Auditing standards: PSA 240 & Fraud

Related Standards

• PSA 240 (Redrafted) relates to the auditor's responsibilities relating to fraud in an audit.
• PSA 315 (Redrafted) involves identification of risks of material misstatements.
• PSA 330 covers the auditor's procedures in response to assessed risks.
• PSQC 1 relates to Philippine Standards on Quality Control.
• The Code of Ethics for CPAs in the Philippines is a related standard.

Basic Premise

• An auditor is responsible for obtaining reasonable assurance that financial statements are free from material misstatement, whether from fraud or error, per PSA 240.5.
• Financial statements are still the responsibility of management.
• Auditors are concerned with errors and frauds affecting the financial statements.

Error vs. Fraud

• Misstatements arise from either fraud or error, according to PSA 240.2.
• Fraud is intentional misstatement, while error is unintentional.

Error Defined

• Error is an involuntary or unintentional misstatement in financial statements.
• Errors include omission of an amount or disclosure, incorrect accounting estimates, mistakes in applying accounting policies, and preparer limitations.

Fraud Defined

• PSA 240.11 defines fraud as an intentional act involving deception to obtain unjust or illegal advantage.
• The act is by one or more individuals among management, those charged with governance, employees, or third parties.

Important Considerations (PSA 240.6)

• The risk of not detecting material misstatement from fraud is higher than from error.
• Collusion may cause auditors to believe false audit evidence. -Auitor's ability to detect fraud depends on the skillfulness of the perpetrator, the degree of collusion, and the seniority of involved individuals.

Auditor Responsibilities for Fraud

• PSA 240 outlines the auditor's objectives in identifying fraud
• The objectives are to identify and assess risks of material misstatement.
• The objectives also include to obtain sufficient audit evidence about assessed risks and appropriately respond to suspected fraud.

Management's Role in Fraud Prevention

• Management and those charged with governance are primarily responsible for fraud prevention and detection.
• Management should emphasize fraud prevention to reduce opportunities.
• Management has to emphasize fraud deterrence to persuade individuals not to commit fraud.

Existence of Fraud

• Fraud occurs when someone intentionally makes an untrue representation.
• Fraud occurs when the untrue representation is believed by a victim.
• Fraud occurs when the victim relies upon the untrue representation.
• Fraud occurs when the victim suffers a loss by relying on the untrue representation.

Fraud Types

• Fraud includes misappropriation of assets and fraudulent reporting.
• Employee and Management Fraud are types of fraud

Misappropriation of Assets (How?)

• Stealing something of value (an asset)
• Converting the asset to usable form (cash)
• Concealing the crime to avoid detection

Management Fraud

• Management fraud is perpetrated by those at higher levels than where internal controls typically relate.
• It involves using financial statements to create an illusion of a healthier, prosperous entity.
• Asset misappropriation is often hidden in complex transactions involving related third parties.

Fraud Schemes

• Fraudulent financial reporting and asset misappropriation are types of fraud scheme.
• Corruption is another type of fraud scheme.

Fraudulent Financial Reporting

• Fraudulent financial reporting misstate the financial statements to make copy "better".
• It often involves management overriding controls.
• Inappropriately adjusting assumptions and judgements can result in fraudulent financial reporting.
• Omitting, advancing, or delaying recognition in the financial statements can result in in fraudulent financial reporting
• Concealing facts that could affect recorded amounts can also result in in fraudulent financial reporting

More elements of of Fraudulent Financial Reporting

• Engaging in complex transactions misrepresents financial position/performance.
• Altering records related to significant transactions is fraudulent.
• This usually occurs as management fraud.
• Fraud may be tied to short-term financial measures, or bonus packages.

Methods of Fraudulent Financial Reporting

-Manipulating, falsifying, or altering accounting records or documentation.

• Misrepresenting or intentionally omitting information from financial statements.
• Intentionally misapplying accounting principles.

Asset Misappropriation Details

• Asset misappropriation involves theft of an entity's assets, often perpetrated by employees in small amounts.
• Common schemes involve directly or indirectly diverting assets to perpetrators.

Examples of Asset Misappropriation

• Skimming, cash larceny, and lapping are examples of asset misappropriation.
• Embezzling receipts is also an example of asset missapropriation

Billing Schemes (Vendor Fraud)

• Employees cause their employer to issue payment to a false supplier.
• They submit invoices for fictitious goods/services, inflated invoices, or invoices for personal purchases.
• Shell company fraud, pass-through fraud, and pay-and-return are examples.

Check Tampering

• Involves forging or changing a check the organization has written to a legitimate payee.
• An employee steals an outgoing check to a vendor, forges the payee's signature, and cashes it.
• Stealing blank checks and making them out to oneself or an accomplice is also check tampering.

Other Examples of Asset Misappropriation

• Payroll fraud and expense reimbursements are examples of asset misappropriation.
• Theft of cash and non-cash fraud are other examples of asset misappropriation

Computer Fraud

• Altering computer-readable records/files involves theft/misuse of assets.
• Altering the logic of computer software involves theft/misuse of assets.
• Illegal use of computer-related information is computer fraud.
• Theft, corruption, or intentional destruction of computer software is a type of computer fraud.
• Theft, misuse, or misappropriation of computer hardware is computer fraud.

Summary per PSA

• Embezzling receipts and stealing physical assets are types of fraud.
• Causing an entity to pay for goods/services not received is a type of fraud.
• Using an entity's assets for personal use is fraud.

Corruption

• Defined as the misuse of entrusted power for private gain.
• It involves an executive, manager, or employee colluding with an outsider.
• Bribery, illegal gratuity, conflicts of interest, and economic extortion are examples.

Characteristics of Fraudsters

• Fraudsters are generally male, or female.
• Fraudsters are intelligent, egotistical, and inquisitive.
• Fraudsters are risk takers and rule breakers.
• Fraudsters are also hard workers, often under stress, greedy, or have financial needs.

Potential Fraudsters

• Disgruntled workers who are big spenders may try to "get even".

The Fraud Diamond

• The Fraud Diamond consists of four factors contributing to fraud.
• Opportunity, motivation, rationalization, and capability are components of the fraud diamond.

Components of the Fraud Diamond

-Opportunity includes environmental factors and victim characteristics.

• Motivation comprises financial pressure, monetary gain, achievement, and manipulation. -Rationalization is belief that violating rules is acceptable, or a disdain for others.
• Capability includes knowledge of governance/economic institutions, ability to manipulate, and technical knowledge to exploit weaknesses.

The Fraud Triangle

• The Fraud Triangle is a framework for spotting high-risk fraud situations.
• Pressure, opportunity, and rationalization are components.

Fraud Triangle Components

• Pressure includes financial or emotional forces.
• Opportunity is the ability to execute a plan without getting caught.
• Rationalization is the personal justification of dishonest actions.

Fraud Risk Factors

• Fraud risk factors cannot be easily ranked in order of importance.
• Determining whether a fraud risk factor is present requires professional judgment.
• The size, complexity, and ownership affect consideration of fraud risk factors.

Risk Assessment Procedures

• Inquiries of management are risk assessment procedures.
• Management is responsible for internal control, so inquiries are appropriate.
• The auditor also makes inquiries about management's fraud risk assessment.
• The auditor makes inquiries to management about its process for identifying and responding to risk of fraud.

Inquiries of Management and Others

• Management fraud makes management inquiries unlikely to provide useful information.
• Inquiries of others may allow them to convey information not otherwise communicated.
• In-house legal counsel, chief ethics officers, and operating personnel can all be inquired with.

Responses to Assessed Risks of Material Misstatement Due to Fraud

• The auditor should determine overall responses by considering how the audit can reflect increased professional skepticism.
• Assigning/supervising personnel and evaluating accounting policies are overall responses.
• Incorporating unpredictability and changing the NTE of tests are also responses.

Communication to Management

• When an auditor finds evidence of fraud, it should be promptly communicated to the appropriate management level.
• Level determination is a matter of judgment, based on factors such as collusion and magnitude.
• The appropriate level is at least one level above those who appear to be involved.

Communication to Governance

• Communication with those charged with governance may be oral or written.
• PSA 260 lists factors for determining how to communicate.
• Material misstatement of fraud involving senior management should be reported in a timely manner.
• Communication is assisted if the auditor and the governance agree on the extent of communication early on.
• Auditors may seek legal advice if they doubt the integrity of management.

Communication to Authorities

• Auditors must maintain client confidentiality, but this may be overridden by regulatory requirements.
• Auditors of financial institutions have a statutory duty to report fraud to the BSP.
• Auditors have a duty to report material audit findings to the SEC if management fails to do so on a timely basis.
• The auditor may seek legal advice to determine steps to take regarding public interest aspects of identified fraud.

Reasons for Fraud

• Lack of auditor independence and director independence contribute to fraud.
• Questionable executive compensations schemes and inappropriate accounting practices contribute to fraud.
• Poor/weak/absent effective systems of internal control also contribute to fraud

Fraud Deterrents

• Is there a Framework to Deter Fraud
• Deterrents include accounting oversight board with auditor independence.
• Corporate governance and issuer/management disclosure are also deterrents.
• Fraud and criminal penalties are also a deterrent
• The Sarbanes-Oxley Act (SOx) aims to foster American Competitiveness with Corporate Accountability (2002).