ASA 240 - The Auditor’s Responsibility to Consider Fraud in an Audit of a Financial Report - April 2006
Responses to the Risks of Material MisstResponses to the Risks of Material Misstatement Due to Fraud
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Responses to the Risks of Material Misstatement Due to Fraud
65 The auditor shall determine overall responses to address the assessed risks of material misstatement due to fraud at the financial report level and shall design and perform further audit procedures whose nature, timing and extent are responsive to the assessed risks at the assertion level.
66 Under ASA 330, the auditor needs to perform substantive procedures that are specifically responsive to risks that are assessed as significant risks.
67 The auditor ordinarily responds to the risks of material misstatement due to fraud in the following ways:
A response that has an overall effect on how the audit is conducted, that is, increased professional scepticism and a response involving more general considerations apart from the specific procedures otherwise planned.
A response to identified risks at the assertion level involving the nature, timing and extent of audit procedures to be performed.
A response to identified risks involving the performance of certain audit procedures to address the risks of material misstatement due to fraud involving management override of controls, given the unpredictable ways in which such override could occur.
68 The response to address the assessed risks of material misstatement due to fraud may affect the auditor’s professional scepticism in the following ways:
Increased sensitivity in the selection of the nature and extent of documentation to be examined in support of material transactions.
Increased recognition of the need to corroborate management explanations or representations concerning material matters.
69 The auditor may conclude that it would not be practicable to design audit procedures that sufficiently address the risks of material misstatement due to fraud. In such circumstances under paragraphs 94 and 111 of this Auditing Standard, the auditor needs to consider the implications for the audit.
Overall Responses
70 In determining overall responses to address the risks of material misstatement due to fraud at the financial report level the auditor shall:
(a) consider the assignment and supervision of personnel;
(b) consider the accounting policies used by the entity; and
(c) incorporate an element of unpredictability in the selection of the nature, timing and extent of audit procedures.
71 The knowledge, skill and ability of the individuals assigned significant engagement responsibilities are commensurate with the auditor’s assessment of the risks of material misstatement due to fraud for the engagement. For example, the auditor may respond to identified risks of material misstatement due to fraud by assigning additional individuals with specialised skill and knowledge, such as forensic and IT experts, or by assigning more experienced individuals to the engagement. In addition, the extent of supervision reflects the auditor’s assessment of risks of material misstatement due to fraud and the competencies of the engagement team members performing the work.
72 Under paragraph 70 of this Auditing Standard, the auditor needs to consider management’s selection and application of significant accounting policies, particularly those related to subjective measurements and complex transactions. Ordinarily the auditor considers whether the selection and application of accounting policies may be indicative of fraudulent financial reporting resulting from management’s effort to manage earnings in order to deceive financial report users by influencing their perceptions as to the entity’s performance and profitability.
73 Individuals within the entity who are familiar with the audit procedures normally performed on engagements may be more able to conceal fraudulent financial reporting. Therefore, in accordance with paragraph 70 of this Auditing Standard, the auditor is required to incorporate an element of unpredictability in the selection of the nature, extent and timing of audit procedures to be performed. This can be achieved by, for example, performing substantive procedures on selected account balances and assertions not otherwise tested due to their materiality or risk, adjusting the timing of audit procedures from that otherwise expected, using different sampling methods, and performing audit procedures at different locations or at locations on an unannounced basis.
Audit Procedures Responsive to Risks of Material Misstatement Due to Fraud at the Assertion Level
74 The auditor’s responses to address the assessed risks of material misstatement due to fraud at the assertion level may include changing the nature, timing, and extent of audit procedures in the following ways:
The nature of audit procedures to be performed may need to be changed to obtain audit evidence that is more reliable and relevant or to obtain additional corroborative information. This may affect both the type of audit procedures to be performed and their combination. Physical observation or inspection of certain assets may become more important or the auditor may choose to use computer-assisted audit techniques to gather more evidence about data contained in significant accounts or electronic transaction files. In addition, the auditor may design procedures to obtain additional corroborative information. For example, if the auditor identifies that management is under pressure to meet earnings expectations, there may be a related risk that management is inflating sales by entering into sales agreements that include terms that preclude revenue recognition or by invoicing sales before delivery. In these circumstances, the auditor may, for example, design external confirmations not only to confirm outstanding amounts, but also to confirm the details of the sales agreements, including date, any rights of return and delivery terms. In addition, the auditor might find it effective to supplement such external confirmations with enquiries of non-financial personnel in the entity regarding any changes in sales agreements and delivery terms.
The timing of substantive procedures may need to be modified. The auditor may conclude that performing substantive testing at or near the period end better addresses an assessed risk of material misstatement due to fraud. The auditor may conclude that, given the risks of intentional misstatement or manipulation, audit procedures to extend audit conclusions from an interim date to the period end would not be effective. In contrast, because an intentional misstatement, for example a misstatement involving improper revenue recognition, may have been initiated in an interim period, the auditor may elect to apply substantive procedures to transactions occurring earlier in or throughout the reporting period.
The extent of the procedures applied reflects the assessment of the risks of material misstatement due to fraud. For example, increasing sample sizes or performing analytical procedures at a more detailed level may be appropriate. Also, computer-assisted audit techniques may enable more extensive testing of electronic transactions and account files. Such techniques can be used to select sample transactions from key electronic files, to sort transactions with specific characteristics, or to test an entire population instead of a sample.
75 If the auditor identifies a risk of material misstatement due to fraud that affects inventory quantities, examining the entity’s inventory records may help to identify locations or items that may require specific attention during or after the physical inventory count. Such a review may lead to a decision to observe inventory counts at certain locations on an unannounced basis or to conduct inventory counts at all locations on the same date.
76 The auditor may identify a risk of material misstatement due to fraud affecting a number of accounts and assertions, including asset valuation, estimates relating to specific transactions (such as acquisitions, restructurings, or disposals of a segment of the business), and other significant accrued liabilities (such as pension and other post-employment benefit obligations, or environmental remediation liabilities). The risk may also relate to significant changes in assumptions relating to recurring estimates. Information gathered through obtaining an understanding of the entity and its environment may assist the auditor in evaluating the reasonableness of such management estimates and underlying judgements and assumptions. A retrospective review of similar management judgements and assumptions applied in prior periods may also provide insight about the reasonableness of judgements and assumptions supporting management estimates.
77 Examples of possible audit procedures to address the assessed risks of material misstatement due to fraud are presented in Appendix 2 to this Auditing Standard. The appendix includes examples of responses to the auditor’s assessment of the risks of material misstatement resulting from both fraudulent financial reporting and misappropriation of assets.
Audit Procedures Responsive to Management Override of Controls
78 As noted in paragraph 22, management is in a unique position to perpetrate fraud because of management’s ability to directly or indirectly manipulate accounting records and prepare a fraudulent financial report by overriding controls that otherwise appear to be operating effectively. While the level of risk of management override of controls will vary from entity to entity, the risk is nevertheless present in all entities and is a significant risk of material misstatement due to fraud. Accordingly, in addition to overall responses to address the risks of material misstatement due to fraud and responses to address the assessed risks of material misstatement due to fraud at the assertion level, under paragraph 80 of this Auditing Standard, the auditor needs to perform audit procedures to respond to the risk of management override of controls.
79 Paragraphs 80-86 set out the audit procedures that respond to risk of management override of controls. However, the auditor also ordinarily considers whether there are risks of management override of controls for which the auditor needs to perform procedures other than those specifically referred to in these paragraphs.
80 To respond to the risk of management override of controls, the auditor shall design and perform audit procedures to:
(a) test the appropriateness of journal entries recorded in the general ledger and other adjustments made in the preparation of a financial report;
(b) review accounting estimates for biases that could result in material misstatement due to fraud; and
(c) obtain an understanding of the business rationale of significant transactions that the auditor becomes aware of that are outside of the normal course of business for the entity, or that otherwise appear to be unusual given the auditor’s understanding of the entity and its environment.
Journal Entries and Other Adjustments
81 Material misstatements of the financial report due to fraud often involve the manipulation of the financial reporting process by recording inappropriate or unauthorised journal entries throughout the year or at period end, or making adjustments to amounts reported in the financial report that are not reflected in formal journal entries, such as through consolidating adjustments and reclassifications. In designing and performing audit procedures to test the appropriateness of journal entries recorded in the general ledger and other adjustments made in the preparation of the financial report the auditor ordinarily:
Obtains an understanding of the entity’s financial reporting process and the controls over journal entries and other adjustments.
Evaluates the design of the controls over journal entries and other adjustments and determines whether they have been implemented.
Makes enquiries of individuals involved in the financial reporting process about inappropriate or unusual activity relating to the processing of journal entries and other adjustments.
Determines the timing of the testing.
Identifies and selects journal entries and other adjustments for testing.
82 For the purposes of identifying and selecting journal entries and other adjustments for testing, and determining the appropriate method of examining the underlying support for the items selected, the auditor ordinarily considers the following:
The assessment of the risks of material misstatement due to fraud – the presence of fraud risk factors and other information obtained during the auditor’s assessment of the risks of material misstatement due to fraud may assist the auditor to identify specific classes of journal entries and other adjustments for testing.
Controls that have been implemented over journal entries and other adjustments – effective controls over the preparation and posting of journal entries and other adjustments may reduce the extent of substantive testing necessary, provided that the auditor has tested the operating effectiveness of the controls.
The entity’s financial reporting process and the nature of evidence that can be obtained – for many entities routine processing of transactions involves a combination of manual and automated steps and procedures. Similarly, the processing of journal entries and other adjustments may involve both manual and automated procedures and controls. When information technology is used in the financial reporting process, journal entries and other adjustments may exist only in electronic form.
The characteristics of fraudulent journal entries or other adjustments – inappropriate journal entries or other adjustments often have unique identifying characteristics. Such characteristics may include entries:
(a) made to unrelated, unusual, or seldom-used accounts;
(b) made by individuals who typically do not make journal entries;
(c) recorded at the end of the period or as post-closing entries that have little or no explanation or description;
(d) made either before or during the preparation of the financial report that do not have account numbers; or
(e) containing round numbers or consistent ending numbers.
The nature and complexity of the accounts – inappropriate journal entries or adjustments may be applied to accounts that
(a) contain transactions that are complex or unusual in nature;
(b) contain significant estimates and period-end adjustments;
(c) have been prone to misstatements in the past;
(d) have not been reconciled on a timely basis or contain unreconciled differences;
(e) contain inter-company transactions; or
(f) are otherwise associated with an identified risk of material misstatement due to fraud.
In audits of entities that have several locations or components, consideration is given to the need to select journal entries from multiple locations.
Journal entries or other adjustments processed outside the normal course of business – non standard journal entries may not be subject to the same level of internal control as those journal entries used on a recurring basis to record transactions such as monthly sales, purchases and cash disbursements.
83 The auditor uses professional judgement in determining the nature, timing and extent of testing of journal entries and other adjustments. Because fraudulent journal entries and other adjustments are often made at the end of a reporting period, the auditor ordinarily selects the journal entries and other adjustments made at that time. However, because material misstatements in the financial report due to fraud can occur throughout the period and may involve extensive efforts to conceal how the fraud is accomplished, the auditor ordinarily considers whether there is also a need to test journal entries and other adjustments throughout the period.
Accounting Estimates
84 In preparing a financial report, management is responsible for making a number of judgements or assumptions that affect significant accounting estimates and for monitoring the reasonableness of such estimates on an ongoing basis. Fraudulent financial reporting is often accomplished through intentional misstatement of accounting estimates. In reviewing accounting estimates for biases that could result in material misstatement due to fraud the auditor ordinarily:
Considers whether differences between estimates best supported by audit evidence and the estimates included in the financial report, even if they are individually reasonable, indicate a possible bias on the part of the entity’s management, in which case the auditor reconsiders the estimates taken as a whole.
Performs a retrospective review of management judgements and assumptions related to significant accounting estimates reflected in the financial report of the prior year. The objective of this review is to determine whether there is an indication of a possible bias on the part of management, and it is not intended to call into question the auditor’s professional judgements made in the prior year that were based on information available at the time.
85 If the auditor identifies a possible bias on the part of management in making accounting estimates, under paragraph 6 of this Auditing Standard the auditor needs to evaluate whether the circumstances producing such a bias represent a risk of material misstatement due to fraud. The auditor ordinarily considers whether, in making accounting estimates, management’s actions appear to understate or overstate all provisions or reserves in the same fashion so as to be designed either to smooth earnings over two or more accounting periods, or to achieve a designated earnings level in order to deceive financial report users by influencing their perceptions as to the entity’s performance and profitability.
Business Rationale for Significant Transactions
86 Under paragraph 80, the auditor needs to obtain an understanding of the business rationale for significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual given the auditor’s understanding of the entity and its environment and other information obtained during the audit. The purpose of obtaining this understanding is to consider whether the rationale (or the lack thereof) suggests that the transactions may have been entered into to engage in fraudulent financial reporting or to conceal misappropriation of assets. In gaining such an understanding the auditor ordinarily considers the following:
Whether the form of such transactions appears overly complex (for example, the transaction involves multiple entities within a consolidated group or multiple unrelated third parties).
Whether management has discussed the nature of and accounting for such transactions with those charged with governance of the entity, and whether there is adequate documentation.
Whether management is placing more emphasis on the need for a particular accounting treatment than on the underlying economics of the transaction.
Whether transactions that involve non-consolidated related parties, including special purpose entities, have been properly reviewed and approved by those charged with governance of the entity.
Whether the transactions involve previously unidentified related parties or parties that do not have the substance or the financial strength to support the transaction without assistance from the entity under audit.
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