FRAUD - AUDITING STUDY NOTES

Auditing – Study Notes Chapter 21 Fraud
CHAPTER TWENTY ONE
FRAUD
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1 By: Muhammad Asif, ACA

PART A – THEORY OF FRAUD
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Distinction between Error and Fraud:
Misstatements in the financial statements can arise from either fraud or error.
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.
Error: an unintentional misstatement in financial statements.
Fraudulent Financial Reporting:
Fraudulent financial reporting involves intentional misstatements including omissions of amounts
or disclosures in financial statements to deceive financial statement users.
Fraudulent financial reporting may be accomplished by the following:
 Manipulation, falsification (including forgery), or alteration of accounting records or
supporting documentation from which the financial statements are prepared.
 Misrepresentation in, or intentional omission from, the financial statements of events,
transactions or other significant information.
 Intentional misapplication of accounting principles relating to amounts, classification,
manner of presentation, or disclosure.
Misappropriation of Assets:
Misappropriation of assets involves the theft of an entity’s assets and is often perpetrated by
employees
Misappropriation of assets can be accomplished in a variety of ways including:
 Embezzling receipts (for example, misappropriating collections on accounts receivable or
diverting receipts in respect of written-off accounts to personal bank accounts).
Fraudulent financial reporting can be committed by management overriding
controls using such techniques as:
 Recording fictitious journal entries, particularly close to the end of an
accounting period, to manipulate operating results or achieve other
objectives.
 Inappropriately adjusting assumptions and changing judgments used to
estimate account balances.
 Omitting, advancing or delaying recognition in the financial statements of
events and transactions that have occurred during the reporting period.
 Concealing, or not disclosing, facts that could affect the amounts recorded in
the financial statements.
 Engaging in complex transactions that are structured to misrepresent the
financial position or financial performance of the entity.
 Altering records and terms related to significant and unusual transactions.

 Stealing physical assets or intellectual property (for example, stealing inventory for
personal use or for sale, stealing scrap for resale, colluding with a competitor by disclosing
technological data in return for payment).
 Causing an entity to pay for goods and services not received (for example, payments to
fictitious vendors, kickbacks paid by vendors to the entity’s purchasing agents in return for
inflating prices, payments to fictitious employees).
 Using an entity’s assets for personal use (for example, using the entity’s assets as collateral
for a personal loan or a loan to a related party).
CONCEPT REVIEW QUESTION
Because of its ability to exert influence, management is in a position to perpetrate fraud and prepare fraudulent financial
statements.
Identify six different ways in which fraud may be committed by management through overriding of controls. (06 marks)
(CA Inter – Spring 2016)
Recent worldwide events of fraud have raised several questions over the role of external auditors in relation to
identification of fraud.
Required:
Define the term .fraud. and describe any two major categories of fraud. (08 marks)
(ICMAP – February 2014)
Explain the term ‘fraudulent financial reporting’, illustrating your explanation with examples. (04 marks)
(ACCA P7 – June 2009)
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Responsibility of Management regarding Fraud:
The primary responsibility for the prevention and detection of fraud rests with both those charged
with governance of the entity and management. Management should create a culture of honesty
and ethical behaviour with oversight of TCWG to prevent fraud. Oversight by TCWG should also
include consideration for potential for management override of control.
Responsibility of Auditor regarding Fraud:
Overall responsibility for error and fraud:
An auditor conducting an audit in accordance with ISAs 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. Owing to the inherent limitations of an audit, there is an
unavoidable risk that some material misstatements of the financial statements may not be detected,
even though the audit is properly planned and performed in accordance with the ISAs.
Specific responsibility for fraud:
In relation to fraud, it is auditor’s responsibility to:
 Assess risk of material misstatement due to fraud.
 Perform substantive procedures to address risk of fraud.
 Maintain professional skepticism throughout the audit recognizing the possibility that a
material misstatement due to fraud may exist.
However, risk of not detecting a material misstatement resulting from fraud is higher than the risk
of not detecting one resulting from error. This is because:
 fraud may involve sophisticated and carefully organized schemes.
 there may be collusion.

 Management fraud is more difficult to detect than other frauds because of management
override of control
 The auditor’s ability to detect a fraud depends on factors such as the skillfulness of the
perpetrator, the frequency and extent of manipulation, the degree of collusion involved, the
relative size of individual amounts manipulated, and the seniority of those individuals
involved.
What are the responsibilities of an auditor and those charged with governance with respect to fraudulent financial
reporting? (06 marks)
(CA Final – Winter 2003)
State external auditor’s responsibilities in relation to the prevention and detection of fraud and error. (04 marks)
(ACCA F8 – June 2015)
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Misappropriation of Assets Fraudulent Financial Reporting
Incentives
/Pressures
1. Personal Financial Obligations.
2. Adverse Relationships between
entity and employee.
1. Intended sale of shares or business.
2. Management holds majority shareholding.
3. Bonuses based on financial performance.
4. Pressure on management to meet financial
targets e.g. debt-covenant or investor’s
expectations.
5. Personal guarantee of management for
repayments of loans.
6. Going Concern Issues e.g. increased
competition, product failures, operating losses
Opportunity
1. Excessive cash in hand.
2. Portable and precious inventory
or fixed assets.
3. Deficiencies in internal control
over assets e.g.
a. Inadequate segregation of
duties for assets (e.g. cash,
inventory).
b. Inadequate record keeping
and reconciliations for assets.
c. Inadequate physical
safeguards over tangible
assets.
1. Domination of management by a single
person or small group without audit
committee or internal audit function.
2. Ineffective oversight by audit committee or
internal
audit function (due to lack of
independence from management).
3. Significant transactions outside the normal
course of business with related parties.
4. Deficiencies in internal control over
financial
reporting.
5. High turnover of senior management.
6. Nature of entity’s operations e.g. operations
in diversified jurisdictions and use of
business intermediaries.
Attitudes/
Rationalizations
1.Disregard for monitoring of control.
2.Tolerance on petty theft.
3.Disregard for internal control
by overriding.
4.Dissatisfied or unhappy employees
5.Change in lifestyle.
1. Lack of integrity in management.
2. Ineffective communication of code of conduct.
3. Non-financial management’s excessive
participation in accounting policies and
estimates.
4. Management failing to correct material
weakness in internal controls.

(a) Identify the two categories in which fraud risk factors relating to misstatements resulting from misappropriation of
assets may be grouped. (02 marks)
(b) For each of the above two categories, identified in (a) above, list examples of fraud risk factors which relate to
misstatements that results from misappropriation of assets. (08 marks)
PART B – RISK ASSESSMENT AND RESPONSE TO FRAUD
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ISAs require the auditor to perform the following procedures to identify the risks of
material misstatement due to fraud:
1. Make enquiries of management in respect of:
a) their assessment of the risk of fraud
b) their process in place for identifying and responding to the risks of fraud
c) any specific risks of fraud identified or likely to exist
d) any communications within the entity in respect of fraud (e.g. code of conduct).
2. Make inquiries of management and others within the entity as to whether they
have any knowledge of any actual, suspected or alleged frauds.
3. Evaluate any unusual or unexpected relationships identified in performing
analytical procedures which may indicate a risk of material fraud.
4. Evaluate whether any fraud risk factors are present.
Briefly state the audit procedures which may be performed to identify the risks of material misstatement due to fraud.
(05 marks)
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Auditor shall perform following audit procedures to respond to the risk of management
override of controls:
1. Test the appropriateness of journal entries (for fake entries)
2. Review accounting estimates (for biases)
3. Obtain an understanding of the business rationale for significant transactions outside the
normal course of business
Test the appropriateness of journal entries:
In designing and performing audit procedures for such tests, auditor shall:
i. Inquire of individuals involved in the financial reporting process about inappropriate or
unusual activity relating to the processing of journal entries and other adjustments;
ii. Select (judgementally) and Test the journal entries and other adjustments made at the
end of a reporting period; and
iii. Select (judgementally) and Test the journal entries and other adjustments
throughout the reporting period. (if considered necessary)

Review accounting estimates:
In performing this review, auditor shall:
i. Perform comparative review with other estimates for indication of possible biases.
ii. Perform a retrospective review of significant accounting estimates reflected in the
financial statements of the prior periods.
iii. Use an expert to develop an independent estimate for comparison to management’s
estimate.
iv. Extend inquiries to individuals outside of management and the accounting
department to corroborate management’s ability and intent to carry out plans that
are relevant to developing the estimate.
Understand business rationale of significant transactions outside the normal course of
business:
Following characteristics of significant transactions outside the normal course of business
suggests/indicates fraud:
 Transaction:
 Lacks an apparent logical business reason for its occurrence.
 Has unusual terms of trade.
 Is processed in an unusual manner.
 Is overly complex (for example, it may involve multiple related parties within a
consolidated group).
 Management has not discussed such transaction with TCWG.
 Management is placing more emphasis on a particular accounting treatment instead
of underlying substance of the transaction.
 Transaction involves parties which do not have financial strength to support the
transaction.
Management is in a unique position to perpetrate fraud because of its ability to manipulate accounting records and
prepare fraudulent financial statements by overriding controls that otherwise appears to be operating effectively.
Required:
Determine the audit procedures that may be performed by the auditor to address the risks related to override of controls.
(08 marks)
(CA Inter - Spring 2014)
During the course of audit an auditor is expected to be vigilant enough to develop understanding about the propriety of
important transactions and to determine whether or not such transactions have appropriate business rationale.
Required:
Briefly describe the situations in which a transaction is indicative of fraud or an attempt to conceal fraud or fraudulent
reporting. (07 marks)
(CA Inter -Autumn 2009)
Characteristics of Journal entries that auditor should select to test for fraud:
(a) made to unrelated, unusual, or seldom-used accounts,
(b) made by individuals who typically do not make journal entries,
(c) recorded at the end of the period or as post-closing entries that have little or no
explanation or description,
(d) made either before or during the preparation of the financial statements that do
not have account numbers, or
(e) containing round numbers or consistent ending numbers.

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Overall response to risk at financial statement level has been covered in chapter 10.
Describe what actions are to be taken by an auditor on identifying a fraud risk factor. (04 marks)
(CA Inter - Spring 2015)
PART C – ADDITIONAL MATTERS
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Written Representation:
(already covered in chapter of written representation).
Communication to TCWG:
1. If the auditor has identified or suspects fraud, the auditor shall communicate these matters
on a timely basis to the appropriate level of management (regardless of size of fraud).
2. Auditor shall also communicate identified/suspected fraud to TCWG if fraud involves
management or is significant.
3. If management is involved in a fraud, integrity of management becomes doubtful and auditor
may consider appropriate action (e.g. withdrawal) based on advice of his legal advisor.
Is an auditor responsible for detection of frauds in the financial statements? What an auditor should do when he becomes
aware about existence of fraud in the financial statements? (06 marks)
(CA Final - Winter 2001)
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Circumstances indicating Misstatement in Financial Statements due to Fraud:
Following are examples of circumstances which indicate possibility of fraud in financial statements.
Discrepancies in
accounting records
− Transactions not recorded/completed in timely manner or improperly
recorded as to amount, period, or classification.
− Supporting documents are not available for transactions/balances.
− Last minute adjustments that significantly affect financial statements
− Tips or complaints to the auditor about the alleged fraud.
Conflicting or
missing evidence
− Missing accounting records
− Altered accounting records
− Unavailability of original documents when they are expected to exist
− Significant unexplained items on reconciliations
− Unusual discrepancies between the entity’s record and confirmation replies
− Large amount of credit entries and other adjustments at year end.
Problematic or
unusual
relationships
between the auditor
and management
− Denial of access to records, employees or other evidence
− Undue time pressure by management to resolve complex or contentious
issues
− Management intimidation
− Unusual delays by entity in providing requested information
Others − Accounting policies at variance with industry norms
− Frequent changes in accounting estimates

Auditing – Case Studies Chapter 21 Fraud
CHAPTER TWENTY ONE (CASE STUDIES)
FRAUD
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Model Case Study From Examination Questions:
Case Study 1:
During the planning of an audit, auditor has come to know about following situations. Indicate whether each of the
situations given below indicates risk of fraud. If so, also identify type of fraud risk factor involved.
1. Management wants to minimize profit to save tax.
2. Company' board of directors include non-executive, independent directors.
3. Significant judgments, estimates are uncertainties are involved in financial statements.
4. Manager accounts has applied for a loan. Application was rejected by CFO.
5. The company has to meet stock exchange listing requirements and debt-covenant requirements.
6. The company has experienced low turnover in management and its internal audit function.
7. Purchase Manager was found involved in a petty theft. Although amount involved was immaterial, he was issued a
warning.
8. Significant operations of business in different jurisdictions with different environments.
9. Company deals in imported watches, which have high demand in market.
10. There is high competition and market saturation.
Solution:
1. Risk of fraud is increased. Type of fraud is fraudulent financial reporting.
2. There is no risk involved in this situation.
3. There is risk of material misstatement, but no risk of fraud.
4. Risk of fraud is increased. Type of fraud is misappropriation of asset.
6. There is no risk involved in this situation.
Case Study 2:
Standard Commercial Bank (SCB) is an audit client of your firm. Given below are some factors which you came to know
during risk assessment procedures. For each of the factor mentioned below Indicate whether it increases, decreases or
has no effect on audit risk, and whether it affects risk of fraud.
1. SCB is a continuing audit client.
2. SCB has remained profitable over the years.
3. SCB's board of directors is controlled by Saqib, the majority stockholder, who also acts as the chief executive officer.
4. Management at the bank's branch offices has authority for directing and controlling SCB's operations and is
compensated based on branch profitability.
5. The internal auditor reports directly to Haris, a minority shareholder, who also acts as chairman of the board's audit
committee.
6. During 20X1, SCB increased the efficiency of its accounting operations by installing a new, sophisticated computer
system.
7. SCB’s formula has consistently underestimated the allowance for loan losses in current years.
8. Management has been receptive to auditor’s suggestions relating to accounting adjustments.
Solution:
1. It decreases audit risk. No effect on risk of fraud.
1 By Muhammad Asif, ACA

3. It increases audit risk. It also increases fraud risk factor relating to fraudulent financial reporting.
6. It increasers audit risk. No effect on risk of fraud.
Case Study 3:
Greater Engineering Designs (GED) is a private eight-partner firm that provides engineering services to the commercial
building industry. You are planning the audit for GED for the year ended 30 June 2015 and are assessing the risk of fraud
occurring. You note the following characteristics of the business:
 GED was established over 40 years ago and has maintained a good reputation in the marketplace.
 As well as its partners, all of GED’s senior engineers also have shares in the business. They are paid a lower-
than-market salary, but in return receive a profit share via dividends.
 Many of GED’s projects are complex and long term (for example, infrastructure development).
 The company is in a sound financial position and has solid cash reserves.
 Management is reasonably vigilant in overseeing the accounting staff, although it is having trouble
understanding the reports produced by the new accounting system.
 The credit controller, about whom there have been many complaints in relation to poor job performance, is the
brother-in-law of one of the directors.
 The chair of the board and the finance director have worked together for around 15 years and both have
domineering personalities.
 In the past, management has refused to sign a management representation letter on the grounds that you would
not need one if the auditor was doing their job properly.
Required
Referring to the information above, explain whether there is a significant risk of fraud at GED.
Source: This question was adapted from the Chartered Accountants Program of The Institute of Chartered Accountants in
Australia—2008 (1) Audit & Assurance Module.
Solution:
Fraud Risk factors include following:
1. Management is having trouble in understanding reports produced by new accounting system. This will cause
ineffective controls over the system.
2. Complains about credit controllers are also a fraud risk factor, which is further increased by the fact that this
managerial role has close association with those charged with governance.
3. There is domination of management by finance director which creates risk of fraud. Further, close association
between finance director and chairman of board of director also increases risk of fraud as audit committee lacks
independence and may not oversee management effectively.
4. Management’s refusal to sign written representation letter also raises concerns about integrity of management
and increases risk of fraud.
Additional Concepts:
Factors which reduces risk of fraud are:
 The company is in a sound financial position and has solid cash reserves.
 Management is reasonably vigilant in overseeing the accounting staff.
“Many of GED’s projects are complex” increases risk of material misstatement, but not necessarily risk of fraud.
Engineers having shares does not increases risk because engineers have no influence over financial statements.
Case Study 4:
While reviewing the audit files of four different clients you confronted the following situations:
(i) Due to tough competition in the market, the company has been unable to increase the prices of its products since last 5
years.
(ii) Addition to intangible assets, amounting to Rs. 500 million include research cost of Rs. 10 million which is duly
supported by invoices from suppliers.
(iii) During the last three years, the Chief Executive and higher management has been earning handsome bonuses, based
on the profitability of the company.
(iv) Physical stock take on 31 December 2014 included goods sold but not despatched amounting to Rs. 52 million. The
delivering of goods was stopped on the request of a distributor. Upto 20 January 2015, the distributor has taken delivery
of goods amounting to Rs. 2 million.

Required:
In each of the above situations, identify with justification whether it represents a risk of fraud. (06 marks)
Solution:
(i) This situation represents risk of fraud relating to fraudulent financial reporting, because company there is increased
competition in the market and company is unable to increases its price of product since last 5 years. Due to decreasing
profitability, company may face going concerns problems and may attempt to hide it in financial statements.
(ii) This appears to be an error as there is inherent risk in research and development costs for misclassification. Further,
supporting evidence is also available.
(iii) This represents risk of fraud relating to fraudulent financial reporting, because chief executive and higher
management may attempt to overstate profits to earn high bonuses.
(iv) This appears to be a risk of fraud relating to fraudulent financial reporting, because significant sales has been made
on the last day of the accounting year which have not been dispatched within reasonable time. However, there should be
further investigations to confirm whether a related party is involved and whether terms of the transactions are normal.
Case Study 5:
You are the Audit Manager on the audit of Al-Salam Pakistan Limited (ASPL) for the year ended June 30, 2010. ASPL is
engaged in the manufacture of a wide range of plastic products. While reviewing the initial work performed by the audit
team, the following matters have come to your notice:
(i) The quantity of material scrapped during the year is materially different from the quantity of scrap sold. The
company’s records show nil balance both at the beginning and at the close of the year. No reconciliation for the difference
has been provided by the company.
(ii) Sales for the year have increased by 7% over the previous year. However, it has been noted that sales in the last two
weeks of June 2010 have been exceptionally high and represent 15% of the annual sales.
The audit working papers carry the following observations in respect of the above:
 70% of the sales in the last two weeks of June were made to two new customers whose credit assessment has
not been formally documented;
 a significant portion of the goods sold to the above referred customers were returned in the first week of July
2010; and
 management bonuses are linked to the operating performance of the company.
(iii) During the year, ASPL purchased a machine for Rs. 25 million. The payment voucher is duly supported by the invoice
from the supplier. However, the fixed assets schedule provided by the client shows the amount capitalized as Rs. 2.5
million. Depreciation has been charged on this amount. The difference of Rs. 22.5 million is appearing in the Bank
Reconciliation Statement.
Required:
Analyze each of the above situations and assess whether it represents a fraud or an error. (06 marks)
(CA Inter – Autumn 2010)
Solution:
(i) This situation represents risk of fraud relating to misappropriation of assets as scrap inventory of company is missing,
and no reconciliation has been performed which shows deficiencies in internal control over assets.
(ii) This situation represents risk of fraud relating to fraudulent financial reporting on following grounds:
 there have been unusually high sales in the last two weeks of the year.
 there have been week internal controls over financial reporting i.e. credit assessment is not made for new
customers.
 Significant portion of sales has been returned soon after the year.
 Management may intentionally overstate profits to get its bonuses based on profits of the company.
(iii) This appears to be an error of transposition as supporting documents are available (neither missing or altered).
Although there is a difference in bank reconciliation but it has been duly explained by management.

Case Study 6:
You are the audit senior at Clifton & Associates and are in the process of planning the 30 June 2015 audit of Sweet Pty Ltd
(Sweet), a large confectionery manufacturer. You have the following information about Sweet’s acquisition of 100 per
cent of White Magic Pty Ltd on 3 April 2015:
 White Magic operates a small liquorice operation based in Queensland. White Magic was owned by Sam Quick
(CEO) and Joelene Walters (CFO). Sam and Joelene were motivated to sell the business because of restricted cash
flows that prevented them from investing in new technology to improve production efficiency.
 Sam and Joelene started White Magic immediately on finishing university and this has been their only
employment. They have similar philosophies and together they have kept close control of the operations of
White Magic, being involved in all day-to-day aspects of the entity’s operations. Given the size of White Magic,
there is no separate audit committee or internal audit function.
 The accounting function of White Magic consisted of Joelene and one part-time and two full-time employees.
White Magic’s sales staff have been with the business since its incorporation. They are paid a relatively low
retainer, with generous bonuses if sales targets are met.
 White Magic’s external borrowings at the time of acquisition were related to the construction of a new liquorice-
packaging plant. These borrowings contained net asset and interest coverage loan covenants. In order to obtain
the funding, the lender required that Sam provide a personal guarantee that the loan would be repaid.
 The quarterly management accounts for White Magic contained an actual versus budget comparison of revenues
and expenses. For the four quarters prior to acquisition, actual revenue was consistently in excess of budget by 5
to 10 per cent. This is a very good result given current tough conditions in the confectionary industry.
 White Magic’s sales and receipts systems are well controlled. The terms of sale are well defined, with
approximately 75 per cent on 30-day account and the remainder on a cash on delivery basis.
Required
Based on the information provided above, identify five fraud risk factors in relation to Sweet’s acquisition of White Magic.
Solution:
Following factors represent risk of fraud:
1. Management is the majority shareholders. They may ‘window-dress’ financial statements to increase personal
wealth.
2. Business is facing liquidity problems and shareholders are intending to sale the business.
3. There is domination of management by just 2 persons without audit committee or internal audit function.
4. Bonuses of sales staff are based on sales target of the company. This gives them incentive to inflate or falsify
sales.
5. There is pressure on management to meet debt-covenant requirements relating to net assets and interest
coverage.
6. Management has given personal guarantee of loans.
7. Financial results of the company are significantly different from industry.
8. There is excessive dealing in cash, which may be misappropriated by dishonest employees.
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Case Study 1:
You are part of the Houston & Associates (Houston) audit team working on the audit for Shiny Shoes Ltd (Shiny Shoes) for
the year ending 30 June 2015. Shiny Shoes is a national fashion footwear retail chain with stores located throughout
Australia. Shiny Shoes specialises in women’s designer footwear. Shiny Shoes designs its footwear in Australia and
manufactures them in China from Italian-sourced materials. The only exception is the leather for Shiny Shoes’ designer
boots, which is purchased from an Australian company, Luxury Leather Pty Ltd (Luxury).
On 1 August 2011, Shiny Shoes obtained additional financing from Big Bank (BB). This financing was subject to strict loan
covenants. During the 2015 audit, Shiny Shoes’ chief financial officer (CFO) confided that he suspected Shiny Shoes was in

breach of its loan covenants during the course of the 2015 financial year. This would put his bonus in jeopardy, as
maintaining loan covenants is one of his KPIs. A refinancing with BB was due to occur on 31 July 2015. No refinancing
documents had been provided by BB as at 30 June 2015 and Shiny Shoes had not attempted to secure financing from
other financial institutions.
Since Houston started auditing Shiny Shoes five years ago, Shiny Shoes has been plagued by poor internal controls over
accounts payable operations. In past audits, Houston has brought the poor internal controls to management’s attention.
One example of Shiny Shoes’ poor internal control is that Bruce Franklin, one of the accounts payable clerks, is able to
approve and pay transactions of up to $3000 per transaction. You have learned that Bruce is currently having trouble
paying his mortgage. Despite Houston bringing these weaknesses to management’s attention, processes at Shiny Shoes
remained unchanged.
Kylie Fine was in charge of purchases during 2015 and renegotiated Shiny Shoes’ contract with Luxury so that Shiny
Shoes pays cash on delivery for all Luxury materials, instead of the industry standard 30 days. No one outside of the
purchasing department is aware of the renegotiation.
Required
State three potential fraud risk factors that indicate fraud could be an issue at Shiny Shoes and provide explanations for
your answer.
Solution:
Fraud Risk Factor: CFO bonus linked to the achievement of KPIs, including the maintenance of loan covenants:
Incentive to manipulate the accounts to ensure this occurs
Fraud Risk Factor: Bruce Franklin can approve and pay invoices of up to $3000, and is under personal financial
obligation:
Bruce could misappropriate company funds by, for example, paying dummy invoices.
Fraud Risk Factor: Shiny Shoes pays Luxury cash on delivery, contrary to normal terms.
There is a risk that the cash is misappropriated
Case Study 2:
You are the audit senior at Quality Chartered Accountants working on the financial audit for Cruise Ship Maintenance Ltd
(CSML) for the year ended 30 June 2015. CSML is a large commercial cruise ship maintenance business that supports
various shipping routes in and around Australian and New Zealand ports. CSML has 10 maintenance workshops
throughout the region, with its head office based in Brisbane. Parts for cruise ships are often expensive, as they are
precision-engineered from high-grade materials in order to withstand the harsh conditions in which the vessels operate.
CSML holds a stock of standard parts that are most frequently required for repairs. Specialist parts are ordered from
overseas as and when required. No formal inventory record of parts is maintained at the CSML workshops. When parts
arrive, they are simply stored in the workshop without any reconciliation back to the packing slip or the invoice. The
parts are charged to clients as disbursements when invoicing for the finished job.
The spare parts and consumables line in the statement of financial position is not updated year to year. Instead, the
balance carries forward from one year to the next. Management at head office is not concerned, and advise that as the
balance won’t have changed much, it is not worth the effort to conduct a stocktake.
CSML’s accounts receivable function is managed by an employee who prepares invoices and credit notes, and receipts and
bank payments. They also have signing authority on the bank account and perform bank reconciliations.
CSML’s division managers receive a bonus of 15 per cent of their base remuneration if profit targets are reached. These
profit targets are set by head office without input from the managers and are based on aggressive growth assumptions.
Required
List three fraud risk factors indicated by the information above and explain why they are a fraud risk.

Solution:
Fraud Risk Factor: Inadequate record keeping over the spare parts and consumables asset.
Risk of misappropriation of the spare parts and consumables asset due to a lack of supervision over assets at CSML’s
many different locations.
Fraud Risk Factor: Inadequate segregation of duties between management of accounts receivable and cash at
bank.
The accounts receivable staff member has the opportunity to misappropriate assets, by, for example, crediting invoices
and diverting cash to their own account.
Fraud Risk Factor: Management remuneration is contingent upon achieving aggressive forecasts.
Management may attempt to overstate profit by recording fictitious revenue or incorrectly recording revenue in the
current period. Similarly, expenses may be incorrectly recorded in a subsequent period or expenditure may be incorrectly
capitalised.
Case Study 3:
Your firm is the auditor of Cell Phones (Private) Limited (CPPL), which operates a chain of mobile phone retail outlets.
About 25% of shareholding in CPPL is owned by Anwar and his wife. Anwar is the Chief Executive of CPPL and also looks
after the finance and operations of the company. There are five other directors and each of them holds 15% shares in
CPPL.
The Internal Audit Function comprises of three senior officers who are graduates. Their duties include checking of
accounting records, physical stock taking, preparation of bank reconciliations, reviewing payments and verification of
fixed and current assets.
During the planning phase, Anwar stressed the need for early completion of audit, in order to be able to submit the
audited financial statements for seeking a long term finance. He was of the view that internal audit working papers would
be of enormous help in performing and early completion of the audit.
Required:
Identify and briefly describe the fraud risk factors in the above scenario. (06 marks)
Solution:
Fraud Risk Factor: Portable and precious inventory:
Mobiles can be easily misappropriated by dishonest employees or customers.
Fraud Risk Factor: Management is the majority shareholder:
They may ‘window-dress’ financial statements to increase personal wealth.
Fraud Risk Factor: Internal audit function is given conflicting responsibilities:
There is ineffective oversight by internal audit function as they are given managerial responsibilities like stocktaking and
preparation of bank reconciliations.
Fraud Risk Factor: Undue time pressure from management:
This makes auditors suspicious because, because not given appropriate time to auditor may be an attempt to hide some
misstatements.
Fraud Risk Factor: Seeking long term finance on the basis of financial statements:
Management may manipulate the figures to show better financial performance and position to the bank.
Case Study 4:
At the planning phase of the audit of Prudent Limited, a listed company, senior auditor of your team submitted the
following information;
− The Board of Directors of the company has recently appointed Mr. Smart as new chief executive whose
remuneration is mostly based on efficiency bonus and stock options.
− Mr. Smart is reputed as a seasoned business executive and has been a very good friend of the Chairman of the
audit committee.
− Since his joining he has proved to be the main decision maker and the Board appears to be relying considerably
on Mr. Smart and less interested in day to day operations of the company.
− Board’s main concern is now the growth in net earnings estimated for the next year, which Mr. Smart strongly

believes, will be 30% at the minimum.
− There are a number of instances of lack of segregation of duties and Mr. Smart being cost conscious, has allowed
the situation to continue.
− There is a big lay off plan in place and employees are expecting such plan although it has been kept as top secret.
This lay off will help the company to achieve higher growth in earnings.
− Mr. Smart has introduced an employees’ skill development scheme only for top management personnels.
Describe the fraud risk factors, if any, that are indicated in the above information. (07 marks)
Solution:
Fraud Risk Factors: Chief Executive’s remuneration linked with operating results
This may create Incentive for fraudulent financial reporting.
Fraud Risk Factors: Close relation of higher management with audit committee
Such a close relation impairs independence of audit committee and renders control environment as weak. This provides
opportunity of fraud.
Fraud Risk Factors: Undue reliance of board on management
Ineffective oversight of board on activities of management provides opportunity of fraud.
Fraud Risk Factors: Focus of board on growth
Excessive pressure on management to meet the requirements or expectations of board creates pressure to commit fraud.
Fraud Risk Factors: Lack of segregation of duties
Ineffective monitoring of management over financial reporting process and internal control creates opportunities for
lower management to commit fraud.
Fraud Risk Factors: Layoff of employees
Adverse Relationships between entity and employee having access over assets provides employees Incentive for fraud.
Fraud Risk Factors: Skills development schemes only for top management
Dissatisfaction among employees provides them rationalization for fraud.
Case Study 5:
During the external audit of Tuna Ltd for the year ended 31 March 2010, the following matters were discovered:
(i) cheques received from customers, listed as outstanding lodgements in the bank reconciliation at the year end, were
cleared through the bank on 21 April 2010; and
(ii) a sales credit note, relating to a pre-year-end delivery of inventory, was issued to a major customer on 20 April 2010.
Explain why these matters should be investigated further. (04 marks)
(ICAEW – June 2010)
Solution:
(i) There is an undue delay in cash clearing. This may be because of poor controls over cash. This is also an indication of
fraud of teeming and lading.
(ii) A return of goods after the year end indicates that goods may be faulty, which require provision for closing stock. It
also indicates fraudulent transaction to window-dress financial statements by inflating sales.

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Case Study 1:
The following issues were highlighted in a meeting of the audit committee of XYZ Limited with regard to financial
statements of one of its subsidiaries on which auditors had issued an unmodified audit report:
(i) The audit procedures were unable to detect a material error in inventory valuation, because it occurred under
exceptional circumstances and the internal controls established by the management could not prevent and detect the
same.
(ii) The provision for bad debt was insufficient and the impact was material. It was also evident from the subsequent
events, which came into the knowledge of the auditors before they issued their report.
You are one of the independent members of the audit committee and are considered an expert on financial reporting
issues. The chairman of the audit committee has asked your comments with regard to the responsibilities of management
and auditors of the above mentioned subsidiary. Give your comments on each of the above matters. (06 marks)
Solution:
(i)
In this case, although financial statements contained a material misstatement but auditor was justified in issuing
unmodified audit report because error occurred in exceptional circumstances.
However as the matter has come to attention now, auditor should take necessary steps to ensure that financial statements
are revised and should issue new audit report on them because subsequent discovery of errors or frauds is an adjusting
event.
(ii)
In this case, auditor can be held responsible for this because matter had come into his knowledge before issuance of
auditor’s report. He should have proposed adjustment for the misstatement and if uncorrected, he should have issued
Qualified Opinion or Adverse Opinion.
Case Study 2:
You have received a letter from the managing director of one of your audit clients, informing you that he has recently
dismissed his payables ledger clerk. It was discovered that the clerk had set up a number of fictitious supplier accounts as
a means of paying company funds into his own bank account. The total amounts defrauded have been estimated at
£50,000 over the last two years. The managing director is unhappy that the fraud was not detected earlier by your firm,
and has requested an immediate explanation. The company’s revenue last year was £5,000,000 and its profit was
£750,000.
Briefly set out the points to include in your response to the managing director. (02 marks)
(ICAEW – March 2007)
Solution:
Primary responsibility to prevent and detect fraud rests with management and those charged with governance. Auditor is
required to obtain reasonable assurance. In this case auditor has not detected this fraud because it may have involve
sophisticated techniques. Further, amounts involved are immaterial (if divided in two years) for which auditor does not
provide reasonable assurance.

FRAUD - AUDITING STUDY NOTES

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FRAUD - AUDITING STUDY NOTES