ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY

CPA Review Batch 45  May 2023 CPA Licensure Examination

AT-14
AUDITING (Auditing Theory) J. IRENEO  E. ARAÑAS  F. TUGAS  C. ALLAUIGAN

FRAUD, ERROR & NON-COMPLIANCE

REQUIRED READINGS
• PSA 240 (Redrafted) The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements
• PSA 250 (Revised) Consideration of Laws and Regulations in an Audit of FS

Characteristics of Fraud
• Misstatements in the financial statements can arise from either fraud or error.
• The distinguishing factor is that fraud is intentional and error is unintentional.
• The auditor is concerned with fraud that causes a material misstatement in the financial
statements.
• Two types of intentional misstatements are relevant to the auditor – A.) misstatements
resulting from fraudulent financial reporting and B.) misstatements resulting from
misappropriation of assets.
• The auditor may suspect or, in rare cases, identify the occurrence of fraud, the auditor does
not make legal determinations of whether fraud has actually occurred.

Responsibility for the Prevention and Detection of Fraud

• Primary responsibility of both management and those charged with governance (TCWG).
• Management must place a strong emphasis on fraud prevention and fraud deterrence with the
oversight with TCWG.
• In exercising oversight responsibility TCWG consider the potential for override of controls or
other inappropriate influence over the financial reporting process.

Responsibilities of Auditors
• Auditors are responsible for obtaining reasonable assurance that the financial statements taken
as a whole are free from material misstatement, whether caused by fraud or error.
• The risk of not detecting a material misstatement resulting from fraud is higher than the risk
of not detecting one resulting from error. (example: forgery, deliberate failure to record
transactions, intentional misrepresentation and collusions)
• The risk of the auditor not detecting a material misstatement resulting from management fraud
is greater than for employee fraud.
• The auditor is responsible for maintaining an attitude of professional skepticism throughout the
audit. (procedures that are effective in detecting error might not be effective in detecting
fraud).

Audit Objective
• To identify and assess the risks of material misstatement of the financial statements due to
fraud.
• To obtain sufficient appropriate audit evidence about the assessed risks of material
misstatement due to fraud, through designing and implementing appropriate responses
• To respond appropriately to identified or suspected fraud.

Fraud – An 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.

Fraud risk factors – Events or conditions that indicate an incentive or pressure to commit fraud or
provide an opportunity to commit fraud.

Audit Requirements
• Attitude of professional skepticism
• Discussion among the engagement team
• Inquiries with management regarding
o Process for identifying and responding to risk of fraud
o Communication with TCWG regarding the process of identifying and responding to risk
of fraud
o Management's communication, if any, to employees regarding its views on business
practices and ethical behavior
o Knowledge of any actual, suspected or alleged fraud affecting the entity (including
internal audit function and TCWG).

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• Inquiries with TCWG in how it exercises its oversight function for identifying and responding to
the risks of fraud in the entity and the internal control that management has established to
mitigate these risks.
• Evaluate whether unusual or unexpected relationships that have been identified in performing
analytical procedures, including those related to revenue accounts, may indicate risks of
material misstatement due to fraud.

Responses to the Assessed Risks of Material Misstatement Due to Fraud

• Assign and supervise personnel taking account of the knowledge, skill and ability of the
individuals to be given significant engagement responsibilities and the auditor's assessment of
the risks of material misstatement due to fraud for the engagement.

• Evaluate whether the selection and application of accounting policies by the entity, particularly
those related to subjective measurements and complex transactions, may be indicative of
fraudulent financial reporting resulting from management's effort to manage earnings.

• Incorporate an element of unpredictability in the selection of the nature, timing and extent of
audit procedures.

• Test the appropriateness of journal entries recorded in the general ledger and other
adjustments made in the preparation of the financial statements. In designing and performing
audit procedures for such tests, the auditor shall:
✓ Make inquiries of individuals involved in the financial reporting process about inappropriate
or unusual activity relating to the processing of journal entries and other adjustments.
✓ Select journal entries and other adjustments made at the end of a reporting period; and
✓ Consider the need to test journal entries and other adjustments throughout the period.

• For significant transactions that are outside the normal course of business the auditor shall
evaluate whether the business rationale (or the lack thereof) of the transactions suggests that
they may have been entered into to engage in fraudulent financial reporting or to conceal
misappropriation of assets.

Effect of Laws and Regulations

• Laws and regulations to which an entity is subject constitute the legal and regulatory
framework.
• Non-compliance with laws and regulations may result in fines, litigation or other consequences
for the entity that may have a material effect on the financial statements.

It is the responsibility of management, with the oversight of TCWG to ensure that the entity's
operations are conducted in accordance with the provisions of laws and regulations, including
compliance with the provisions of laws and regulations that determine the reported amounts and
disclosures in an entity's financial statements.

Auditor’s responsibilities
• The auditor is responsible for obtaining reasonable assurance that the financial statements,
taken as a whole, are free from material misstatement, whether caused by fraud or error.
• Provisions of laws and regulations generally recognized to have a direct effect on the
determination of material amounts and disclosures in the financial statements such as tax and
pension laws and regulations: (The auditor obtain sufficient appropriate audit evidence
regarding compliance with the provisions of those laws and regulations).
• Other laws and regulations that do not have a direct effect on the determination of the amounts
and disclosures in the financial statements: (limited to undertaking specified audit procedures
to help identify non-compliance with those laws and regulations that may have a material effect
on the financial statements).

Non-compliance – Acts of omission or commission by the entity, 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 those charged with governance,
management or employees. Non-compliance does not include personal misconduct (unrelated to
the business activities of the entity) by those charged with governance, management or employees
of the entity.

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Reporting Non-Compliance in the Auditor's Report on the Financial Statements
• If the auditor concludes that the non-compliance has a material effect on the financial
statements, and has not been adequately reflected in the financial statements, the auditor
shall express a qualified opinion or an adverse opinion on the financial statements.
• If the auditor is precluded by management or those charged with governance from obtaining
sufficient appropriate audit evidence to evaluate whether non-compliance that may be
material to the financial statements has, or is likely to have, occurred, the auditor shall
express a qualified opinion or disclaim an opinion on the financial statements on the basis of
a limitation on the scope.

If the auditor has identified or suspects non-compliance with laws and regulations, the auditor shall
determine whether the auditor has a responsibility to report the identified or suspected non-
compliance to parties outside the entity.

PSA 240 (Redrafted) The Auditor's Responsibilities Relating to Fraud in an Audit of Financial
Statements

1. Which of the following most accurately summarizes what is meant by the term “material
misstatement”?
A. Fraud and direct-effect NOCLAR
B. Fraud involving senior management and material fraud
C. Material error, material fraud and certain NOCLAR
D. Material error and material NOCLAR

2. Fraud includes all of the following, except:

A. Recording of transactions without substance
B. Suppression or omission of the effects of transactions from records or documents
C. Mathematical or clerical mistakes in the underlying records and accounting data
D. Misappropriation of assets

3. The Taal Company has two bank accounts. A check for ₱20,000 is drawn on bank one late on
December 31 and deposited into bank two on the same day. In preparing a year-end bank
reconciliation for bank two, the check is listed as a deposit in transit. In preparing a year-end bank
reconciliation for bank one, the check is not listed as outstanding. What is the client most likely
doing here?
A. A wash transfer
B. Kiting
C. A reciprocal transaction
D. Realignment posting

4. Which of the following statements concerning fraud is incorrect?

A. Fraud generally involves incentive or pressure to commit fraud, a perceived opportunity to do
so, and some rationalization of the act.
B. Two types of misstatements relevant to the auditor include material misstatements arising from
fraudulent financial reporting and material misstatements arising from misappropriation of
assets.
C. Fraud involves actions of management but excludes the actions of employees or third parties.
D. An audit rarely involves the authentication of documentation; thus, fraud may go undetected
by the auditor.

5. Which of the following statements is/are correct?

S1: The responsibility for the prevention and detection of fraud and error rests with the auditor
through implementation of accounting and internal control systems.
S2: The accounting and internal control systems eliminate the possibility of fraud and error.

A. Only statement 1 is correct

B. Both statements are correct
C. Only statement 2 is correct
D. Both statements are incorrect

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6. Audits of financial statements are designed to obtain reasonable assurance of detecting
misstatement due to
Errors Fraudulent financial reporting Misappropriation of assets
A. Yes Yes Yes
B. Yes Yes No
C. Yes No Yes
D. No Yes No

7. Which of the following is least likely to be included in an auditor’s inquiry of management while
obtaining information to identify the risks of material misstatement due to fraud?
A. Does it have knowledge of fraud or suspect fraud?
B. Does it have programs to mitigate fraud risks?
C. Are financial reporting operations controlled by and limited to one location?
D. Has it reported to the audit committee the nature of the company’s internal control?

8. misstatement due to fraud for the existence of inventory is high?

A. Observe test counts of inventory at certain locations on an unannounced basis.
B. Perform analytical procedures rather than taking test counts.
C. Request that inventories be counted prior to year-end.
D. Request that inventory counts at the various locations be counted on different dates so as to
allow the same auditor to be present at every count.

9. If the auditor has determined that there may be fraud that may have material effect on the financial
statements, all of the following should be done, except
A. Consider the implications for other aspects of the audit.
B. Discuss the matter with a level of management where fraud might have occurred.
C. Try to obtain evidence to determine whether the fraud is material and what its effect will be
on the financial statements.
D. If appropriate, suggest that the client consult with legal counsel on matters of law.

10. The regular examination of financial statements is not primarily designed to disclose fraud and
other irregularities although their discovery may result. Normal audit procedures are more likely
to detect a fraud arising from:
A. Forgeries on company checks
B. Collusion on the part of several employees
C. Theft of inventories
D. Failure to record cash receipts for services rendered

11. In general, material fraud perpetrated by which of the following are most difficult to detect?
A. Cashier situated at the 5th floor.
B. Keypunch operator situated at the 10th floor.
C. Controller situated at the 2nd floor.
D. Internal auditor situated at the 3rd floor.

12. Which of the following statements describes why a properly designed and executed audit may not
detect a material fraud?
A. Audit procedures that are effective for detecting unintentional misstatements may be
ineffective for an intentional misstatement that is concealed through collusion.
B. An audit is designed to provide reasonable assurance of detecting material errors, but there is
no similar responsibility concerning material fraud.
C. The factors considered in assessing control risk indicated an increased risk of intentional
misstatements, but only a low risk of unintentional errors in the financial statements.
D. The auditor did not consider factors influencing audit risk for account balances that have
pervasive effects on the financial statements taken as a whole.
13. According to PSA 240 Redrafted, the auditor may consider withdrawing from the engagement
A. If the fraud is perpetrated through the connivance of some employees
B. When the fraudulent act affects the financial statements, even if such effect is reflected in the
financial statements
C. When the entity does not take the remedial action regarding fraud, even if it is not material to
the financial statements.
D. When the auditor is unable to gather evidence that will corroborate his suspicion that possible
occurrence of fraud may have materially affected the financial statements

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Fraud Risk Factors
14. Which of the following best describes what is meant by the term “fraud risk factor?'
A. Factors whose presence indicates that the risk of fraud is high.
B. Factors whose presence often have been observed in circumstances where frauds have
occurred.
C. Factors whose presence requires modification of planned audit procedures.
D. Material weaknesses identified during an audit.

15. At which stage(s) of the audit may fraud risk factors be identified?
Obtaining Conducting
Planning understanding fieldwork
A. Yes Yes Yes
B. Yes Yes No
C. Yes No No
D. No Yes Yes

16. Which of the following characteristics most likely would heighten an auditor’s concern about risk
of intentional manipulation of financial statements?
A. Turnover of senior accounting personnel is low.
B. Insiders recently purchased additional shares of the entity’s stock.
C. Management places substantial emphasis on meeting earnings projections.
D. The rate of change in the entity’s industry is slow.

17. Which of the following conditions or events may create incentive/pressures to commit fraud?
A. Inadequate accounting system of authorization and approval of transactions.
B. Lack of mandatory vacations for employees performing key control functions.
C. Excessive pressure on management or operating personnel to meet financial targets
established by those charged with governance, including sales or profitability incentive goals.
D. Inadequate access controls over automated records.

18. Opportunities to misappropriate assets increase when there are (select the exception)
A. Large amounts of cash on hand or processed
B. Inventory items that are small in size, of high value, or in high demand
C. Known or anticipated future employee layoffs
D. Easily convertible assets, such as bearer bonds, computer chips or diamonds

19. Which of the following statements is correct?

A. It is usually easier for the auditor to uncover irregularities than errors.
B. It is usually easier for the auditor to uncover errors than irregularities.
C. It is usually equally difficult for the auditor to uncover errors or irregularities.
D. None of the given statements is correct.

PSA 250 (Redrafted): Consideration of Laws and Regulations in an Audit of Financial

Statements
20. According to PSA 250 Redrafted, the term NOCLAR as used in the standards 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 do not include
A. Transactions entered into by the entity.
B. Transaction entered into in the name of the entity.
C. Transaction entered into on the entity’s behalf by its management or employees.
D. Personal misconduct (unrelated to the entity’s business activities) by the entity’s management
or employees.

21. What should the auditor do first when in an audit of a client entity, an illegal act has been identified?
A. Consider the effects of the illegal act on the financial statements
B. Communicate the matter with the audit committee of the board of directors
C. Submit a confidential report to the SEC
D. Consult the client’s legal counsel about the matter

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22. The following are examples of the type of information that may come to the auditor’s attention
which might indicate that noncompliance with laws or regulations have occurred. One of them is
not. Identify the exception:
A. Media comment
B. Industry is regulated by various government agencies
C. Unusual payments in cash, purchases in the form of cashier’s checks payable to bearer or
transfers to numbered bank accounts
D. Payments without proper exchange control documentation

23. An auditor who finds that the client has committed a noncompliance with laws and regulations
would be most likely to withdraw from the engagement when the
A. Noncompliance with laws and regulations has received widespread publicity
B. Noncompliance with laws and regulations has material financial statements implications
C. Noncompliance with laws and regulations affects the auditor’s ability to rely on management
representations
D. Auditor cannot reasonably estimate the effect of the noncompliance with laws and regulations
on the financial statements.

24. Which of the following information discovered during an audit most likely would raise a question
concerning possible noncompliance with laws and regulations?
A. A piece of obsolete office equipment was not retired
B. Material internal control weakness previously reported to management were not corrected
C. The client receives financial assistance from a national government agency
D. There was an illegal payment to a government official

25. The auditor’s responsibility regarding material misstatements caused by fraud is:
A. Less than the auditor’s responsibility regarding material misstatements caused by error
B. Greater than the auditor’s responsibility regarding material misstatements caused by error
C. The same as the auditor’s responsibility regarding material misstatements caused by error
D. Either less than or greater than the auditor’s responsibility regarding material misstatement
caused by error, depending on the specific circumstances

Success is the maximum utilization of the ability that you have. - Zig Ziglar
The way to succeed is to double your error rate. - Thomas Watson,
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