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Auditor's Responsibility for
Detecting Errors and Fraud
The Auditor's Responsibility
Material Misstatements
Material misstatements in financial statements may arise from various sources, except for the inadequacy of accounting records. The sources of material misstatements include:
Fraud Error Noncompliance with laws and regulations
Level of Assurance
The level of assurance provided by an audit in detecting material misstatements is referred to as "reasonable assurance." This means that the audit is designed to provide reasonable, but not absolute, assurance that the financial statements are free from material misstatement.
Fraud vs. Error
Fraud is an intentional act by one or more individuals, such as management, employees, or third parties, that results in a misrepresentation of financial statements. In contrast, an error is an unintentional misrepresentation of financial information.
The primary factor that distinguishes errors from fraud is whether the underlying cause of the misstatement is intentional or unintentional. Examples of errors include:
Misapplication of accounting policies Clerical mistakes in the processing of transactions Omission of the effects of transactions from the records
Examples of fraud include:
Misappropriation of assets Fraudulent financial reporting, such as overstating ending inventory and understating cost of goods sold
Responsibility for Detecting and Preventing Errors and
Fraud
The responsibility for the detection and prevention of errors, fraud, and noncompliance with laws and regulations rests with the client's
management. Management is responsible for adopting sound accounting policies, maintaining adequate internal control, and making fair representations in the financial statements.
The auditor's responsibility is to design the audit to provide reasonable assurance of detecting material errors and fraud. However, due to the inherent limitations of an audit, there is a possibility that material misstatements may not be detected.
Auditor's Responsibility for Detecting Errors and Fraud
The auditor's responsibility for the failure to detect material errors and fraud arises when such failure clearly results from noncompliance with Professional Standards on Auditing (PSA). The auditor is not responsible for the failure to detect material errors and fraud if the audit was conducted in accordance with PSA.
The auditor should maintain an attitude of professional skepticism, corroborating management representations with other supporting documentation whenever possible. The auditor's risk of failing to detect fraud is generally greater for management fraud due to management's ability to override existing internal controls.
Distinguishing Errors and Fraud
The key distinction between errors and fraud is the intentionality of the underlying cause of the misstatement. Errors are unintentional, while fraud is intentional. The auditor's responsibility for detecting errors is generally greater than for detecting fraud, as fraud is often more difficult to uncover due to concealment and collusion.
Fraud Risk Factors and Auditor
Responsibilities
Risk of Detecting Fraud vs. Error
The risk of not detecting material misstatement resulting from fraud is greater than the risk of not detecting a material misstatement arising from error. This is because fraud ordinarily involves acts designed to conceal it, such as collusion, forgery, or deliberate failure to record transactions. The professional standards do not require the auditor to discover information that is indicative of fraud. It is the responsibility of the management to detect fraud, and the auditor's responsibility is confined only to the detection of material errors.
Assessing Fraud Risk
When performing a financial statement audit, auditors are required to explicitly assess the risk of material misstatement due to fraud.
Circumstances identified during fieldwork that are most likely to affect the auditor's assessment of the risk of misstatement due to fraud include missing documents.
Indicators of Potential Misstatement
Circumstances that would least likely suggest to an auditor that the client's financial statements are materially misstated include management not correcting material internal control weaknesses that it knows about. Conditions that would least likely cause an auditor to consider whether material misstatements exist include the turnover of senior accounting personnel being exceptionally low. Circumstances that most likely would cause an auditor to believe that material misstatements exist in an entity's financial statements include there being substantial payments for services that appear excessive in relation to services provided.
Auditor Responses to Fraud Risk
Possible overall responses to fraud risks identified in an audit include using less predictable audit procedures. If the auditor believes a misstatement is or may be the result of fraud but that the effect is not material, the auditor is required to consider the implications for other aspects of the audit.
Reporting on Fraud and Errors
If the auditor believes the fraud or error has a material effect on the financial statements but the client is not willing to correct the misstatement, the auditor would most likely issue a qualified or adverse opinion. If the auditor is precluded from obtaining evidence to evaluate whether fraud or error that may be material has occurred, the auditor should issue a report containing either a qualified opinion or a disclaimer of opinion.
Auditor Responsibilities
When a user sees that an unmodified opinion has been expressed, they may correctly infer that any differences between management and the auditor on accounting matters have been resolved to the auditor's satisfaction. The profession has placed the responsibility for detecting employee fraud and errors equally on the auditor. Judgments about the increased risk of misstatement due to fraud may influence the auditor's professional judgments, such as the auditor's ability to assess control risk below the maximum and the need for a heightened level of professional skepticism.
Auditor's Responsibility Regarding Fraud and
Noncompliance
Fraud Detection
The auditor is required to provide reasonable assurance that both material errors and fraud are detected. The auditor's evaluation of the likelihood of material employee fraud is normally done as part of understanding the entity's internal control. The auditor should plan and perform the engagement with an attitude of professional skepticism, recognizing that the application of auditing procedures may produce evidence indicating the possibility of errors or fraud.
Noncompliance with Laws and Regulations
Noncompliance with laws and regulations are acts of omission or commission by the entity being audited, either intentional or unintentional, which are contrary to the prevailing laws and regulations. Most noncompliance affects the financial statements only indirectly. When the auditor knows that a noncompliance with laws and regulation has occurred, the auditor must consider the effects on the financial statements, including the adequacy of disclosure. The decision to notify parties outside the client's organization regarding noncompliance with laws and regulations is the responsibility of the management. The auditor is least likely to contact the local law enforcement regarding potential criminal wrongdoing when aware of noncompliance. An audit in accordance with PSA cannot be expected to detect all noncompliance with laws and regulations, and the determination of whether a particular act constitutes noncompliance is ultimately based on the judgment of the auditor. Indicators of possible noncompliance include payment of fines or penalties, payments without proper documentation, and existence of an accounting system which fails to provide an adequate audit trail or sufficient evidence. The risk of not detecting material misstatement due to noncompliance is high due to the many laws and regulations, the limitations of the audit, and the possibility of noncompliance involving conduct designed to conceal it. When the auditor becomes aware of information concerning a possible instance of noncompliance, the auditor should obtain an understanding of the nature of the act, and the circumstances in which it has occurred and sufficient other information to evaluate the possible effect on the financial statements. If the client does not take remedial action that the auditor considers necessary, the auditor most likely would withdraw from the engagement.
