both expressions aim to convey same meaning. On a consideration of what has been discussed, it may be summed up that auditing has the principal objective of seeing whether or not the financial statement portray a true and fair state of affair and of reporting accordingly. An incidental and secondary, but by no means an insignificant audit objective, flowing from the former, is detection of errors and frauds and making recommendations to prevent their occurrence.
- Errors and Frauds
Accounting is a device for collecting and presenting useful information in financial terms about a business enterprise. It should as well be recognised that accounting data may contain errors for a variety of reasons, and those who rely on accounting data frequently have no way of determining for themselves the reliability of data presented. Even today the human element is the most significant element for recording and processing the accounting data. Human beings as they are, are always open to personal failures and allurement. The audit objective, in the past was, primarily concerned with the detection of errors and frauds and now, though the general audit engagement do not specifically require their detection, they do not rule them out and in fact stipulate their detection on the premise that no statements of account can be considered true and fair if substantial errors and frauds remain to distort the picture. Another presumption about errors and frauds which has wide recognition, is that the audit techniques and processes, if carried on conscientiously would bring to light errors and frauds even though the examination was not specifically directed to reveal them. In the context of auditor’s role in detection of frauds, a significant development in the sphere of management is the installation of control devices by the management to ensure compilation of reliable statements of account. These are designed to plug the possibilities of errors and frauds as they provide means for their early detection. It is true that management is responsible for prevention of errors and frauds. It can be argued that the auditor’s role in their detection is very much conditioned by these developments. The auditor can achieve a lot by a purposeful review of those control systems and their operation. While conducting audit, the auditor may come to know the area where control is not fool proof or where control measures have not been properly operated with a view to ensuring better control over errors and frauds. In such instances, the auditor may provide the management with practicable suggestions for alteration or modification of the controls and checks. This is a safety for the future. It is a matter of safety for the business because by acting on the expert suggestions, a better assurance for obtaining reliable accounts is there. It is a safety for the auditor, if in future he is hauled up before the Court to defend a charge of negligence for non-detection of errors and frauds; it would be to his defence that he had already made the management aware of the weaknesses in the book-keeping system and procedures and the management had failed to act on his suggestions [Re S. P. Catterson & Sons Ltd.]. If the books of account are not properly maintained and if the control system is weak, the possibility of frauds and errors are enormous and the auditor, even with the best of his efforts, may not be able to detect all of them. The fact is recognised by the Courts as is obvious from a study of the various judgments. The auditor’s performance is judicially viewed by applying the following tests :
- whether the auditor has exercised reasonable care and skill in carrying out his work;
- whether the errors and frauds were such as could have been detected in the ordinary course of checking without the aid of any special efforts;
- whether the auditor had any reason to suspect the existence of the errors and frauds; and
- whether the error or fraud was so deep laid that the same might not have been detected by the
application of normal audit procedures.
We have so far discussed the general background and the position of the auditors as regards errors and frauds and we know that the auditor has a certain amount of responsibility for their detection. We shall now analyse the causes and nature of errors and frauds. If an auditor is aware of these, detection becomes easier in the sense that he can direct his enquiry more objectively and plan his work having regard to general possibility of errors and frauds. R.K. Mautz, in his book on “Fundamentals of Auditing” has classified the reasons and circumstances of errors and he has included fraud in the broad category of errors. The classifications are the following :
- Ignorance on the part of employees of accounting developments, generally accepted accounting principles, appropriate account classification of the necessary reconciling subsidiary ledgers with controlling accounts and of good accounting practices in general.
- Carelessness on the part of those doing the accounting work.
- A desire to conceal the effect of defalcations of shortages of one kind or another.
- A tendency of the management to permit prejudice or bias to influence the interpretation of transactions or events or their presentation in the financial statements. An ever present desire to hold taxes on income to minimum.
A sixth cause may be added to those Mr. Mautz has listed and that is more serious in nature. It is the intentional effort committed by persons in position of authority to :
- show up the picture depicted by the statements;
- depress the picture depicted by the statements; and
- convert the error to a personal benefit.
Errors and frauds both distort the true picture either by omission or by commission but the distinction
between the two lies in intent. Error is an involuntary act whereas fraud is a deliberate act. Mautz also
has classified the types of errors. These are :
- Self-revealing and not self-revealing
- Unintentional and intentional
- Unconcealed and concealed.
- Affecting general ledger balances and not affecting general ledger balances.
Self-revealing errors: These are such errors the existence of which becomes apparent in the processof compilation of accounts. A few illustrations of such errors are given hereunder, showing how theybecome apparent.
- Omission to post a part of a journal entry to the ledger. Trial balance is thrown out of agreement.
- Wrong totalling of the Purchase Register. Control Account (e.g., the Sundry Creditors Account) balances and the aggregate of the balances in the personal ledger will disagree.
- A failure to record in the cash book amounts paid into or withdrawn from the bank Bank reconciliation statement will show up error.
- A mistake in recording amount received from X in the account of Y. Statements of account parties will reveal mistake.
From the above, it is clear that certain apparent errors balance almost automatically by double entry accounting procedure and by following established practices that lie within the accounting system but not being generally considered to be a part of it, like bank reconciliation or sending monthly statements of account for confirmation.
Many other errors, however, are not revealed by either of these possibilities. If an item of expense which should have been charged to repairs account has been charged by mistake to the building account or if the amount of depreciation is calculated incorrectly, there is nothing in the book-keeping system which will bring the error to notice. Such errors are non self-revealing errors. Suppose a debit entry is omitted to be posted in the ledger and there are one or more of such omissions of credit entries which exactly compensate the effect of the former omission, then another self-revealing error turns to be not so. Such mistakes may remain undetected indefinitely unless measures aimed at discovering such errors are applied. Intentional Errors or Frauds: Fraud is the word used to mean intentional error. This is done deliberately which implies that there is an intent to deceive, to mislead or at least to conceal the truth. It follows that other things being equal, they are more serious than unintentional errors because of the implication of dishonesty which accompanies them.
As per AAS-4, “Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements”, two types of intentional misstatements are relevant to the auditor’s consideration of fraudmisstatements:
Fraudulent Financial Reporting: It involves intentional misstatements or omissions of amounts
or disclosures in financial statements to deceive financial statement users. Fraudulent financial
reporting may involve:
- Deception such as manipulation, falsification, or alteration of accounting records or supporting documents from which the financial statements are prepared. For example, in a period of rising prices, sales contract documents may be ante-dated to record sales at prices lower than the prices at which sales have actually taken place.
- Misrepresentation in, or intentional omission from, the financial statements of events, transactions or other significant information. For example, goods sold may not be recorded as sales but included in inventories.
- Intentional misapplication of accounting principles relating to measurement, recognition, classification, presentation, or disclosure. For example, where a contracting firm follows the ‘completed contract’ method of accounting but does not provide for a known loss on incomplete contracts.
Misappropriation of Assets: It involves the theft of an entity’s assets. Misappropriation of assets can be accomplished in a variety of ways (including embezzling receipts, stealing physical or intangible assets, or causing an entity to pay for goods and services not received); it is often accompanied by false or misleading records or documents in order to conceal the fact that the assets are missing. Therefore, it is clear from the above that the ‘fraud’ deals with intentional misrepresentation but, ‘error’, on the other hand, refers to unintentional mistakes in financial information. Intentional errors are most difficult to detect and auditors generally devote greater attention to this type because out of long and sometimes unfortunate experience, auditors have developed a point of view that if they direct their procedures of discovering the more difficult intentional errors, they are reasonably certain to locate the more simple and far more common unintentional errors on the way. The auditors have also learnt by experience that although most people are honest under different circumstances but they may be unable to resist temptations. When circumstances are such that the possibility of being caught is rather remote, most people are likely to respond to temptation. This is a well known aspect of human behaviour. Auditors while studying the possibility and nature of fraud, must keep this always in mind and should not make any exception for those who held high offices. Factors, like job satisfaction in terms of responsibility, trust and reward, personal habits, temporary requirements etc., have great bearing on the matter of commission of fraud. These things generally start in a non-consequential wayoften a subordinate staff member first borrows small amounts from the cash box to meet his temporary difficulty and then gradually it becomes his habit to borrow in such manner whenever he is in difficulty;
when he finds that nobody has even an inkling of the matter, he ventures with far larger amounts which on many occasions, he finds himself unable to replace. Fraud also takes place in forms other than cash defalcation, discussed above. It may be misappropriation of goods or manipulation of accounts with a view to presenting a false state of affairs. Defalcation of Cash: Defalcation of cash has been found to perpetrated generally in the following
- By inflating cash payments.
Examples of inflation of payments:
- Making payments against fictitious vouchers.
- Making payments against vouchers, the amounts whereof have been inflated.
- Manipulating totals of wage rolls either by including therein names of dummy workers or by
inflating them in any other manner.
- Casting a larger totals for petty cash expenditure and adjusting the excess in the totals of the
detailed columns so that cross totals show agreement.
- By suppressing cash receipts. Few Techniques of how receipts are suppressed are:
- 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. Similarly, moneys received from the customer who has paid thereafter being credited to the account of the second customer and such a practice is continued so that no one account is outstanding for payment for any length of time, which may lead the management to either send out a statement of account to him or communicate with him.
- Adjusting unauthorised or fictitious, rebates, allowances, discounts, etc. customer’ accounts and misappropriating amount paid by them.
- Writing off as debts in respect of such balances against which cash has already been received but has been misappropriated.
- Not accounting for cash sales fully.
- Not accounting for miscellaneous receipts, e.g., sale of scrap, quarters allotted to the employees, etc.
- Writing down asset values in entirety, selling them subsequently and misappropriating the proceeds.
- By casting wrong totals in the cash book.
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 the various 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 stationary. The goods may be removed by subordinate employees or even by persons quite higher up in the management. Auditors can detect this by undertaking a thorough and strenuous checking of records followed by physical verification process. Also, by resorting to intelligent ratio analysis, auditors may be able to form an idea whether such fraud exists. For example, the gross profit ratio adjusted for any recorded change during the year, reveals whether the value of stock is reasonable with reference to the amount of the sale. Similarly, the input-output ratio of production in terms of physical quantity may reveal whether output is normal with reference to the quantity consumed for production. 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 :
- to avoid incidence of income-tax or other taxes;
- for declaring a dividend when there are insufficient profits;
- to withhold declaration of dividend even when there is adequate profit (this is often done to manipulate the value of shares in stock market to make it possible for selected persons to acquire shares at a lower cost); and
- 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:
- inflating or suppressing purchases and expenses;
- inflating or suppressing sales and other items of income,
- inflating or deflating the value of closing stock;
- failing to adjust outstanding liabilities or prepaid expenses; and
- charging items of capital expenditure to revenue or by capitalising revenue expenses.
Concealed and Unconcealed Errors: As a general rule, mistakes are unconcealed but frauds are deliberately concealed. This proposition does not need any elaboration; but exceptions are in both cases. Mistakes become concealed if compensated by another or more mistakes in the opposite direction; or it may even be greatly minimised by that chance happening. For example, by mistake one or more accounts were short debited by an aggregate figure of Rs. 30,000 and this short debit is compensated by chance error or say short casting or one or more credit accounts to the tune of say Rs. 30,200 the dimension of the error would apparently be Rs. 200 by which the trial balance would be thrown out of agreement and there may be a temptation to think, “the error is small, let us ignore it”. This
attitude towards apparently small errors is dangerous because its true dimensions remain concealed and that may render the statements of account totally unacceptable. Mistakes may as well be concealed for wrong arithmetical calculations or for a faulty process of verification. Depreciation and stocks are examples which immediately come to one’s mind. Wrong calculation of depreciation or omission to include certain stocks in the inventory or wrong valuation of stocks are not apparent. Petty cash defalcation is often unconcealed because petty cash is an item which on many occasions is left out of checking.
Procedural Errors: Sometimes we become so obsessed with the general ledger and its supporting records that we neglect other important features of the accounting system. An accounting system includes both records and procedure. Errors can appear in either or both. Whatever errors occur in the implementation of the procedures may be termed as procedural errors (which include frauds also). For example, the sales procedure of a company may include the following steps:
- Receipt of an order through salesman.
- Review of order by the credit department to determine whether the customer should be given credit as requested.
- Clearance with inventory department to be sure that the order can be executed.
- Preparation of forwarding note with copies to obtain the customer’s acknowledgement of the receipt of goods.
- Preparation of invoice and despatch of the same to the customer. If the procedure requires that these steps should be taken in the order indicated and if, for any reason, the second step is omitted, or is not completed before subsequent steps have been taken an error in procedure has been made and this may lead the company into financial loss caused by non-recovery of the money. Procedures are established to maintain control over resources and over transactions; any failure to follow the established procedures lessens the control and may permit errors which do affect ledger accounts. Any breakdown in established procedures thus suggests not only the presence of a procedure type error but also of other consequences.
Other errors of this type include the approving of transactions of documents by some one other than the person authorised to do so, failure to ensure that all preceding steps have been taken before approving a document and substitution of one person by another in a procedural function without proper authority. It is the normal procedure that goods, when received should be inspected for quality by the inspection department staff. If the store-keeper carried out this function it is indeed risky. Similarly, if the procedure requires that the timber godown should have been given periodical insecticide treatment and management has ignored that, a great loss may be caused to the timber by white ants. What is needed to be emphasised here is this that a procedural error, which is neither a defalcation nor misappropriation, may involve the company in a sizeable loss. This type of error or fraud cannot be
located by any rigorous examination of the books of account.
All these errors discussed above may be grouped in the following categories in terms of their accounting
- Errors of omission – where a transaction has been omitted either wholly or partially.
- Errors of commission – where a transaction has been misrecorded either wholly or partially.
- Compensating errors – where there are two or more errors which exactly counter balance each other, so that the trial balance agrees in spite of them.
- Errors of principle – these are errors arising as a result of transactions having been recorded in a fundamentally incorrect manner; for example, a distinction not being made between capital and revenue income or expenditure.
- Procedural errors.
Detection of Fraud and Error : Duty of an Auditor
AAS-4, “Auditors Responsibility to Consider Fraud and Error in an Audit of Financial Statements”, deals at length with the auditor’s responsibilities for the detection of material misstatements resulting from fraud and error when carrying out an audit of financial information and to provide guidance as to the procedures that the auditor should perform when he encounters circumstances that cause him to suspect, or when he determines, that fraud or error has occurred. Broadly, the general principles laid down in the AAS may be noted as under:
- In planning and performing his examination, the auditor should take into consideration the risk of material misstatement of the financial information caused by fraud or error. He should inquire of management as to any fraud or significant error which has occurred in the reporting period and modify his audit procedures, if necessary.
- If circumstances indicate the possible existence of fraud or error, the auditor should consider the potential effect of the suspected fraud or error on the financial information. If the auditor believes the suspected fraud or error could have a material effect on the financial information, he should perform such modified or additional procedures as he determines to be appropriate.
- The auditor should satisfy himself that the effect of fraud is properly reflected in the financial information or the error is corrected in case the modified procedures performed by the auditor confirm the existence of the fraud. In case auditor is unable to obtain evidence to confirm or dispel a suspicion of fraud, the auditor should consider relevant laws and regulations and may wish to obtain legal advice before rendering any report on the financial information or before withdrawing from the engagement.
- The reporting responsibilities would also include communicating with management. When those persons ultimately responsible for the overall direction of the entity are doubted, the auditor may seek legal advice to assist him in the determination of procedures to follow. The auditor should also consider the implications of the circumstances on the true and fair view which the financial statements ought to convey and frame his report appropriately. Where a significant fraud has occurred the auditor should consider the necessity for a disclosure of the fraud in the financial statements and if adequate disclosure is not made, the necessity for a suitable disclosure in his report.
AAS 4, “Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements”, by way of example lists certain risk factors and circumstances relating to possibility of fraud which may be considered by the auditor are dealt in the following paragraphs.
Examples of Risk Factors Relating to Misstatements Resulting from Fraud: The fraud risk factors identified below are examples of such factors typically faced by auditors in a broad range of situations. However, the fraud risk factors listed below are only examples; not all of these factors are likely to be present in all audits, nor is the list necessarily complete. Furthermore, the auditor exercises professional judgment when considering fraud risk factors individually or in combination and whether there are specific controls that mitigate the risk.
Fraud Risk Factors Relating to Misstatements Resulting from Fraudulent Financial
Reporting: Fraud risk factors that relate to misstatements resulting from fraudulent financial
reporting may be grouped in the following three categories:
- Management’s Characteristics and Influence over the Control Environment.
- Industry Conditions.
- Operating Characteristics and Financial Stability.
For each of these three categories, examples of fraud risk factors relating to misstatements arising from fraudulent financial reporting are set out below:
- Fraud Risk Factors Relating to Management’s Characteristics and Influence over the Control
1. These fraud risk factors pertain to management’s abilities, pressures, style, and attitude relating to
internal control and the financial reporting process. There is motivation for management to engage in fraudulent financial reporting. Specific indicators might include the following:
- A significant portion of management’s compensation is represented by bonuses, stock options or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position or cash flow.
- There is excessive interest by management in maintaining or increasing the entity’s stock price or earnings trend through the use of unusually aggressive accounting practices.
- Management commits to analysts, creditors and other third parties to achieving what appear to be unduly aggressive or clearly unrealistic forecasts.
- Management has an interest in pursuing inappropriate means to minimize reported earnings for tax-motivated reasons.
2. There is a failure by management to display and communicate an appropriate attitude regarding
internal control and the financial reporting process. Specific indicators might include the following:
- Management does not effectively communicate and support the entity’s values or ethics, or management communicates inappropriate values or ethics.
- Management is dominated by a single person or a small group without compensating controls such as effective oversight by those charged with governance.
- Management does not monitor significant controls adequately.
- Management fails to correct known material weaknesses in internal control on a timely basis.
- Management sets unduly aggressive financial targets and expectations for operating
- Management displays a significant disregard for regulatory authorities.
- Management continues to employ ineffective accounting, information technology or internal auditing staff.
- Non-financial management participates excessively in, or is preoccupied with, the selection of accounting principles or the determination of significant estimates.
- There is a high turnover of management, counsel or board members.
- There is a strained relationship between management and the current or predecessor auditor. Specific indicators might include the following:
- Frequent disputes with the current or a predecessor auditor on accounting, auditing or reporting matters.
- Unreasonable demands on the auditor, including unreasonable time constraints regarding the completion of the audit or the issuance of the auditor’s report.
- Formal or informal restrictions on the auditor that inappropriately limit the auditor’s access to people or information, or limit the auditor’s ability to communicate effectively with those charged with governance.
- Domineering management behaviour in dealing with the auditor, especially involving attempts to influence the scope of the auditor’s work.
- There is a history of securities law violations, or claims against the entity or its management alleging fraud or violations of securities laws.
- The corporate governance structure is weak or ineffective, which may be evidenced by, for
- A lack of members who are independent of management.
- Little attention being paid to financial reporting matters and to the accounting and internal control systems by those charged with governance.
3. Fraud Risk Factors Relating to Industry Conditions: These fraud risk factors involve the economic
and regulatory environment in which the entity operates.
- New accounting, statutory or regulatory requirements that could impair the financial stability or
profitability of the entity.
- A high degree of competition or market saturation, accompanied by declining margins.
- A declining industry with increasing business failures and significant declines in customer demand.
- Rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid
4. Fraud Risk Factors Relating to Operating Characteristics and Financial Stability: These fraud risk factors pertain to the nature and complexity of the entity and its transactions, the entity’s financial condition, and its profitability.
- Inability to generate cash flows from operations while reporting earnings and earnings growth.
- Significant pressure to obtain additional capital necessary to stay competitive, considering the financial position of the entity (including a need for funds to finance major research and development or capital expenditures).
- Assets, liabilities, revenues or expenses based on significant estimates that involve unusually subjective judgments or uncertainties, or that are subject to potential significant change in the near term in a manner that may have a financially disruptive effect on the entity (for example, the ultimate collectibility of receivables, the timing of revenue recognition, the realisability of financial instruments based on highly-subjective valuation of collateral or difficult-to-assess repayment sources, or a significant deferral of costs).
- Significant related party transactions which are not in the ordinary cours of business.
- Significant related party transactions which are not audited or are audited by another firm.
- Significant, unusual or highly complex transactions (especially those close to year-end) that pose difficult questions concerning substance over form.
- Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business justification.
- An overly complex organizational structure involving numerous or unusual legal entities, managerial lines of authority or contractual arrangements without apparent business purpose.
- Difficulty in determining the organization or person (or persons) controlling the entity.
- Unusually rapid growth or profitability, especially compared with that of other companies in the same industry.
- Especially high vulnerability to changes in interest rates.
- Unusually high dependence on debt, a marginal ability to meet debt repayment requirements, or debt covenants that are difficult to maintain.
- Unrealistically aggressive sales or profitability incentive programs.
- A threat of imminent bankruptcy, foreclosure or hostile takeover.
- Adverse consequences on significant pending transactions (such as a business combination or contract award) if poor financial results are reported.
- A poor or deteriorating financial position when management has personally guaranteed significant debts of the entity.
Fraud Risk Factors Relating to Misstatements Resulting from Misappropriation of Assets: Fraud risk
factors that relate to misstatements resulting from misappropriation of assets may be grouped in the
following two categories:
- Susceptibility of Assets to Misappropriation.
For each of these two categories, examples of fraud risk factors relating to misstatements resulting from misappropriation of assets are set out below. The extent of the auditor’s consideration of the fraud risk factors in category 2 is influenced by the degree to which fraud risk factors in category 1 are present.
1. Fraud Risk Factors Relating to Susceptibility of Assets to Misappropriation: These fraud risk factors pertain to the nature of an entity’s assets and Fraud Risk Factors Relating to Controls the degree to which they are subject to theft.
- Large amounts of cash on hand or processed.
- Inventory characteristics, such as small size combined with high value and high demand.
- Easily convertible assets, such as bearer bonds, diamonds or computer chips.
- Fixed asset characteristics, such as small size combined with marketability and lack of ownership identification.
2. These fraud risk factors involve the lack of controls designed to prevent or detect misappropriation of assets.
- Lack of appropriate management oversight (for example, inadequate supervision or inadequate monitoring of remote locations).
- Lack of procedures to screen job applicants for positions where employees have access to assets susceptible to misappropriation.
- Inadequate record keeping for assets susceptible to misappropriation.
- Lack of an appropriate segregation of duties or independent checks.
- Lack of an appropriate system of authorization and approval of transactions (for example, in purchasing).
- Poor physical safeguards over cash, investments, inventory or fixed assets.
- Lack of timely and appropriate documentation for transactions (for example, credits for merchandise returns).
- Lack of mandatory vacations for employees performing key control functions.
Examples of Circumstances that Indicate the Possibility of Fraud or Error
The auditor may encounter circumstances that, individually or in combination, indicate the possibility that the financial statements may contain a material misstatement resulting from fraud or error. The circumstances listed below are only examples; neither all of these circumstances are likely to be present in all audits nor is the list necessarily complete.
- Unrealistic time deadlines for audit completion imposed by management.
- Reluctance by management to engage in frank communication with appropriate third parties, such as regulators and bankers.
- Limitation in audit scope imposed by management.
- Identification of important matters not previously disclosed by management.
- Significant difficult-to-audit figures in the accounts.
- Aggressive application of accounting principles.
- Conflicting or unsatisfactory evidence provided by management or employees.
- Unusual documentary evidence such as handwritten alterations to documentation, or handwritten documentation which is ordinarily electronically printed.
- Information provided unwillingly or after unreasonable delay.
- Seriously incomplete or inadequate accounting records.
- Unsupported transactions.
- Unusual transactions, by virtue of their nature, volume or complexity, particularly if such transactions occurred close to the year-end.
- Transactions not recorded in accordance with management’s general or specific authorization.
- Significant unreconciled differences between control accounts and subsidiary records or between physical count and the related account balance which were not appropriately investigated and corrected on a timely basis.
- Inadequate control over computer processing (for example, too many processing errors; delays in processing results and reports).
- Significant differences from expectations disclosed by analytical procedures.
- Fewer confirmation responses than expected or significant differences revealed by confirmation responses.
- Evidence of an unduly lavish lifestyle by officers or employees.
- Unreconciled suspense accounts.
- Long outstanding account receivable balances.