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According to statutory requirements under US GAAP, companies are mandated to conduct an audit of their financial statements to ensure compliance with applicable regulations. It is the auditor’s responsibility to identify any material errors or fraudulent activities within the financials.
It is essential for organizations to appoint a competent auditor who is well-versed in U.S. GAAP and possesses a deep understanding of regulatory compliance who can effectively detect misstatements or irregularities that may otherwise lead to legal penalties or financial losses. For this purpose, the organization must be aware of various considerations regarding fraudulent activities and how to improve them.
The general responsibilities of the auditor in conducting an audit require the auditor to plan and perform the audit to obtain Sufficient Appropriate Audit Evidence (SAAE) to obtain reasonable assurance about whether the Financial Statements (FS) are free of material misstatement, whether due to error or fraud. This article outlines the auditor’s responsibilities in identifying, addressing, and communicating fraud risks during an audit of financial statements.
Fraud is a deliberate act intended to mislead users about their financial information, and it is a significant concern in financial reporting and auditing. The primary distinction between fraud and error is whether the underlying action is intentional or unintentional. Fraud typically requires more serious actions to conceal, whereas errors are often unintentional mistakes that can be corrected once identified.
1. Misstatements arising from fraudulent financial reporting: These are the intentional misstatements or omissions of amounts or disclosures in financial statements. Fraudulent financial reporting misstatements may be accomplished by the following:
In some cases, fraudulent financial reporting may not be part of a grand plan or conspiracy. Sometimes, management rationalizes material misstatements as “aggressive interpretations” of complex accounting rules or considers the misstatements as temporary errors, hoping to correct them later. This is an example of how management can rationalize misstatements.
2. Misstatements arising from misappropriation of assets (sometimes referred to as theft or defalcation): It occurs when individuals steal or misuse company resources, where the effect of theft causes a misrepresentation in the financial statements
Misappropriation of assets and misstatements can be accomplished by the following:
1. Incentive or Pressure: Management or other employees feel pressure (e.g., unrealistic performance targets) or have a financial incentive, which provides a reason to commit fraud.
2. Opportunity: Circumstances exist—for example, the absence of oversight by senior management and those charged with governance, ineffective internal controls, or the ability of management to override controls—that provide an opportunity for fraud to be perpetrated.
3. Rationalization: Those committing fraud may justify their actions, even to themselves. They may believe the business can “afford” the theft or that a perceived short-term setback justifies their behavior. Sometimes, due to perceived unfairness or unrealistic expectations, employees may justify dishonest behavior.
Since management often has the power to modify financial records or override controls, they are in a position to commit fraud. In particular, management’s overriding of controls often results in fraudulent financial reporting, which makes it more difficult for auditors to detect.
The following are some examples of how management commits fraud:
These types of fraud can be particularly difficult for auditors to detect, especially when management, employees, and outside parties collude.
When fraud risks related to fraudulent financial reporting are assessed, auditors may perform the following procedures:
When the auditor identifies a fraud risk related to misappropriation of assets, such as easily accessible cash or movable inventory like laptops, the audit procedures focus on the specific risks identified.
1. Account Balances: Audit procedures should be tailored to the fraud risk, such as cash or inventory that is vulnerable to theft.
2. Control Testing: The auditor should assess and test the controls designed to prevent and detect asset misappropriation. This includes evaluating the design and effectiveness of these controls.
3. Physical Inspection: If applicable, the auditor may conduct physical inspections of assets, such as counting cash or securities, especially near the end of the reporting period.
4. Substantive Analytical Procedures: In certain cases, auditors may develop a high level of precision in estimating an expected dollar amount to compare with the recorded amount, identifying any discrepancies that could indicate misappropriation.
The risk of management override of controls is a significant concern because management can manipulate accounting records and override internal controls. To mitigate this risk, the auditor should perform specific procedures to detect and address potential fraud. Below are key audit procedures to address this risk:
The auditor should document the following:
This is the result of ever-growing desires and an urge to have a competitive edge in the market, as frauds and scandals have gained pace in our country and the entire world. Witnessing such unethical practices, our role as auditors is crucial, as we are the ones entrusted with the responsibility to report such fraud.
With the rapid change in technology and perpetrating minds, auditors need to pull up their socks and equip themselves and their teams to detect fraud and report it to discharge their duties well professionally and as citizens of our Nation.
At Mercurius, we take pride in being a trusted CPA firm with industry-wide experience, holding both PCAOB and IFRS registration. We assist our clients in dealing with internal audits, government audits of various corporate matters (including company incorporation), statutory audits, ROC compliance, and company winding-up. In India, we can provide them adequate support and guidance from our end. If you have any questions or would like to learn more about the Reporting of fraud by auditors, please get in touch with us.
