Frauds & Errors Auditors Encounter

Frauds and errors result in misstatements in financial statement. Frauds result in a loss to the entity and an error vitiates the true and fair view. In either case, the financial statements cannot be said to be showing a true and fair view unless the situation is set right.

What is fraud?

A fraud is a wilful act of dishonesty perpetuated with an intent to defraud the employer for a personal gain.

The features of a fraud are:

Wilful act

Act of dishonesty

Intention to defraud the employer

 Personal gain.

Frauds can be committed by misuse or abuse of power, by misuse or misappropriation of assets belonging to the employer, and falsification of records.

Misuse of power

If a purchase officer releases a purchase order on a particular supplier who should not have been considered, against a kickback it is a clear case of a fraud as it satisfies all the conditions of a fraud. If sub-standard goods supplied are cleared by the quality assurance department, it amounts to a fraud since it is a wilful act of dishonesty to defraud the employer for a personal gain.

But if the finance department releases the cheque against such purchase, it cannot be termed as a fraud as there is no act of dishonesty on the part of the finance department and there is no intention to defraud the employer. Even if the finance officer receives a gratification it cannot be termed a fraud. He has demanded gratification to do a thing that he is supposed to do. It is a case of bribe and cannot be a fraud.

Misuse/misappropriation

If the employee is provided with a car for office use and if he uses it for personal use such as dropping children at school, etc., it is a case of misuse of the assets belonging to the employer.

If an employee carries stationery of the employer to his residence and his children use it, it is misappropriation of the assets of the employer.

The difference between misuse and misappropriation is that the asset remains after misuse but it does not remain after misappropriation.

If an employee is given some New Year gifts and a list of the persons to whom they are to be distributed, it would be misappropriation of assets belonging to the employer if they are distributed by the employee to his friends, cousins, so on instead of the persons to whom they are intended.

Normally, such frauds are resorted to by the top management.

It could be by way of deliberately treating an item as capital instead of revenue so that it does not appear in the Profit and Loss Account. Over- or under-valuation of stocks is also a case of falsification of records.

Classification of frauds

Frauds can be classified as management and line frauds. Falsification of records is resorted at the end of the year, to which the management could be a party. It is a management fraud. Abuse of power, misuse of assets can be done either by the management or by the people down the line.

Errors

Contrary to frauds, errors are unintentional and the result of ignorance. Errors are committed by employees placed low in the hierarchy. There is always the possibility of the seniors and bosses unearthing such errors.

An accounts clerk might pass an entry debiting cash with expenditure.

This is obviously wrong but it is a genuine mistake. No doubt there is wrong accounting but it does not result in any loss to the management.

The situation can be rectified at a later date.

There is always the accounts officer to rectify the mistake.

Frauds vs errors

Intent: Frauds are intentional while errors are not

Loss: Frauds result in a loss whereas an error may or may not.

Errors are isolated and hold a characteristic. A person commits errors in only one sphere. Frauds can occur in any form, any place and at any time

Errors are committed by a single person while it needs two or more persons to perpetuate a fraud because of the internal control systems.

Errors are committed only at lower levels of hierarchy while frauds can be committed at any level or at multiple levels.

Causes of frauds

Frauds can be attributed to several causes

Greed: The employee may be greedy to earn that extra rupee

Lack of internal control systems: Absence of Internal control systems or their failure provides an opportunity to commit a fraud

Compulsions: Management frauds are more out of compulsions, which may be pressure to project a better picture, earn a higher commission (again greed), satisfy bankers, and so on

Legal implications such as to suppress the turnover to escape central excise, tax audits, so on

Auditor's responsibility

AAS 2 clearly takes locating or unearthing of frauds out of the scope of audit. An auditor draws up his programme to form and express his opinion upon the financial statements. The audit programme is not aimed at unearthing of frauds and errors. An audit is not an insurance against frauds and errors. An audited balance-sheet cannot be taken to be free of all frauds and errors. There may still be some frauds in the financial statements even after the audit is completed.

An auditor should be sceptical while carrying out his audit. This scepticism helps the auditor to be on guard in the matter of frauds and errors. Frauds can be buried deep in the records and the auditor may not possess the technical knowledge to unearth them. Scepticism, diligence, alertness, intelligence, integrity — all these are needed for an auditor to arm himself in such situations.

When the auditor comes across a situation to arouse his suspicion about the existence of a fraud, he should probe the matter further (AAS 2), which is carried out by lowering the materiality levels, enlarging the sample size, subjecting larger number of transactions to examination in depth, taking a second look at the internal control systems, so on.

At the planning stage, the auditor should be on the look out for the areas where frauds can be perpetuated. There should be an in-built mechanism in the audit programme to provide for such an exercise. The auditor should carefully evaluate the internal control systems and decide the quantum of risk he is willing to take. He should document any weakness in the internal control system.

During the course of audit, he should exercise utmost caution and diligence before placing reliance on any person, including his own staff. He should check the vulnerable areas of work. He may have to refer the matter to an expert. Caution should be exercised during the selection of the expert, drafting the terms of reference, evaluating the work of the expert etc.

At the end of the audit, he should methodically review the entire exercise to see that there are no loose ends. AAS 17 suggests that the auditor should require a partner or other person in his organisation to vet the audit file before reporting to bring out any lapses or shortcomings on the audit work.

The auditor should not hesitate to offer a comment or observation in the audit report if the situation so warrants. He should exercise his diligence and independence to offer the comments.

What if he identifies a fraud?

Though it is not his job, the auditor may smell a fraud and probe the matter, which may turn out to be true. Once he identifies a fraud, the auditor should communicate the matter to a level higher at it was committed. This is one area the audit communications (AAS 27) should be properly targeted. "Those charged with governance" bear the brunt under these circumstances. The auditor should document (AAS 3) these communications and the follow-up action taken by the management. The cause of fraud, which may be a weakness in the internal control system, should also be probed. The auditor would do well to issue a letter of weakness under these circumstances (AAS 6).

The middle management might grapple with the situation and pin the responsibility. The auditor should monitor the actions. Internal controls may be spruced up and remedial actions initiated. These should be documented by the auditor and he should consider if any additional, amended, altered or extended audit procedures would be necessary.

If the loss is recovered by the management from the person(s) committing the fraud, the auditor may document the same and release an unqualified report. If the loss is not recoverable, appropriate accounting treatment and disclosures would be essential.

Going by the norm, the auditor should communicate with the management at a level higher than the level at which the fraud is committed. Thus, if those charged with governance (management frauds) are involved in a fraud, the matter should be brought to the notice of the whole-time director or CEO of the company. If the CEO commits a fraud, the board of directors should be informed of it.

If a director commits a fraud, the position becomes precarious. The matter should be brought to the notice of the shareholders, being the highest authority of the company. Even if the management makes good the loss, the auditor is obliged to inform the same to the shareholders.

The method to be adopted for such a communication is important. The auditor is governed by confidentiality (AAS 1 and code of conduct). Without getting stumped by confidentiality, if the auditor has to discharge such a crucial responsibility, he should use his diligence, care, and caution.

This issue cannot become a matter to be mentioned in the audit report since it is a public document. The auditor should consider other alternatives such as speaking at an EGM, a separate communication to the shareholders of the company or other modes as he deems fit. He might also seek professional help from legal experts (AAS9).

Courtesy : Mr. M. V. Kali Prasad , Source : The Hindu Business line