Question 2 - Notes

Risk of Fraud

The auditor's responsibility is to obtain reasonable assurance that financial statements are free from material misstatement, whether due to fraud or error. Fraud differs from errors, as errors are unintentional mistakes, such as mathematical errors or misinterpretations of facts, while fraud involves intentional deception to gain an unjust or illegal advantage, as defined in ISA (NZ) 240.12.

Definition of Fraud (ISA (NZ) 240.12)

Fraud is defined as an intentional act by individuals within management, governance, employees, or third parties, involving deception to obtain an unjust or illegal advantage.

The responsibility for preventing and detecting fraud primarily lies with those charged with governance. ISA (NZ) 240.3 emphasizes that audits should be planned to provide reasonable assurance that material fraud has not occurred or that its effects are appropriately reflected in the financial report.

There are two relevant types of misstatements:

• Misstatements from fraudulent financial reporting: Involves manipulating records, omitting transactions, recording fake transactions, or intentionally misapplying accounting policies.
• Misstatements from misappropriation of assets: Includes stealing assets, using business assets for personal benefit, or paying for goods not received.

The Fraud Triangle

The fraud triangle identifies three core factors leading to fraudulent behavior:

• Perceived Pressure: Motivation to commit fraud.
• Perceived Opportunity: Circumstances that allow the perpetrator to commit fraud.
• Rationalization or Attitude: Justification of the behavior to align with the perpetrator's moral compass.

Key Definitions Related to Fraud

• Risk of Fraud: The risk that material misstatements resulting from fraud will not be detected.
• Fraud: An intentional act involving deception to gain an unjust or illegal advantage.
• Fraudulent Financial Reporting: Manipulation, falsification, alteration of records, suppression/omission of transactions, or intentional misapplication of accounting policies.
• Misappropriation of Assets: Embezzling receipts, stealing assets, causing an entity to pay for goods not received, or using an entity's assets for personal use.
• Errors: Unintentional mistakes or omissions in financial reports, including mathematical errors, misinterpretation of facts, or misapplication of accounting policies.

Audit Planning: Understanding the Entity and its Environment

To plan an audit, auditors must understand the entity, including its internal controls, events, and transactions that could materially impact the financial report, according to ISA (NZ) 315. This understanding helps identify risks and assess their potential impact.

ASA 315.A1 (ISA 315.A1) highlights that knowledge of the entity and its environment helps the auditor to:

• Assess risks and identify problems.
• Determine materiality.
• Consider the appropriateness of accounting policies and disclosures.
• Identify areas requiring special audit consideration.
• Develop expectations for analytical procedures.
• Design audit procedures in response to assessed risks.
• Evaluate audit evidence.

Factors for Auditors to Understand

Auditors need to understand several factors about the entity and its environment:

• Industry, regulatory, and other external factors: Understanding industry and economic conditions, government regulations, technological changes, and competitive conditions.
• Nature of the entity: Understanding the entity’s operational structure, including types of products/services, locations, and methods of production, distribution, and compensation. This can be gathered through manuals, inquiries, observations, reviewing past files and touring facilities.
  The operational structure includes methods of compensation.
• Accounting policies: Understanding the entity’s accounting policies, including reasons for changes, to assess appropriateness and design audit procedures.
• Objectives, strategies, and related business risks: Considering the entity’s objectives, strategies, and any related business risks that may result in material misstatement.
• Measurement and review of financial performance: Examining how management and external stakeholders measure financial performance to gain insight into potential risks. These measurements could motivate misstatements of the financial report or motivate management to improve performance.