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ASA 240 - The Auditor’s Responsibility to Consider Fraud in an Audit of a Financial Report - April 2006
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Turn the raw legal text into a practical explanation grounded in ASA 240 - The Auditor’s Responsibility to Consider Fraud in an Audit of a Financial Report - April 2006.
7 Misstatements in the financial report 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 report is intentional or unintentional.
8 The term “error” refers to an unintentional misstatement in the financial report, including the omission of an amount or a disclosure, such as the following:
9 The term “fraud” refers to 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 this Auditing Standard, the auditor is concerned with fraud that causes a material misstatement in the financial report. Auditors do not make legal determinations of whether fraud has actually occurred. Fraud involving one or more members of management or those charged with governance is referred to as “management fraud;” fraud involving only employees of the entity is referred to as “employee fraud.” In either case, there may be collusion within the entity or with third parties outside of the entity.
10 Two types of intentional misstatements are relevant to the auditor, that is, misstatements resulting from fraudulent financial reporting and misstatements resulting from misappropriation of assets.
11 Fraudulent financial reporting involves intentional misstatements including omissions of amounts or disclosures in the financial report to deceive financial report users. Fraudulent financial reporting may be accomplished by the following:
12 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:
13 Fraudulent financial reporting can be caused by the efforts of management to manage earnings in order to deceive financial report users by influencing their perceptions as to the entity’s performance and profitability. Such earnings management may start out with small actions or inappropriate adjustment of assumptions and changes in judgements by management. Pressures and incentives may lead these actions to increase to the extent that they result in fraudulent financial reporting. Such a situation could occur when, due to pressures to meet market expectations or a desire to maximise compensation based on performance, management intentionally takes positions that lead to fraudulent financial reporting by materially misstating the financial report. In some other entities, management may be motivated to reduce earnings by a material amount to minimise tax or to inflate earnings to secure bank financing.
14 Misappropriation of assets involves the theft of an entity’s assets and is often perpetrated by employees in relatively small and immaterial amounts. However, it can also involve management who are usually more 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 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).
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 authorisation.
15 Fraud involves incentive or pressure to commit fraud, a perceived opportunity to do so and some rationalisation of the act. Individuals may have an incentive to misappropriate assets for example, because the individuals are living beyond their means. Fraudulent financial reporting may be committed because management is under pressure, from sources outside or inside the entity, to achieve an expected (and perhaps unrealistic) earnings target – particularly since the consequences to management for failing to meet financial goals can be significant. A perceived opportunity for fraudulent financial reporting or misappropriation of assets 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 weaknesses in internal control. Individuals may be able to rationalise 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. However, even otherwise honest individuals can commit fraud in an environment that imposes sufficient pressure on them.