Auditor's

Responsibility
The fair presentation of the financial statements in accordance
with the applicable financial reporting standards is the
responsibility of the client's management. The auditor's
responsibility is to design the audit to provide reasonable
assurance of detecting material misstatements in the financial
statements. These statements may emanate from:
1. Error
2. Fraud, and
3. Noncompliance with Laws and Regulations
 Error
The term "error" refers to unintentional misstatements in the
financial statements, including the omission of an amount, or a
disclosure, such as:
Mathematical or clerical mistakes in the underlying records
and accounting data
An incorrect accounting estimate arising from oversight or
misinterpretation of facts
Mistake in the application of accounting policies
 Fraud
Fraud refers to 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, the
auditor is primarily concerned with fraudulent acts that cause a
material misstatement in the financial statements.
TYPES OF FRAUD
There are two types of fraud that are relevant to financial statement audit.
Misstatements resulting from fraudulent financial reporting and misstatements
resulting from misappropriation of assets.

1.Fraudulent financial reporting involves intentional misstatements or

omissions of amounts or disclosures in the financial statements to deceive
financial statement users. This type of fraud is also known as management fraud
because it usually involves members of management or those charged with
governance. This may involve:
Manipulation, falsification or alteration of records or documents
Misrepresentation in or intentional omission of the effects of transactions
from records or documents
Recording of transactions without substance
Intentional misapplication of accounting policies
2. Misappropriation of assets or employee fraud involves theft of an entity's
assets committed by the entity's employees. This may include:
Embezzling receipts
Stealing entity's assets such as cash, marketable securities, and inventory
Lapping of accounts receivable

This type of fraud is often accompanied by false or misleading records or

documents in order to conceal the fact that the assets are missing.
Fraud involves motivation to commit it and a perceived opportunity to do so. For
example, an employee might be motivated to steal company's assets because this
employee lives beyond his means. Also, a member of management may be forced
to manipulate the financial statements in order to meet an overly optimistic
projection. A perceived opportunity to commit fraud may exist when there is no
proper segregation of duties among employees or when management believes
internal control can be easily circumvented.

The primary factor that distinguishes fraud from error is whether the underlying
cause of misstatement in the financial statements is intentional or unintentional.
Although the auditor may be able to identify opportunities for fraud to be
perpetrated, it is often difficult, if not impossible, for the auditor to determine
intent, particularly in matters involving management judgment such as accounting
estimates and the appropriate application of accounting principles. Consequently,
the auditor's responsibility for the detection of fraud and error is essentially the
same.
Responsibility of Management and Those Charged with Governance
The responsibility for the prevention and detection of fraud and error rests
with both management and those charged with governance of the entity. In
this regard, PSA 240 requires
Management to establish a control environment and to implement
internal control policies and procedures designed to ensure, among
others, the detection and prevention of fraud and error
Individuals charged with governance of an entity to ensure the integrity
of an entity's accounting and financial reporting systems and that
appropriate controls are in place
Auditor's Responsibility
Although the annual audit of financial statements may act as
deterrent to fraud and error, the auditor is not and cannot be held
responsible for the prevention of fraud and error. The auditor's
responsibility is to design the audit to obtain reasonable
assurance that the financial statements are free from material
misstatements, whether caused by error or fraud.
PLANNING PHASE
1.When planning an audit, the auditor should make inquiries of management about
the possibility of misstatements due to fraud and error. Such inquiries may include:
Management's assessment of risks due to fraud
Controls established to address the risks
Any material error or fraud that has affected the entity or suspected fraud that
the entity is investigating

The auditor's inquiries of management may provide useful information concerning

the risk of material misstatements in the financial statements resulting from
employee fraud. However, such inquiries are unlikely to provide useful information
regarding the risk of material misstatements in the financial statements resulting
from management fraud. Accordingly, the auditor should also inquire of those
individual in charge of governance to seek views on the adequacy of accounting and
internal control systems in place, the risk of fraud and error, and the integrity of the
management.
2. The auditor should assess the risk that fraud and error may cause the
financial statements to contain material misstatements. In this regard, PSA 240
requires the auditor to specifically "assess the risk of material misstatements
due to fraud and consider that assessment in designing the audit procedures to
be performed".

The fact that fraud is usually concealed can make it very difficult to detect.
Nevertheless, using the auditor's knowledge of the business, the auditor may
identify events or conditions that provide an opportunity, a motive or a means
to commit fraud, or indicate that fraud may have already occurred. Such events
or conditions are referred to as "fraud risk factors". Fraud risk factors do not
necessarily indicate the existence of fraud, however, they often have been
present in circumstances where frauds have occurred.
Judgements about the increased risk of material misstatements due to
fraud may influence the auditor's professional judgements in the following
ways:
The auditor may approach the audit with a heightened level of
professional skepticism.
The auditor's ability to assess control risk at less than high level may be
reduced and the auditor should be sensitive to the ability of the
management to override controls.
The audit team may be selected in ways that ensure that the knowledge,
skill, and ability of personnel assigned significant responsibilities are
commensurate with the auditor's assessment of risk.
The auditor may decide to consider management selection and
application of significant accounting policies, particularly those related
to income determination and asset valuation.
TESTING PHASE
3. During the course of the audit, the auditor may encounter circumstances that may
indicate the possibility of fraud and error. For example, there are discrepancies found
in the accounting records, conflicting or missing documents or lack of cooperation
from management. In these circumstances, the auditor should perform procedures
necessary to determine whether material misstatements exist.

4. After identifying material misstatement in the financial statements, the auditor

should consider whether such a misstatement resulted from a fraud or an error: this
is important because errors will only result to an adjustment of the financial
statements but fraud may have other implications on an audit.

If the auditor believes that the misstatement is, or may be the result of fraud, but the
effect on the financial statements is not material, the auditor should:
Refer the matter to the appropriate level of management at least one level above
those involved, and
 Be satisfied that, given the position of the likely perpetrator, the fraud has
no other implications for other aspects of the audit or that those
implications have been adequately considered.

However, if the auditor detects a material fraud or has been unable to evaluate
whether the effect on financial statement is material or immaterial, the auditor
should
Consider implication for other aspects of the audit particularly the reliability
of management representations.
Discuss the matter and the approach to further investigation with an
appropriate level of that is at least one level above those involved,
Attempt to obtain evidence to determine whether a material fraud in fact
exists, and if so, their effect, and
Suggest that the client consult with legal counsel about questions of law.
COMPLETION PHASE
5. The auditor should obtain a written representation from the client's
management that
it acknowledges its responsibility for the implementation and operations of
accounting and internal control systems that are designed to prevent and
detect fraud and error
it believes the effects of those uncorrected financial statement misstatements
aggregated by the auditor during the audit are immaterial, both individually
and in the aggregate, to the financial statements taken as a whole. A summary
of such items should be included in or attached to the written representation;
it has disclosed to the auditor all significant facts related to any frauds or
suspected frauds known to management that may have affected the entity;
and
it has disclosed to the auditor the results of its assessment of the risk that the
financial statements may be materially misstated as a result of fraud.
CONSIDER THE EFFECT ON THE AUDITOR'S REPORT
6. When the auditor believes that material error or fraud exists, he should
request the management to revise the financial statements. Otherwise,
the auditor will express a qualified or adverse opinion.

7. If the auditor is unable to evaluate the effect of fraud on the financial

statements because of a limitation on the scope of the auditor's
examination, the auditor should either qualify or disclaim his opinion on
the financial statements.
Because of the inherent limitations of an audit there is an unavoidable risk
that material misstatements in the financial statements resulting from fraud
and error may not be detected. Therefore, the subsequent discovery of
material misstatement in the financial statements resulting from fraud or
error does not, in and of itself, indicate that the auditor has failed to adhere
to the basic principles and essential procedures of an audit.

The risk of not detecting a material misstatement resulting from fraud is

higher than the risk of not detecting misstatements resulting from error. This
is due to the fact that fraud may involve sophisticated and carefully organized
schemes designed to conceal it, such as forgery, deliberate failure to record
transactions, or intentional misrepresentation being made to the auditor.
Hence, audit procedures that are effective for detecting material errors may
be ineffective for detecting material fraud, especially those concealed
through collusion.
Furthermore, the risk of the auditor not detecting a material
misstatement resulting from management fraud is greater than for
employee fraud, because those charged with governance and
management are often in a position that assumes their integrity and
enables them to override the formally established control procedures.
Certain levels of management may be in a position to override control
procedures designed to prevent similar frauds by other employees, for
example, by directing subordinates to record transactions incorrectly or
to conceal them. Given its position of authority within an entity,
management has the ability to either direct employees to do something
or solicit their help to assist management in carrying out a fraud, with or
without the employee's knowledge.
Noncompliance with Laws & Regulations
Noncompliance refers to acts of omission or commission by the
entity being audited, either intentional or unintentional, which are
contrary to the prevailing laws or regulations. Such acts include
transactions entered into by, or in the name of the entity or on its
behalf by its management or employees. Common examples include:
Tax evasion
Violation of environmental protection laws
Inside trading of securities
Management's Responsibility
It is management's responsibility to ensure that the entity's operations are
conducted in accordance with laws and regulations. The responsibility for the
prevention and detection of noncompliance rests with management. (PSA 250)

The following policies and procedures, among others, may assist management in
discharging its responsibilities for the prevention and detection of noncompliance:
Monitoring legal requirements and ensuring that operating procedures are
designed to meet these requirements.
Instituting and operating appropriate systems of internal control.
Developing, publicizing and following a Code of Conduct.
Ensuring employees are properly trained and understand the Code of Conduct.
Monitoring compliance with the Code of Conduct and acting appropriately to
discipline employees who fail to comply with it.
Engaging legal advisors to assist in monitoring legal requirements.
Maintaining a register of significant laws with which the entity has to comply
within its particular industry and a record of complaints.
Auditor's Responsibility
An audit cannot be expected to detect noncompliance with all laws and
regulations. Nevertheless, the auditor should recognize that noncompliance by the
entity with laws and regulations may materially affect the financial statements.

PLANNING PHASE
1.In order to plan the audit, the auditor should obtain a general understanding of
the legal and regulatory framework applicable to the entity and the industry and
how the entity is complying with that framework.

To obtain the general understanding of laws and regulations, the auditor would
ordinarily:
Use the existing knowledge of the entity's industry and business.
Inquiry of management concerning the entity's policies and procedures
regarding compliance with laws and regulations.
 Inquire of management as to the laws or regulations that may be expected to
have a fundamental effect on the operations of the entity.
Discuss with management the policies or procedures adopted for identifying,
evaluating and accounting for litigation claims and assessment.
Discuss the legal and regulatory framework with auditors of subsidiaries in
other countries (for example, if the subsidiary is required to adhere to the
securities regulations of the parent company).

After obtaining the general understanding, the auditor should design procedures
to help identify instances of noncompliance with those laws and regulations
where noncompliance should be considered when preparing financial statements,
such as:
Inquiring of management as to whether the entity is in compliance with such
laws and regulations.
Inspecting correspondence with the relevant licensing or regulatory
authorities.
3. The auditor should design audit procedures to obtain sufficient appropriate audit
evidence about compliance with those laws and regulations generally recognized by
the auditor to have an effect on the determination of material amounts and
disclosures in financial statements.

TESTING PHASE
4. 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. When evaluating the
possible effect on the financial statements, the auditor considers:
The potential financial consequences, such as fines, penalties, damages, threat of
expropriation of assets, enforced discontinuation of operations and litigation.
Whether the potential financial consequences require disclosure.
Whether the potential financial consequences are so serious as to call into
question the fair presentation given by the financial statements.
5. When the auditor believes there may be noncompliance, the auditor should
documents the findings, discuss them with management, and consider the implication
on other aspects of the audit.

COMPLETION PHASE
6. The auditor should obtain written representations that the management has
disclosed to the auditor all known actual or possible noncompliance with laws and
regulations that could materially affect the financial statements.

CONSIDER THE EFFECT ON THE AUDITOR'S REPORT

7. When the auditor believes that there is noncompliance with laws and regulations that
materially affects the financial statements, he should request the management to revise
the financial statements. Otherwise, a qualified or adverse opinion will be issued.

8. If a scope limitation has precluded the auditor from obtaining sufficient appropriate
evidence to evaluate the effect of noncompliance with laws and regulations, the auditor
should express a qualified opinion or a disclaimer of opinion.
An audit is subject to the unavoidable risk that some material misstatements in the
financial statements will not be detected, even though the audit is properly planned
and performed in accordance with PSAs. This risk is higher with regard to material
misstatements resulting from noncompliance with laws and regulations because:
There are many laws and regulations relating principally to the operating aspects
of the entity that typically do not have a material effect on the financial
statements and are not captured by the accounting and internal control systems.
Auditors are primarily concern with the noncompliance that will have a direct and
material effect in the financial statements. Hence, auditors do not normally
design audit procedures to detect noncompliance that will not directly affect the
fair presentation of the financial statements unless the results of other
procedures that were applied cause the auditor to suspect that a material indirect
effect noncompliance may have occurred.
Noncompliance may involve conduct designed to conceal it, such as collusion,
forgery, deliberate failure to record transactions, senior management override of
controls or intentional misrepresentations being made to the auditor.
Questions?