1. Error & Fraud True & Fair Materiality Lecture 2

2. Objectives What is Fraud What is error What is an Illegal Act Reasons and Circumstances of Errors Types of fraud Risk of Fraud and Error in Audit Conditions that Lead to Frauds Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts Define True and Fair Materiality

3. What is Fraud The term fraud means the willful misrepresentation made with an intention of deceiving others. It is a deliberate mistake committed in the accounts with a view to get personal gain. In accounting, fraud means two things. a. Defalcation involving misappropriation of either cash or goods b. Fraudulent manipulation of accounts

4. What is Error Error refers to unintentional mis-statements or mis- descriptions in the records or books of accounts by the book keeper. In other words, they are unintentional mistakes arising on account of negligence or ignorance. Errors may be basically of two types : (a) Principal Errors (b) Clerical Errors

5. What is Error (a) Principal Errors: arise generally when the principals of accountancy are not taken into consideration while recording a transaction. It arises on account of ignorance of accounting principles. (b) Clerical Errors: arise on account of negligence of the accounting staff. This type of error is further divided as errors of omission, errors of Commission, duplicating errors and compensating errors.

6. Illegal Acts Illegal acts are violations of laws or government regulations by the company or its management or employees. – Direct-effect illegal acts produce direct and material effects on the financial statements (e.g., income tax evasion). – Indirect-effect illegal acts are far removed from financial statement (e.g., violations relating to insider securities trading, occupational health and safety, food and drug administration, environmental protection, and equal employment opportunity).

7. Potential Illegal Acts Unauthorized transactions. Government investigations. Regulatory reports of violations. Payments to consultants, affiliates, or employees for unspecified services. Excessive sales commissions and agents’ fees. Unusually large cash payments. Unexplained payments to government officials. Failure to file tax returns or to pay duties and fees.

8. Reasons and Circumstances of Errors 1. Ignorance on the part of employees 2. Carelessness on the part of those doing the accounting work. 3. A desire to conceal information 4. A tendency of the management to permit prejudice or bias to influence the interpretation of transactions or events or their presentation in the financial statements.

9. Reasons and Circumstances of Errors 5. To reduce taxes 6. The intentional effort committed by persons in positions of authority to: I. Overestimate actual performance presented by the financial statements II. Underestimate actual performance presented by the financial statements III. Convert the error to a personal benefit.

10. Types of Frauds Frauds may be of different types: i) Manipulation of accounts, ii) Misappropriation of cash, iii) Misappropriation of Goods.

11. Misappropriation of Cash Misappropriation of cash is also called embezzlement of cash. This is fraudulent appropriation of cash belonging to another person by one who has been entrusted to it.

12. Misappropriation of Goods Misappropriation of goods refers to fraudulent application of goods by those who handle them.

13. Manipulation of Accounts Manipulation of accounts happens when a person makes a false entry in the books of accounts knowing it to be wrong, alters or destroys a true entry in the business records or prevents the making of a true entry in the business records. It is done by people at the top management level. It is done to overstate or understate the profits and the financial conditions of the business so as to serve their purpose. Such fraud is relatively difficult to detect.

14. Risk of Fraud and Error in Audit The following events may increase the risk of fraud or error : 1. Internal Control Faults: Weaknesses in the design of internal control system and non- compliance with control procedures. 2. Doubts about the integrity or competence of the management 3. Unusual pressures within the entity 4. Unusual transactions 5. Problems in obtaining sufficient and appropriate audit evidence

15. 15 Definitions Related to Fraud Fraud consists of knowingly making material misrepresentations of fact, with the intent of inducing someone to believe the falsehood and act upon it and thus suffer a loss or damage. – Employee fraud: The use of fraudulent means to take money or other property from an employer. It usually involves falsifications of some kind. Three phases of employee fraud: – fraudulent act – conversion of the money or property – cover -up

16. 16 Definitions Related to Fraud – Embezzlement: A form of fraud involving employees’ wrongfully taking money or property entrusted to their care, custody, and control, often accompanied by false accounting entries and other forms of lying and cover-up. – Defalcation: The term used when someone in charge of safekeeping the assets is doing the stealing. – Management fraud: A deliberate fraud committed by management that injures investors and creditors through materially misleading financial statements.

17. 17 Conditions that Lead to Frauds. Motive A motive is some kind of pressure experienced by a person and believed un-shareable with others (Psychotic, Egocentric, Ideological, Economic)

18. 18 Conditions that Lead to Frauds. Opportunity An opportunity is an open door for solving the unshareable problem in secret by violating a trust. – The violation may be the circumvention of internal control policies and procedures. – Everyone has some degree of trust conferred by a job. The higher the position in the organization, the higher the trust.

19. 19 Conditions that Lead to Frauds. Lack of Integrity Unimpeachable integrity is the ability to act in accordance with the highest moral and ethical values all the time. – Lapses in integrity may occur and be rationalized: I need it more than the other person. I’m borrowing the money and will pay it back. Nobody will get hurt. The company is big enough to afford it. A successful image is the name of the game. Everybody is doing it.

20. Auditor Responsibility for Detecting Errors, Frauds, and Illegal Acts Responsible for Detection?Must Communicate Findings? Material Immaterial Material Immaterial Errors Yes No Yes (Audit Committee) No Fraud Yes No Yes (Audit Committee) Yes (One level above) Illegal Acts Yes (Direct Effect) No Yes (Audit Committee) Yes (One level above)

21. True and Fair An audit of accounts by an independent expert assures the outside user that the accounts are proper and reliable. The outsiders can rely on the accounts if the auditor reports that the accounts are true and fair.

22. True and Fair The accounts are considered true and fair: When the profit and loss shown in the profit and loss account is true and fair. When the value of assets and liabilities shown in the balance sheet is true and fair. True and fair is not defined by any law. However, there are general guidelines set in connection with true and fair.

23. True and Fair The accounting books must conform to accounting principles. No window dressing or secret reserves: the accounts must show the financial position and the profit or loss as they are. The accounting books must disclose all material information regarding assets, liabilities, revenues and expenses. Material means important and essential. All legal requirements must be met by the company.

24. 2-24 Materiality A misstatement or the aggregate of all misstatements in financial statements is considered to be material if, in light of surrounding circumstances, it is probable that the decision of a person who is relying on the financial statements, and who has a reasonable knowledge of business and economic activities ( the user), would be changed or influenced by such misstatement or the aggregate of all misstatements.

25. Judgments about materiality are made in light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both. Judgments about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of users as a group. The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered. Materiality

26. ‘ Misstatements or omissions are material if they could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements’ Materiality is influenced by size, nature, and circumstances

27. Materiality Size, Nature, Circumstances Size of the Item. The most common application of materiality has to do with the size of the item considered. Nature of the Item. The nature of an item is a qualitative characteristic. Circumstances The materiality of an error depends upon the circumstances of its occurrence.

28. Materiality Steps in Applying Materiality

29. Step 1 in Applying Materiality Set preliminary judgment about materiality The preliminary judgment about materiality is the maximum amount the auditor believes the statements could be misstated and still not affect the decisions of reasonable users.

30. Step 2 in Applying Materiality An allocation is necessary because evidence is accumulated by segments rather than the financial statements taken as a whole. The allocation to account balances is known as the tolerable misstatement.

31. Step 3 in Applying Materiality Estimate total misstatement in the segment The auditor projects the sample results to the population. An allowance for sampling risk is also calculated. This step is performed after the tests for each account are complete.

32. Step 4 in Applying Materiality Estimate the combined misstatement. The projected errors for each account are added, along with total sampling error, to calculate the combined misstatement. This is performed after all tests have been completed.

33. Step 5 in Applying Materiality Compare combined estimated misstatement with preliminary or revised judgment about materiality. If the combined estimated misstatement is less than or equal to the judgment about materiality, than the auditor concludes that the financial statements are fairly presented. This is performed after all tests have been completed in the final review stage of the audit.

34. 3-34 Materiality Communication About Material Misstatement Communications with Management Communications with the Audit Committee of the Board of Directors

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