Question

Assume that you are auditing Paradox, Inc., a manufacturer of hand-held personal digital assistants (PDAs). The following is information that you have extracted from the audit working papers. • The market for PDAs is very competitive with several companies battling for market share, which in turn has put downward pressure on profit margins. • Rapid advances in technology have further reduced the product life cycle. In the race to remain competitive a number of companies, including Paradox, have significantly increased their research and development efforts. • Funding the increased R&D has been a growing concern for Paradox. The company currently is actively seeking capital. • Paradox is a public company listed on the NASDAQ exchange. Top management’s compensation is heavily tied to the company’s profitability. • The company does not have an internal audit function and the audit committee has not been very diligent in the past.

1. What are your responsibilities to make sure the financial statements are free from material misstatement?

2. How will SAS No. 99 affect the procedures you will perform for this audit?

3. SAS No. 99 requires you to conduct a discussion among engagement team personnel. Based on the background information provided, what “insights” would you share with the other audit team members? Describe your insights in terms of the three characteristics of fraud, incentive, and rationalization.

4. When performing field work, you find that in responding to an accounts receivable confirmation, a customer notes that the receivable relates to a purchase that was made under the company’s “new extended return policy” and the customer is still deciding whether to keep the items purchased. How does this new information affect your fraud risk assessments? How should you respond to this situation?

Answer 1

SA 240 – The Auditor’s Responsibility Relating to Fraud In An Audit Of Financial Statements

SA 240 deals with the auditor’s responsibilities towards frauds in the financial statement audits. It explains how the material misstatements in the financials due to fraud can be identified, assessed and appropriate procedures to detect can be implemented.

Auditor’s objectives with respect to the financial statements misstatements are as follows:

Auditor's Respons ibilities Respond appropriately to the identified or Identify and assess the risk of material Obtain adequate audit evidence for the risk misstatement due to identified suspected fraud fraud cleartax

Following are the Auditor’s responsibilities here:

1. Obtain reasonable assurance that the financial statements are free from material misstatements
2. Maintain professional skepticism throughout the audit
3. Should know that Risk of non-detection of management fraud is greater than of employee fraud
4. Must be aware Risk of non-detection of fraudulent material misstatement is higher than the misstatement due to error.

2. SAS NO 99

Describes fraud and its characteristics.Edit

SAS 99 defines fraud as an intentional act that results in a material misstatement in financial statements. There are two types of fraud considered: misstatements arising from fraudulent financial reporting (e.g. falsification of accounting records) and misstatements arising from misappropriation of assets (e.g. theft of assets or fraudulent expenditures). The standard describes the fraud triangle. Generally, the three 'fraud triangle' conditions are present when fraud occurs. First, there is an incentive or pressure that provides a reason to commit fraud. Second, there is an opportunity for fraud to be perpetrated (e.g. absence of controls, ineffective controls, or the ability of management to override controls.) Third, the individuals committing the fraud possess an attitude that enables them to rationalize the fraud.

Requires 'brainstorming' sessions to discuss how and where the entity's financial statements might be susceptible to material misstatement due to fraud.Edit

This requirement is a new concept in audit standards and it has two primary objectives. The first objective is so the engagement team will have an opportunity for the seasoned team members to share their experiences with the client and how a fraud might be perpetrated and concealed. The second objective is to set the proper "tone at the top" for conducting the engagement. The brainstorming session is to be conducted in a manner that models the proper degree of professional skepticism and sets the culture for the entire audit.

Requires the auditor to gather information necessary to identify risks of material misstatement due to fraud by the followingEdit

• Making inquiries of management and others within the entity
• Considering the results of analytical procedures performed in planning the audit.
• Considering fraud risk factors.
• Considering certain other information

SAS 99 requires auditors to ask management questions about their awareness and understanding of fraud. Auditors will then make a decision as to whether they need to 'educate' management about fraud and the types of controls that will deter and detect fraud. The standard also requires auditors to make inquiries of the audit committee, internal audit personnel and others within the entity.

Requires the auditor to use the information gathered to identify risks that may result in a material misstatement.Edit

This section provides guidance and support on how to identify and assess risks. It challenges auditors to change the way they think about assessing fraud risks. Auditors should identify risks and synthesize how those risks could lead to a material misstatement. This section specifically requires that improper revenue recognition and management override of controls be considered.

Requires the auditor to evaluate the entity's programs and controls that address the identified risks of material misstatement.Edit

SAS 99 provides specific examples of programs and controls for both large and small businesses. The auditor should consider which controls mitigate the identified fraud risks.

Requires the auditor to assess the risks of material misstatement due to fraud throughout the audit and to evaluate at the completion of the audit whether the accumulated results of auditing procedures and other observations affect the assessment.Edit

The standard provides examples of conditions that may be identified during the audit that might indicate fraud. One example is management denying the auditors access to key IT operations staff including security, operations, and systems development personnel. The auditors must determine whether the results of their tests affect their assessment.

Provides guidance regarding the auditor's communications about fraud to management, the audit committee, and others.Edit

The standard requires that any evidence that fraud may exist must be communicated to management and others. The level of severity is insignificant.

Describes documentation requirements.Edit

SAS 99 significantly extends the documentation requirements of the previous standard. Auditors must document: (1) how and when the brainstorming session occurred and who participated, (2) procedures performed to obtain information to identify and assess fraud risk, (3) specific risks of material misstatement due to fraud (must specifically include discussion of revenue recognition) and the auditor's response to those risks, (4) results of the procedures performed to address the risk of management override of controls, (5) conditions and analytical relationships that led to additional audit procedures or other responses, and (6) nature of communications about fraud made to management and others.

3.  

SAS no. 99 requires the audit team to discuss the potential for a material misstatement in the financial statements due to fraud before and during the information-gathering process. This required “brainstorming” is a new concept in auditing literature, and early in the adoption process firms will need to decide how best to implement this requirement in practice. Keep in mind that brainstorming is a required procedure and should be applied with the same degree of due care as any other audit procedure.

There are two primary objectives of the brainstorming session. The first is strategic in nature, so the engagement team will have a good understanding of information that seasoned team members have about their experiences with the client and how a fraud might be perpetrated and concealed.

The second objective of the session is to set the proper “tone at the top” for conducting the engagement. The requirement that brainstorming be conducted with an attitude that “includes a questioning mind” is an attempt to model the proper degree of professional skepticism and “set” the culture for the engagement. The belief is that such an audit engagement culture will infuse the entire engagement, making all audit procedures that much more effective. The mere fact the engagement team has a serious discussion about the entity’s susceptibility to fraud also serves to remind auditors that the possibility does exist in every engagement—in spite of any history or preconceived biases about management’s honesty and integrity. 4. In this case the customer must be provided with adequate information about the new requirements of the company in order to avoid fraud. If he is not aware of new return policy he made transactions in a manner which leafs to fraud. So in order to avoid this customers must be informed about all information regarding the purchases made by them.