The responsibility rests with management. This is implemented through the implementation and continuous operation of an adequate system of internal control. Such a system reduces but does not eliminate the possibility of fraud and error. The auditor seeks reasonable assurance that fraud or error, which may be material to the financial statements, has not occurred or if it has occurred, the effect is properly reflected in the financial statements. The auditor should plan his work so that he has reasonable expectation of detecting material misstatements in the financial information resulting from fraud and error.
The auditor is and cannot be held responsible for the prevention of fraud and error.
Risk of fraud and error
In addition to weaknesses in the accounting and internal control system events which the risk of fraud and error include:
- Questions in respect to the integrity or competence of management. Where management is not honest and could misappropriate the company’s assets;
- Unusual pressures within an entity e.g. pressure on management to report a certain level of profits;
- Unusual transactions;
- Difficulties in obtaining sufficient appropriate audit evidence.
If circumstances indicate the possible existence of fraud or error, the auditor should consider the potential effect on the financial statements. If the effect is material the auditor should perform additional procedures to dispel the suspicion. Where confirmed the auditor should satisfy himself that the effect of the fraud is properly reflected in the financial statements or errors are corrected. The auditor should communicate his findings to management on a timely basis if:
- He believes fraud may exist, even if the potential effect on the financial statements would be immaterial or
- Fraud or error is actually found to exist.
Auditor’s general responsibility with regard to prevention of fraud
The primary responsibility for the prevention and detection of fraud rests with management. Management meets this responsibility by putting in place an internal control system that is aimed at preventing and detecting such fraud or error. E.g. segregation of duties is aimed at reducing changes of employees defrauding the company.
For the auditor prevention and detection of errors and fraud is only a secondary objective. The auditor seeks reasonable assurance that fraud or error, which may be material to the financial statements, has not occurred or if it has occurred that the effect is properly reflected in the financial statements.
Inherent limitations of an audit.
An audit is subject to the unavoidable risk that some material misstatement of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with the ISA. The risk of not detecting misstatements resulting from fraud is higher than the risk of not detecting a material misstatement resulting from errors. This is because fraud involves acts designed to conceal it such as forgery and deliberate failure to record transactions. Unless the audit reveals evidence to the contrary, the auditor is entitled to accept representations from management as truthful and the documents as genuine.
However, the auditor should plan and perform his work with professional scepticism, recognising that conditions or events may be found that indicate that fraud or error may exist. Existence of an internal control system reduces the probability of misstatements in the financial reporting occurring due to frauds and errors but there is always a risk that the system may fail to operate as designed.
The following procedures could be applied as general leads to where frauds or errors have taken place:
- Compare the company’s balance sheet with those of previous two years.
- Calculate ratios from the two balance sheets. The ratios to be calculated can be leverage ratio, activity ratios, performance ratio and profitability ratios.
- Use searching inquiry to poise questions to management and the accounting staff.
- Audit in depth such that the audit trail is established. Audit trail facilitates the checking a transaction recording process from the initial stage to the final stage of a transaction. For example an item like debtors one checks the date the sale took place, the invoice issued, the cash received at the date ofsale, any other cash receipts after the date of sale and the balance. The balance the auditor gets should correspond with the one in the accounts.
- Consult third parties in and out of the firm for example by use of debtors circularisation or lawyers letters.
- Use surprise checks and visits.
- Compare budgeted and actual results. Investigate in-depth the cause of any variances.
Detection of errors.
- Compare previous year’s figures with the current figure and ascertain that all changes are in order and authentic.
- Cast the trial balance figures and ensure they balance.
- Check the names of the accounts in ledgers and those recorded in the trial balance to ensure that there are no omissions.
- Compare debtors and creditors from ledgers and those in trial balances. Debtors and creditors accounts are easily a source of confusion for incompetent staff especially when they involve many transactions.
- Ensure that the totals of self-balancing accounts agree.
- Count items in trial balance in the current account and compare those in the previous account. Investigate any differences.
- Check totals of subsidiary books.