Chartered Accountants Audit Conference
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Evolution of the Fraud Standard from AUS 210 to ASA 240
Marj Wessels CA
Director Professional Standards
PKF
Content
Objectives
The Enron debacle
AICPA Response
AUASB Response
Conclusion
Objectives
> Provide background against which the current fraud standard has developed
> Examine the revised fraud standard issued shortly after the Enron bankruptcy filing
> Examine the fraud standard updated by the IAASB in conjunction with the risk standards, and adopted by the AUASB 15 December 2004
> Consider the mandatory requirements of the current legislated fraud standard
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The Enron Debacle
The US Sneezes the World catches Cold
Protection of Investors and the Public Pre - EnronUS GAAP – Generally Accepted
Accounting Principles
GAAS – Generally Accepted
Auditing Standards
SAS – Statements on
Auditing Standards & All Professional Ethics
Australia
• AASB
• AUS
• AGS and APS
The Accounting Theory
GAAP defined as:> a dynamic set of both broad and specific guidelines > that companies should follow > when measuring and reporting> Financial information
The Old Auditing Theory
During annual audits performed by external
independent auditors checks were performed to
make sure:> The entity following GAAP consistently> If not, entity to show rationale why not> Entity required to demonstrate treatment is ethical and
appropriate in their specific situation
The Old Auditing Theory Cont’d
This left the field open to interpretation
> AICPA added stipulation of consistent application over time.
> Aim of GAAP & AICPA rules to make > financial statements as accurate and reliable as possible
What Did Enron Do?
> Took existing rules and circumvented them> Balance sheet bolstered by inflated asset values> Dispersed liabilities to subsidiaries> Failed to consolidate these subsidiaries> Massive misstatement of financial statements> Designed so that certain individuals in the company could
make money from increased investments by shareholders
Enron’s GAAP Strategy
> Balance sheet with many intellectual assets> Patents and trademarks were good> Actual assets were bad & should be immaterial compared
to intangibles> Most of the debts and tangible assets on balance sheets
of partnerships run by key officers of the entity.
The Outcome of Enron’s Activities
When Enron declared bankruptcy on December 2001 it had
> $US 13.1 billion in debt on Enron’s books> $US 18.1 billion in debt on subsidiaries books> Estimated $US 20 billion more debt off balance sheet
(Zellner)
Perceived Failings of the Auditors AA
> Perception about their independence• Enron 2nd largest AA client• Consulting fees earned in 2000 more than half total
fees earned> Did not identify fraud where fraud existed> Internal memos evidenced unresolved conflict between
auditors and audit committee
Perceived Failings of the Auditors AA
> Internal AA emails expressing concern about Enron’s accounting practices
> Concerns overturned by the Lead Partner
> Suspicion/ evidence that the Audit Team wrote fraudulent memos stating that the Professional Standards Group approved of the accounting practices.
Perceived Failings of the Auditors AA
AA had 2 major recent audit failures before
Enron:> 1996 Waste Management
Income inflated by over $ 1billion between 1992 and 1996
> 1997 Sunbeam –
SEC determined – Sunbeam used Accounting tricks to
create false sales and profit.
AICPA ResponseSAS Standards
Effective Impact Example
SAS 96 January 2002 Dealt with record retention policies and requirement for auditor to document all significant decisions or judgements
Approval by auditor of client application of GAAP
SAS 98 Made many revisions and amendments to previous statements
Changes to GAAS Relationship between GAAS & Quality Control Standards
Audit risk and materiality concepts in audits
SAS 99 Outlines what fraud is and reaffirms necessity to gather all information
Revenue Recognition recognised as a fraud risk
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AUASB Response
Ongoing update and refinement of the existing Fraud Standard
Content
AUS 210 Issued January 2002
AUS 210 Issued June 2004
ASA 240 Legislated & effective 1 July 2006
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AUS 210- Issued January 2002
Auditor’s responsibility to consider Fraud and Error In an Audit of a
Financial Report
AUS 210 – Issued January 2002
> “Auditors responsibility to consider Fraud and Error In an Audit of a Financial Report”
> Effective 15 December 2002
> Compatible with ISA 250
> Replaced AUS 210 –”Irregularities, Including Fraud , Other Illegal Acts and Errors” – October 1995 revised February 1999
AUS 210 – Issued January 2002
> Focuses on auditor’s responsibilities with respect to fraud and error
> Explains the distinction between fraud and error> Primary responsibility for prevention and detection noted
to rest with both:• Those charged with governance and • Management
AUS 210 – Issued January 2002> AUS 218 “Consideration of Laws and Regulations in an
Audit of a Financial Report” issued to address Laws and Regulations separately
> AUS 210 ( 2002), focuses on Fraud and Error only• Expanded the basic principles and essential
procedures • Relating to risk of material misstatement
resulting from fraud and error• In an audit of a financial report
AUS 210 – Issued January 2002
Introduced requirement for:> Auditor Discussions with Audit Team at planning stage> More extensive enquiries of management with respect to
fraud & error> Fraud & error considerations to be linked to assessment
of inherent and control risk, and vice versa.> Design of audit procedures to specifically respond to and
address identified risk of fraud & to be documented> Consideration whether any misstatement identified
indicates fraud
AUS 210 – Issued January 2002
Management Representation Letters to include:
> Disclosure of all facts relating to fraud or possible fraud
> Managements belief that the uncorrected misstatements> aggregated by the auditor are immaterial to the financial
statements as a whole
AUS 210 – Issued January 2002
Communication by the auditor to the appropriate level
of management or Governance:> Specific matters in relation to fraud or error> Including material misstatements due to error> Timely communication required> Communication to those charged with governance of
uncorrected misstatements aggregated by the auditor and determined by management to be immaterial both:
• Individually and in • Aggregate
AUS 210 – Issued January 2002
> Emphasised the distinction between• Management Fraud• Employee fraud
> Expanded the discussion of fraudulent financial reporting> Clarified the discussion of the inherent limitations of an
audit to detect fraud
AUS 210 – Issued January 2002
> Emphasised the importance of professional scepticism
> Alert to evidence that brings into question reliability of management representations
> Risk of over generalising when drawing conclusions from audit observations
> Risk of using faulty assumptions in determining audit procedures and evaluating results
Distinction Between Fraud and Error
Misstatements in the financial report can
arise from fraud or error:> Fraud – underlying action intentional> Error – underlying action unintentional
Definition of Error Under AUS 210
> A mistake in gathering or processing data from which the financial report is prepared.
> An incorrect accounting estimate arising from oversight or misinterpretation of facts.
> A mistake in the application of accounting principles relating to measurement, recognition, classification, presentation or disclosure.
Fraud for Purposes of AUS 210
> Causes a material misstatement in the financial report
> Intentional Act by management, those charged with governance, employees, or third parties
> Involves the use of deception to obtain an unjust or illegal advantage.
Types of Fraud AUS 210
2 Types of fraud that are relevant to auditors:> Fraudulent financial reporting> Misappropriation of assets
Fraudulent Financial Reporting> Can be accomplished by: Manipulation, falsification
(including forgery), or alteration of accounting records or supporting documentation from which the financial report is prepared
> Misrepresentation, or intentional omission from the financial report of events, transactions and other significant information
> Intentional misapplication of accounting principle relating to amounts, classifications, manner of presentation, or disclosures
Management Override> Examples include:
• Concealing or not disclosing facts that may affect amounts in the financial report
• Engaging in complex transactions that are structured to misrepresent financial position or performance of the entity
• Altering records or terms related to significant and unusual transactions
Misappropriation of Assets> Involves theft of an entity’[s assets and is often
perpetrated by employees in relatively small and immaterial amounts and is usually accompanied by false or misleading documentation to cover up the fact that assets are missing or have been pledged. Examples:
• Embezzling receipts• Stealing physical assets• Causing an entity to pay for goods and services not
received• Using an entity’s assets for personal use
What Does Fraud Involve
> Incentive or pressure to commit the fraud
> Perceived opportunity to commit the fraud
> Rationalisation of the act
AUS 210- Issued June 2004
The Auditors Responsibility to Consider Fraud in an Audit of a
Financial Report
AUS 210 – Issued June 2004
> Effective 15 December 2004> Built on the new Risk Standards issued in 2003> Requires the auditor to:
• Be more proactive in considering the risk of fraud in an audit of a financial report
• Focus on areas where there is a risk of material misstatement due to fraud
• Pay attention to the risk of management fraud• Design and perform procedures to respond to identified risks
AUS 210 – Issued June 2004
> Requires the auditor to:
> Perform procedure to obtain information that is used to identify the risks of material misstatement
> Identify risks at assertion level and at financial report level> Evaluate controls related to material identified risk> Determine responses to identified risk of fraud> Establishes documentation requirements
AUS 210 – Issued June 2004
> Based on revised ISA 240 issued by the IAASB in early 2004.
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ASA 240 Issued April 2006
The Auditors Responsibility to
Consider Fraud in an Audit of a
Financial Report - Legislated
ASA 240 – Issued April 2006
> Effective as a legislated standard 1 July 2006
> Use of word ‘ shall’ instead of ‘should” in mandatory paragraphs
> Clarity on impact of guidance paragraphs
> Need to consider implications of Whistle blowing legislation
Mandatory ( Bold letter) Requirements of ASA 240> Consider the risks of material misstatement in the financial
report due to fraud
> Exercise professional scepticism
> Hold engagement team discussions on risk of fraud
> Communications on fraud to other team members not involved in the team discussion
> Make enquiries of management & others on existence of fraud and risk of fraud
Mandatory (Bold letter) Requirements of ASA 240> Enquiries of those charged with Governance on existence
& risk of fraud
> Consideration of fraud risk factors
> Performing analytical review
> Obtaining and understanding internal control
> Identifying significant risks of fraud at the assertion level and financial report level
> Treat Revenue recognition as a presumed significant risk of fraud.
Mandatory (Bold letter) Requirements of ASA 240In determine overall response to address the risks of
material misstatement due to fraud at the financial report level:
> Consider assignment and supervision of personnel> Consider accounting polices used > Incorporate an element of unpredictability
Mandatory (Bold letter) Requirements of ASA 240
To respond to management override of control:
> Test appropriateness of journal entries> Review accounting estimates for biases> Understand business rationale of significant or unusual
transactions
Mandatory (Bold letter) Requirements of ASA 240> Perform overall analytical review at or near the end of the
audit> Consider whether misstatements identified are indicative
of fraud> Requirement to consider implication for the audit where
fraud exists and financial report may as a result be materially misstated
Mandatory (Bold letter) Requirements of ASA 240Management representation letters obtained
by the auditor to include acknowledgement by
management > Responsibility for design an implementation of internal
control to prevent and detect fraud> Disclosure of results of its assessment of risk that
financial report may be misstated due to fraud> Disclosure of management, employee or other fraud
Mandatory (Bold letter) Requirements of ASA 240
Communication by the auditor of existence of identified fraud to those charged with Governance as soon as practical
Mandatory (Bold letter) Requirements of ASA 240> Considerations if auditor is unable to continue with the
engagement due to fraud
Mandatory (Bold letter) Requirements of ASA 240
Documentation
> Fraud discussions of audit Team> Identified fraud risks at the assertion level and the
financial report level> Overall responses to assessed risks of material
misstatement due to fraud at the financial report level> Linkage of those procedures with assertion level risk> Results of those the audit procedures
Mandatory (Bold letter) Requirements of ASA 240The auditor is required to document:
> Fraud communications to management, those charge with> governance, regulators and others
> If justified, effective rebuttal of the presumption that> revenue recognition is a significant risk of fraud
Summary Activities Under ASA 240
Planning Map Planning to Risk of material misstatement and plan audit response
Respond toManagementOverride
Completion * Reporting on fraud
Team Fraud Discussions
Risk of misstatement at the Financial ReportLevel
Risk of misstatement at the Assertion Level
Revenue Recognition
JE testing
Review Accounting Estimates for Bias
Understand business rationale
Management rep letters
Overall Analytical review
Report to management
Report to TCWG
Report to regulatory bodies
Discussions with management & TCWG
Preliminary Analytical review
Obtainunderstanding of the entity
Obtain understanding of internal control
Conclusion
> Discussion> Enquiry> Professional Scepticism> Understanding risk of fraud> Revenue Recognition mandatory significant risk of fraud> Auditor response> Consider Management Override> Documentation> Communication & Reporting