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FRAUDS AND ERRORS AND LEGAL REQUIREMENT OF AN AUDIT

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FINANCIAL ACCOUNTING AND AUDITING

Financial accounting entails provision of information about a business or company in form of financial statements
which are then made public. These statements are generally prepared on an annual basis and used by
management and other interested parties to make decisions. The information contained in these financial
statements must give a true and fair view of the state of affairs in the organization.
Auditing is a check carried out by an independent auditor to make sure that what a company is saying about its
financial statement is true. Auditing therefore adds credibility to the financial statements by ensuring the
availability of accurate and reliable financial information.

Differences between auditing and Financial Accounting


• Auditing is an independent examination of company accounts and expression of an opinion whether they
contain a true and fair view of company’s state of affairs. Financial accounting is the recording, classifying and
summarizing events of an economic entity in order to assist management in decision making.
• While auditing is conducted once in a financial period and usually at the end, financial accounting is a
continuous process throughout the financial period of a company.
• Auditing is governed by ISA (International Standards on Auditing) while Financial accounting is guided by GAAP
(Generally Accepted Accounting Principles).

Similarities between Auditing and Financial Accounting


• Both auditing and accounting are statutory requirements i.e. that companies must maintain proper books of
accounts at that their financial statement must be audited.

DETECTION OF FRAUD & ERRORS


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.

According to the standard Auditing practices the term fraud refers to intentional misrepresentation of finance
information by one or more individuals among management or third parties. In other words, it is intentional or
willful misrepresentation or deliberate concealed of a material fact with a view to deceive, cheat or mislead
another person.

Fraud Covers the Following

Fraud Through Defalcation.


Following are the methods of defalcation involving misappropriation of cash or goods

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• By misappropriating the receipt by not recording the same in the cashbook
• By destroying the carbon copy or counter foil of the receipt and misappropriating the cash received
• By entering lesser amount on the counterfoil and misappropriating the difference between money
actually-received and the amount entered on the counterfoil of the receipt book
• By not recording the receipt of sale of a casual nature for example sale of scrap, sale of old
newspapers etc.
• By omitting to record cash donations received by non-profit making charitable institutions
• By misappropriating cash received from debtors and concealing the same by giving artificial credit to
the debtors in the form of bad debts, discount or sales return etc.
• By adopting the method of "teeming and lading" or "lapping process". Under this method cash
received from one debtor is misappropriated and deficiency in that debtors account is made good
when another payment is received from second debtor by crediting the second debtors account less
by that amount. This process is carried out round the year.
• By under casting receipt side total of the cashbook
• By recording fictitious or bogus payments
• By recording more payments than actual amounts paid by altering the figures on the vouchers.
• By showing the same payment twice.
• By showing credit purchases as cash purchases and misappropriating the amount
• Recording personal expenses as business expenses
• By not recording discounts and allowances given by the creditors and misappropriating the amounts
• By overcasting the payment side total of the cashbook
• Recording fictitious and inflated purchases and misappropriating that amount
• Recording fictitious and inflated purchases and misappropriating that amount.
• By suppressing the credit notes for returns and showing the full payment to creditors.

Fraud Through Manipulation Of Accounts


It implies presentation of accounts more favorably than what they actually are. Window dressing means showing
a wrong picture. The fraud through manipulation of accounts is also known as window dressing because
accounts are manipulated to show a wrong picture of the profit or loss of the business and its financial state of
affairs. Generally, this type of fraud is committed by the people at the top management level. This does not
involve any misappropriation of cash or goods but it is either over statement of profit or understatement of the
same. Such fraud is committed with certain objective and is relatively difficult to detect.
The Auditor Can Suspect Fraud Under The Following Circumstances.
1. When vouchers, invoices, cheques, contracts are missing etc.
2. When control account does not agree with subsidiary books.
3. When the difference in trial balance is difficult to locate.
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4. When there is greater fluctuation in Gross Profit. and Net Profit ratios.
5. When there is difference between the balance and the confirmation of the balance by the parties.
6. When there is difference between the stock as per records and the stock physically counted.
7. When the explanation given by the client is not satisfactory.
8. When there is an overwriting of some figures.
9. When there is a contradiction in the explanation given by different parties.

Procedure to be followed to detect errors.


Following procedures may be adopted by the auditor to detect the errors.
1. Check the opening balances from the balance sheet of the last year.
2. Check the posting into respective ledger accounts
3. Check the total of the subsidiary books.
4. Verify all the castings and the carry forwards.
5. Ensure that the list of debtors and creditors tally with the ledger accounts.
6. Make sure that all accounts from the ledger are taken into accounts.
7. Verify the total of the trial balance.
8. Compare the various items from the trial balance with that of the previous year.
9. Find out the amount of difference and see whether an item of half or such amount is entered wrongly.
10. Check differences involving round figures.
11. See where there is misplacement or transposition of figures that is 45 for 54; or 81 for 18 etc.
12. Ultimately careful scrutiny is the only remedy for detection of errors.
13. See that no entry of the original book has remained unposted.

The Auditor Should Perform The Following Duties In Respect Of Fraud.


1. Examine all aspects of the finance.
2. Vouch all the receipts from the counterfoils or carbon copies or cash memos, sales mart reports etc.
3. Check thoroughly the salary and wages register.
4. Verify the methods of valuation of stocks.
5. Checkup stock register, goods inwards notes, goods out wards books and delivery books etc
6. Calculate various ratios in order to detect fraudulent manipulation of accounts
7. Go through the details of unusual items.
8. Probe into the details of the problems when there is a suspicion.
9. Exercise reasonable skill and care while performing the duty.
10. Make surprise visit to check the accounts.

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Types Of Errors

Commission
It includes posting errors, casting errors and totaling errors. For example, ale to A has been recorded in B’s A/c,
it is a posting error or it is recorded in A’s A/c but the amount is wrongly recorded. Similarly, the balance of Kshs
510 is carried forward as Kshs.501, and then it is a casting error. Certain errors will not affect the trial balance
for example posting in a wrong account will not affect the trial balance but if there is a totaling error or a casting
error then the trial balance does not agree.

Omission
In the process of recording the accounting clerk may omit a transaction from recording either fully or partially. If
a transaction is fully omitted, then it will be difficult to trace out, as both the debit and the credit are missing and
the trial balance will tally inspite of these errors. However, if a transaction is partly omitted, then only one aspect
of the transaction is recorded. In this case it is easier to locate such an error.

Principle and compensating


A Transaction Is Basically Recorded In The Books In An Incorrect Manner. An error which is counter balanced
by another error, so that it is not disclosed by the trial balance. Types.
(a) Errors which do not affect profit: e.g. manufacturing wages posted to trade expenses A/C or wrong
classification of assets or Liabilities.
(b) Error which affect profit: e.g. treating rent paid as a debtor instead of as expenses, when capital expenditure
is treated as revenue and debited to P&L account. It may or may not affect profit. If both original and
compensating errors arise in revenue accounts, profit will not be affected, but if one arises in a revenue account
and other in an asset or liability account, trial balance will agree, but profit will be incorrectly stated.

Auditor’s Duties And Responsibilities In Respect Of Fraud


The primary objective of an auditor is to express an opinion on the financial statements. However, the auditor
while conducting the audit is required to consider the risk of material misstatements in the financial statements
resulting from fraud or error. The fact that an audit is carried out may act as a deterrent, but the auditor is not
and cannot be held responsible for the prevention of fraud and error.

The auditor’s opinion on the financial statements is based on the concept of obtaining reasonable assurance;
hence, in an audit, the auditor does not guarantee that material misstatements, whether from fraud or error, will
be detected. Therefore, the subsequent discovery of a material misstatement of the financial statement resulting
from fraud or error does not, in and of itself, indicates:
a) Failure to obtain reasonable assurance,

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b) Inadequate planning, performance or judgment,
c) Absence of professional competence and due care,
d) Failure to comply with generally accepted auditing standards

This is particularly the case for certain kinds of intentional misstatements, since auditing procedures may be
ineffective for detecting an intentional misstatement that is concealed through collusion between or among one
or more individuals among management. Those charged with governance, employees, or third parties, or
involves falsified documentation. Whether the auditor has performed an audit in accordance with auditing
standards generally accepted in India is determined by the adequacy of the audit procedures performed in the
circumstances and the suitability of the auditor’s reports based on the result of these procedures.

The auditor also has the responsibility to communicate the misstatement to the appropriate level of management
on a timely basis and consider the need to report to it then changed with governance. He may also obtain legal
advice before reporting on the financial information or before withdrawing from the engagement. The auditor
should satisfy himself that the effect of fraud is properly reflected in the financial information or the error is
corrected in case the modified procedures performed by the auditor confirm the existence of the fraud.

The auditor should also consider the implications of the frauds and errors, and frame his report appropriately. In
case of a significant fraud, the same should be disclosed in the financial statement. If adequate is not made,
there should be a suitable disclosure in his audit report.

LEGAL REQUIREMENT OF AN AUDIT


1. Integrity, objectivity and independence: The auditor should be straightforward, honest and sincere in his
approach to his professional work. He must be fair and must not allow prejudice or bias to override his objectivity.
He should maintain an impartial attitude and appear to be free of any interest which might be regarded. Whatever
its actual effect, as being incompatible with integrity and objectivity.

2. Confidentiality: The auditor should respect the confidentiality of information acquired in the course of his
work and should not disclose any such information to a third party without specific authority or unless there is
legal or professional duty to disclose. It is remarked that an auditor should keep his ears and eyes open but his
mouth shut.

3. Skill and competence: The audit should be performed and the report prepared with due professional care
by persons who have adequate training, experience and competence. This can be acquired through a
combination of general education, technical knowledge obtained through study and formal courses concluded
by a qualifying examination recognized for this purpose and practical experience under proper supervision.

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4. Work performed by others: When the auditor delegates work to assistant* or uses work performed by
other auditors or experts, he will continue to be responsible for forming and expressing his opinion on the financial
information. At the same time he is entitled to rely on work performed by others provided he exercises adequate
skills and care and is not aware of any reason to believe that he should not have relied. The auditor should
carefully direct, supervise & review work delegated by assistants. He should obtain reasonable assurance that
work performed by other auditors or experts is adequate for this purpose.

5. Documentation: The auditor should document matters, which are important in providing evidence that the
audit was carried out in accordance with the basic principles.

6. Planning: The auditor should plan his work to enable him to conduct an effective audit in an efficient and
timely manner. Plans should be based on knowledge of client's business. They should be further developed and
revised, if required, during the course of audit.

7. Audit evidence: The auditor should obtain sufficient appropriate audit evidence through the performance of
compliance and substantive test procedure. It will enable him to draw reasonable conclusions there from on
which he has to base his opinion on the financial information.

8. Accounting system & internal control: The auditor should gain an understanding of the accounting system
and related internal controls. He should study and evaluate the operation of those internal controls upon which
he wishes to rely in determining the nature, timing and extent of other audit procedures.

9. Audit conclusions and reporting: The auditor should review and assess the conclusions drawn from the
audit evidence obtained and from his knowledge of business of the entity as the basis for the expression of his
opinion on the report.
Stages of An Audit
In carrying out an audit the following are the main stages. However, note that the steps followed will vary from
client to client and from auditor to auditor.
• Determining the scope of the audit work. For statutory audits the scope is clearly laid out in the provisions of
the Companies Act and is formally contained in the letter of engagement.
• Ascertain nature of the client’s business. The auditor seeks to obtain some background information of the
nature of the client’s business.
• Planning the audit; the auditor prepares a planning memorandum that shows the general strategy in to be
followed in conducting the audit.

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• Ascertaining and evaluating clients accounting systems and internal controls, use of flow charts and evaluating
using key questions.
• Carrying out tests of controls: This enables the auditor to determine the level of reliance to be placed on the
internal control system and therefore reduce the level of substantive testing.
• Planning the level of substantive testing and formulating the substantive tests to be carried out.
• Carrying out substantive testing on the selecting account balances.
• Carrying out the final analytical review and concluding whether the financial statements show a true and fair
view.
• Drafting the audit opinion and any other reports to be issued under the terms of engagement e.g. the
management letter

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