ABREMA: glossary: fraud

Fraud

The performance of fraud within an entity is the intentional performance by a person (or persons) — including management, other employee or third party — of an action, other than theft, that derives from the entity a benefit to which the person is not otherwise entitled.

Are auditors responsible for the detection of fraud? The primary objective of the audit of the financial statements of an entity is to form (and communicate to the financial statements users) an opinion on management's assertions inherent in the financial statements. This implies that the audit objective includes the detection of misstatements in management's assertions, irrespective of whether or not the misstatements arise from fraud. Auditors argue, however, that bearing in mind they only examine a selection of transactions, and that perpetrators of fraud often conceal their fraud, it is not possible to offer reasonable assurance that an audit will detect misstatements arising from fraud. This argument is reinforced by the facts that:

fraud often involves the use of sophisticated techniques, such as printing bogus suppliers' invoices and other stationery.
an employee involved in fraud will often make fraudulent representations to the auditor.
the fraud may involve collusion between two or more persons.
the fraud may be perpetrated by a member of management who, unbeknown to the auditor, overrides internal control procedures.

Nevertheless, auditors identify and assess the risks of material misstatement due to fraud when planning an audit and specifically consider the risk of management overriding internal controls and the risk that revenues may be intentionally under or overstated. To assess these risks, auditors obtain a detailed understanding of the nature of the entity's business, the reporting and supervisory responsibilities within the organization, and the types of fraudulent misstatements that are likely to occur. Refer to ISA240 "The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements". See also the Journal of Accountancy article A Primer for Brainstorming Fraud Risks.

Whether or not an auditor is responsible for detecting a specific fraud depends on the circumstances. On the one hand, it depends on the complexity of the fraud (the greater the complexity, the lesser the responsibility) and on the other it depends on the adequacy of the auditor's planning, performance and judgment (the lesser the adequacy, the greater the responsibility). In many jurisdictions, the final decision rests with the judiciary. See The CPA Journal article entitled Anatomy of a Financial Fraud: A Forensic Examination of HealthSouth.

Well known types of fraud include lapping and kiting. Less publicized, but still a common fraud is where a senior executive of an entity, whose remuneration (or even continued employment) may be based on the financial results of the entity, misstates the value of an accounting estimate in order to increase (or sometimes decrease or change the composition of) the net income of the entity. This type of activity is an example of what is sometimes euphemistically referred to as earnings management. ^[fn]. For example, the executive may overstate the value of an asset (e.g. a stockpile of raw materials where the value is based on the estimated volume), or understate the value of a liability, particularly provisions for expenses incurred but not paid. In this instance, if the senior executive responsible for this "earnings management" gains some sort of benefit (bonus, continued employment, etc..) that s/he would not have obtained were it not for her/his action, then the senior executive may well have perpetrated a fraud.

Auditors often find this type of fraud particularly difficult to detect, especially where there is collusion between the executive and another party, including another employee. In such circumstances auditors consider accounting estimates with a degree of professional skepticism: the greater the risk of material misstatement, the greater the degree of professional skepticism. See The CPA Journal article entitled Auditors and Earnings Management.

Note that auditors, if fraud is suspected, are particularly astute when making inquiries of the client's staff ^[fn]. See Journal of Accountancy article Answer Please: Fraud-Based Interviewing.

Various studies have shown that fraud usually involves cash at bank (diverted receipts or fictitious disbursements), inventory (misappropriation or deliberate misstatement, such as that referred to above) and accounts receivable (deliberate misstatement). For more information on fraud detection, prevention and investigation, refer to AICPA's Antifraud and Corporate Responsibility Resource Center.

Activity Based Risk Evaluation Model of Auditing

Fraud